May 24. 20:43
Interval Funds vs. Hedge Funds
The name “hedge fund” can invoke an air of mystery, exclusivity, and riskiness. Hedge funds are widely seen as the secretive purview of rich and sophisticated investors – and this impression isn’t entirely wrong. The name “interval fund” is, on the other hand, more obscure. The two investment vehicles have some commonalities, but the distinctions between them are important for investors seeking access to alternatives. Interval funds are more accessible, more liquid, and generally less risky than hedge funds; accordingly, the two should occupy different niches in a person’s portfolio.
THE HEDGE FUND SECTOR IS LARGER
Both interval funds and hedge funds can give exposure to alternative assets – investments like gold, real estate, and long-term debt that fall outside the realm of commonly traded securities like stocks and bonds. However, hedge funds are a far larger investment sector than interval funds. According to Preqin, the world’s hedge funds had over $3.8 trillion under management among over 18,000 active funds as of February 2021. Interval funds, in contrast, manage just over $50 billion across less than 70 active funds. Part of this disparity can be traced to the fact that hedge funds have existed since 1949, while interval funds were created in 1993. However, the differences in risk profile, exclusivity, and public profile that separate interval funds and hedge funds also drive disparities in how much capital each type attracts.
INTERVAL FUNDS ARE LESS EXCLUSIVE
A core facet of a hedge fund’s operational strategy is its exclusivity. Hedge funds are private, and they don’t need to report to the SEC in the same way that ’40 Act vehicles like interval funds do. Registration D of the Securities Act of 1933 allows hedge funds to offer shares without a lengthy filing process, in exchange for certain restrictions on who can purchase them. Hedge funds are limited to 35 accredited investors – those with an investing certification, a net worth greater than $1 million, or an income greater than $200,000. The initial investment to buy into a hedge fund often exceeds $1 million, which contributes to the large amount of wealth currently under hedge fund management.
These accreditation and initial investment hurdles exist partially to protect unsophisticated investors from hedge funds’ potentially risky strategies, which are explored below. Interval funds, by virtue of being SEC-registered and subject to stringent reporting requirements, are able to open their shares to non-accredited investors. Furthermore, most interval funds offer lower initial investment requirements than hedge funds, making them accessible to a broader range of income levels.
Photo by Anastase Maragos
HEDGE FUNDS CAN BE RISKIER
A major part of an interval fund’s value proposition is its stability. Investors favor interval funds for their high yields, low correlation to other markets, and stable share pricing. Hedge funds can employ a variety of investment strategies, but their primary raison d'être is alpha: an increase in total return over a market benchmark like the S&P 500. This profit drive often leads hedge funds to employ riskier strategies than regulated funds, a practice facilitated by their investment structure.
Hedge funds operate as partnerships between a “general partner” and several “limited partners.” The general partner, or GP, is responsible for fund operations and investment management, as well as the distribution of dividends. The role is analogous to that of the advisor in a mutual fund or interval fund. Most of a hedge fund’s capital comes from its limited partners, who contribute a large sum of money when the fund is formed. As noted, these limited partners must be accredited in order to contribute to the hedge fund, which ensures that they have the know-how to understand the risks associated with hedge fund investments.
One of such risks: leverage. Interval funds are limited to 200% leverage in their investment operations, which means a fund can borrow twice as much capital as it holds in assets in order to multiply the effects of its strategies. Leverage increases both the profits from a successful strategy and the losses from an unsuccessful one, so increased leverage means greater risk to the fund. Hedge funds don’t have a limit on how much leverage they can employ – it’s not uncommon to see them operating with 500% leverage or greater.
Furthermore, hedge funds can invest in volatile or exotic derivatives and commodities. For instance, hedge funds held almost half of the risky mortgage-backed securities that were implicated in the 2008 financial crisis, and the high degree of leverage they employed helped to multiply the damage when the mortgages underlying those high-yield securities began to fail. In recent years, an increasing number of hedge funds have invested in the highly volatile cryptocurrency market, while interval funds are limited in their ability to do so.