Interval Funds vs. ETFs

In recent years, ETFs have become wildly popular. But their structural shortcomings have led a growing number of investors to explore interval funds. Here’s how they stack up, and where interval funds have an edge.

THE BASICS

In 1993, the financial sector saw the emergence of two new, very different investment management funds: interval funds and exchange-traded funds (ETFs). It’s no secret that ETFs, with their low fees and tech-native structure, have ballooned in popularity since then. But the interval fund, the ETF’s specialized and poorly understood counterpart, has been steadily gaining steam as well. In an age of rock-bottom interest rates and uncertain stock values, the interval fund’s ability to provide stable exposure to low-correlation alternative assets has shown new appeal.

What gives interval funds their niche, and how do they stack up to ETFs? Before digging into comparisons, it’s important to first understand the fundamentals.

Here are their key similarities:

· Structure: Both ETFs and interval funds are investment management funds. This means that owning shares in either one represents ownership of a broad variety of financial securities like stocks, bonds, and derivatives. Both fund types are registered under the Investment Companies Act of 1940.

· Offering: Both offer their shares continuously, which means that investors can purchase shares during regular market hours and the fund can progressively offer more shares as their asset pool grows.

· Pricing: Both funds trade at net asset value (NAV), which means the price of their shares reflects the total value of their assets divided by the number of shares. Although ETF share price will deviate from NAV throughout a trading day, it normalizes back to that value periodically.

Here are their key differences:

· Selling: ETF shareholders sell their shares to other investors on an exchange, through an intermediary that interfaces with the fund company to constantly bring prices closer to NAV. Interval fund shareholders can only sell their shares directly back to the fund company, with no intermediary or exchange involved.

· Timing: ETF shareholders can sell their shares at any time, while interval fund shareholders must wait until predetermined intervals throughout the year to sell.

· Quantity: ETF shareholders can sell as many of their shares as they want, while interval fund shareholders can only sell up to a certain percentage of all the fund’s outstanding shares.

· Management: Most ETFs are passively managed, and they usually track a specific sector or index. This means that selection of holdings is automatic, and there’s less human judgement involved in their management. Conversely, interval funds are actively managed. This means that the fund advisors commit time and resources to strategizing which assets the fund should hold based on the current economic landscape.

· Fees: Because of their passive management, ETFs tend to have lower operating fees than actively managed interval funds.

· Minimum Investment: Most ETFs don’t have a minimum investment for buying shares, while most interval funds do.

· Illiquidity Threshold: ETFs can’t invest more than 15% of their assets in illiquid assets, which are those with a significant time or monetary barrier to acquisition or selling. Interval funds, however, can invest up to 95% of their total capital in illiquid assets.

Now that the essential details are clear: why do interval funds continue to gain popularity? In short: they give investors deep, stable exposure to asset classes that ETFs can’t reach. Here’s how:

INTERVAL FUNDS PROVIDE ACCESS TO ILLIQUIDITY

ETFs are great for gaining exposure to a broad range of stocks, bonds, or derivatives across a single index or sector. For instance, shares in the popular SPDR S&P 500 ETF Trust contain fractions of every company’s stock on the S&P 500 index. Some ETFs track categories like energy, sovereign bonds, agriculture, or small-cap companies. But what ETFs can’t efficiently access: illiquid assets.

Illiquid assets are, broadly, any type of asset that is time- or effort-intensive to buy or sell. These include hedge fund shares, real estate securities, project loans, small business debt, and private equity. For various reasons, the capital requirements of these investments make it difficult to quickly buy or sell them for their fair market value. For instance, private companies with smaller asset pools may sell shares in exchange for a longer-term investment and may not readily buy them back.

Illiquid assets are a sought-after investment for several reasons: they add valuable diversity to a portfolio, they’re less correlated to the stock market than other assets, and they tend to have higher yields compared to similar, more liquid products. Because ETFs have high trading volumes and need to be able to quickly buy and sell shares of their underlying investments, their structure is ill suited to holding illiquid assets.

Interval funds are built to handle illiquidity. Because of their periodic redemptions and repurchase thresholds, interval funds can accurately plan for when they’ll need cash on hand. This allows their managers to buy and hold illiquid assets with the assurance that investors won’t unexpectedly pull their money from the fund and require an inconvenient sell-off. This access, in turn, makes interval funds a source of diversity across hard-to-reach financial sectors, and gives them a coveted “liquidity premium.” Put simply, it’s the extra bit of yield illiquid assets produce to compensate for the inconvenience of buying and holding them.

Traditional closed-end funds are also a way for retail investors to access illiquid assets, but interval funds have several distinct advantages over them.

Photo by Hans Eiskonen

INTERVAL FUNDS PROVIDE INSULATION FROM VOLATILITY

ETFs owe part of their popularity to their dynamism; their price rises and falls with the caprices of the business cycle, which can be exciting in good times and troubling in downturns. Interval funds, on the other hand, are designed for stability and insulation from economic volatility.

The first component of interval funds’ stability is their holdings. Illiquid assets tend to be less correlated to the broader market than the stocks and bonds that ETFs usually hold. When the market nose-dives, interval funds tend to follow it less closely than more liquid funds.

The second source of stability is interval funds’ repurchase structure. Emotion is the enemy of long-term investing, and it’s common for shareholders to pull their money from funds at the earliest signs of a market downturn. Since most funds are priced at NAV, this further reduces the value of the fund’s shares, causing a downward spiral of selloffs.

Interval funds avoid this process by only buying back shares a few times a year, preventing skittish shareholders from selling prematurely. Plus, the 5-25% redemption limit placed on the buyback period keeps all investors from selling at a single time, adding another buffer. Though some short-term investors may balk at this added degree of illiquidity, more seasoned investors recognize the wisdom of riding out short-term fluctuations in the stock market. Because of this, interval funds make an ideal long-term, stable investment to complement the low-volatility and fixed-income components of a portfolio.

Photo by Maxim Hopman

CONCLUSION

With interval funds and ETFs approaching their 30th birthday, both fund types have proven their financial niche. There’s no question: if an investor wants an easy-in, easy-out investment with good exposure to equity and bond markets, it’s hard to beat the ETF. But a well-balanced portfolio includes both a diversity of holdings and a diversity of fund structures. Alternative assets are an effective hedge against market fluctuations, and they provide access to returns in hard-to-reach sectors of the economy.

Neither the ETF nor the interval fund is a financial silver bullet. But the interval fund’s underdog position, stability, and unique angle on illiquidity make it hard to ignore in the uncertain financial landscape ahead. In a year of overinflated stock prices and zero interest rates, it may be time to seek alpha in less obvious places.

Next: Interval Funds vs. Closed-End Funds