May 28. 16:31
Understanding Interval Fund Liquidity
When investors first discover interval funds and learn about the limits on selling their shares, many wonder:
“Why are there so many restrictions on liquidity? What if the markets go south and I want to withdraw my money?”
This is a fair question. To be clear: short-term investors who aren’t comfortable with not being able to quickly withdraw their money from a fund will find interval funds unsuitable. Interval funds are fundamentally long-term investments, and no portfolio should contain all interval fund shares. They aren’t a place to store cash you might need on a moment’s notice to buy a car or pay bills.
That said, an interval fund’s restricted liquidity is a feature designed to bridge the gap between investors and desirable but tricky asset classes without causing a cash crunch for either the fund’s managers or its investors. Interval funds occupy the middle ground between highly illiquid vehicles like hedge funds and relatively liquid funds like ETFs. However, before diving into the details of interval fund liquidity, it’s important to first define our core concept.
WHAT IS LIQUIDITY?
Broadly speaking, something’s liquidity is the ease with which it can be bought or sold at its fair market price. The “ease” factor is usually based on the time required to make the transaction; something that takes a long time to sell for what it’s worth has low liquidity. If something has low liquidity, we describe it as illiquid.
The asset with the highest liquidity of all is cash. By definition, cash is fungible and can be converted to itself in no time at all. Assets like individual, publicly traded stocks and bonds are also considered highly liquid. This is because they trade on large exchanges with many participants, and someone selling such securities at market price can usually find a buyer in very little time.
Examples of illiquid individual assets include real estate titles, physical collectibles like art, and stocks in private companies that don’t trade on an exchange. These assets require significant forward planning to convert them to cash, which usually involves arranging a buyer outside of the automatic transactions that occur on high-volume markets like the New York Stock Exchange.
Image by Ahmad Ardity
In the world of investment funds, the concept of liquidity takes on some additional nuance. Because the fund’s shares are being sold rather than the actual fund, the liquidity of the fund’s shares refers to a slightly different property than the liquidity of the fund itself.
Since shares are individual securities, their liquidity refers to the ease with which they can be bought or sold for cash. But, since the overarching fund is a collection of underlying securities, the fund’s liquidity refers to its ability to quickly convert its holdings to cash in order to provide shareholders with said cash when they want to redeem their shares.
This distinction is subtle but important. A share with high liquidity can be quickly bought or sold for its market value. A fund with high liquidity has the ability to rapidly provide shareholders with cash if requested. A fund with low liquidity may be forced to sell its holdings below-market in order to produce cash or, in the case of interval funds, will only make cash redemption available at certain times. It’s also important to note that liquidity doesn’t correspond to value. A million-dollar home has high value but low liquidity, while a savings account with twenty dollars in it has low value but high liquidity.
UNDERSTANDING ILLIQUID ASSETS
As mentioned above, the opposite of liquidity is illiquidity. Investments that are difficult to quickly buy or sell at their fair market price are known as “illiquid assets.” This category is often confused with “alternative assets,” a moniker given to any type of investment that falls outside the well-recognized classes of public stocks, bonds, and certificates. Although alternative assets are often illiquid and most illiquid assets are alternative, they’re fundamentally different concepts. However, as we’ll see, the “alternative” nature of most illiquid assets is a core component of their appeal.