Interval Funds

Apr 28. 18:31

The Liquidity Premium: Interval Funds' Secret Weapon

Photo by Enrique Zafra

Interval fund returns are solid because, well, they aren’t liquid

The title says it all.

It’s no secret that interval funds have high returns. But why do interval funds tend to generate a few points more every year? That comes down to the liquidity premium.

The liquidity premium, which is sometimes, confusing, called the “illiquidity premium,” is the additional yield offered in exchange for holding an illiquid asset. Recall that an asset’s liquidity is a measure of how easy it is to convert into cash. An illiquid asset is something that requires a lot of time to sell at its actual price, or which can only be sold in the short term if it’s discounted.

Assets with lower liquidity tend to yield more than more liquid investments because they’re riskier to hold. The liquidity premium compensates investors for this risk, raising demand for an otherwise less-desirable investment. If two investments had the same yield over ten years but one could be quickly converted to cash in case of unexpected need or opportunity, there’s no reason to buy the other one. Therefore, illiquid assets pay a bit more to overcome the inherent risk of not being able to easily cash out -- and thus to incentivize people to buy them.

U.S. treasury bond yields provide an easy visualization of the liquidity premium. A bond’s term is how long it must be held before it can be converted to cash. A one-month bond is more liquid than a one-year bond, and both are more liquid than a ten-year bond. Their respective yields: 0.01%, 0.06%, and 1.63%.

Other common examples of illiquid assets include real estate, long-term bonds, private equity, and infrastructure.

Interval funds are built for illiquid assets. Recall the unique process of selling interval fund shares: shareholders can only sell back to the fund at predetermined intervals throughout the year, and only up to a certain percent of total shares. This means that, unlike mutual funds and ETFs, interval funds don’t need to be ready to sell their holdings at a moment’s notice.

This opens the door to significant investment in illiquid assets. Low cash-on-hand requirements mean that interval funds can hold up to 95% of their assets in illiquid investments, opposed to 15% in mutual funds and ETFs. Because of this, interval funds get much more exposure to assets that offer a liquidity premium – and pass that yield bump on to their investors.