Risk.
In financial settings, it’s invoked both in a general sense and as a statistical concept. Though the word “risk” connotes loss, downside scenarios, and the possibility of losing money, it’s actually more closely related to the idea of “volatility.”
In simplest terms, the “risk” of an investment captures the likelihood that its actual performance will deviate from its expected performance. This is an inherently uncertain calculation, and it’s usually based on the differences between the past expectations and real performance of similar securities. However, it’s important to note that “risk” captures the possibility of unexpectedly good performance alongside that of bad performance.
In many cases, though, risk is expressed in qualitative, relative terms (e.g. one security is riskier than another). Here, we explore the risk potential inherent to investing in interval funds through several different lenses, both in the context of general risks associated with the interval fund structure and the more quantifiable risks associated with the funds’ investment strategies.
Image by Andre Taissin
TIME HORIZON RISK
For interval fund investors, this is the big one. In short: interval fund shareholders can’t exchange their shares for cash except for during predetermined redemption periods – which occur no more than four times per year. This sales configuration insulates the fund from panic selling and allows advisors to invest in alternative assets with more complicated liquidity structures, but it imposes real restrictions on those who choose to buy into the fund.
In this case, the term “risk” is used in a more colloquial sense. Investors who can’t quickly pull their money from an interval fund are exposed to the possibility that the value of their investment will fall dramatically, and that there will be nothing they can do to but watch it happen. Market downturns are often accompanied by selloffs in funds like ETFs and mutual funds that offer day-by-day redemptions, as investors seek safety in the relative stability of cash. Interval fund shareholders must ride out the business cycle until the next redemption period, creating the possibility of serious loss of wealth.
LIQUIDITY RISK
Like time horizon risk, liquidity risk arises from an interval fund’s particular relationship with liquidity. At each buyback period, interval funds are only required to redeem 5-25% of outstanding shares, which may fall well below shareholders’ demand for redemption. Interval funds tend to be heavily invested in illiquid assets that can’t be quickly sold at fair market price, so although they’re required to have the cash on hand to meet their 5-25% redemption threshold, they’re neither required nor likely able to provide any liquidity beyond that.
Therefore, potential shareholders should be aware that interval funds aren’t the place to sequester money that might be needed on a moment’s notice. If too much of a portfolio is locked away in an interval fund, an investor might not be able to produce the cash to meet financial obligations or take advantage of emerging opportunities.