Interval Funds

Apr 12. 15:20

What is an Interval Fund?

Photo by AbsolutVision

What exactly is an interval fund? How do they work? And, most importantly, why would somebody choose to put their money into one? Here’s what you need to know.

THE BASICS

Fundamentally, an interval fund is a type of investment company: a firm that accepts money, invests it on behalf of others in a collective fund, and distributes back the profits and losses of those investments. Investors buy shares of the company, which entitle them to a small portion of the pool of investments (stocks, bonds, and other financial assets) that the fund’s advisor buys with the proceeds from the investors’ purchase of shares. Shareholders gain wealth from this arrangement in two ways:

· As the value of the pool of investments grows, the value of each person’s stake in the fund increases – and the investor can then sell their shares for a profit.

· If the fund includes investments that generate interest, the shareholders are paid portions of that interest in regular dividends, providing a passive source of income.

There are many types of investment company regulated under the Investment Company Act of 1940, but there are several factors that make interval funds distinct.

BUY CONTINUOUSLY, SELL PERIODICALLY

Interval funds’ most important characteristic is the way shares are bought and sold. Here’s how it works:

· Buying: Interval funds are “continuously offered,” which means investors can purchase their shares at any time. There’s no secondary market for interval fund shares, so they must be purchased directly from the fund. Anyone can buy interval fund shares – not just professional or accredited investors.

· Selling: Once shares have been purchased, they can only be sold at fixed times during the year. This is the interval: usually every three, six, or twelve months. The fund will make periodic offers to repurchase shares (up to a certain proportion of the total shares issued), and the shareholders can choose to accept those offers and cash out, or to hold onto their shares and wait until the next interval.

This structuring is useful to the fund’s advisors because it allows them to plan for exactly when investors will want to exchange their shares for cash. That way, the fund can put more of its investments in assets that will produce growth and yield rather than having to reserve a portion as cash-on-hand.

LIMITED LIQUIDITY

Before going further, it’s important to define a key piece of financial jargon: liquidity. In simplest terms, something’s “liquidity” denotes how easy it is to convert into cash without selling for less than its market value. 

The primary downside of interval funds is that they are relatively illiquid – that is, they have low liquidity. Since shareholders can only sell at stated intervals, there’s less opportunity to convert shares to cash than in a fund with continuous selling. Plus, as mentioned earlier, an interval fund will only buy back a certain number of shares at every interval.

Since investors can’t pull their money from the fund unexpectedly, advisors are protected from investors making “runs” on the fund and are given the opportunity invest in assets that have limited liquidity. These can include:

· Loans for infrastructure projects

· Stock in privately held companies

· Residential or commercial real estate

· Farmland or timberland

If shareholders are continuously cashing out their shares, these investments are difficult to make. Interval funds exchange ease of selling for access to alternative assets, which compensate investors for their illiquidity with higher yields and long-term returns.


turned on flat screen monitor

Photo by Chris Liverani


TRANSPARENT, STEADY SHARE PRICING

What determines the price at which interval funds are bought and sold? That comes down to the fund’s net asset value, or NAV. In short, it’s the dollar value of the fund’s whole pool of investments divided by the number of shares issued. The NAV is calculated every day, and investors buy and sell at that number. This makes valuation transparent, unlike the highly speculative pricing of securities (like stocks and shares in other types of fund) which sell on a secondary market.

The structure of an interval fund also gives its share prices an important dimension of stability. Financial markets experience constant booms and busts, and the values of most funds tend to move with them. Interval funds are less attached to the caprices of the market for two key reasons:

· Since investors can only sell their shares occasionally, advisors are shielded from the emotion-driven buying and selling that often accompanies a dip or spike in the market. This means the fund doesn’t need to have an emergency pool of cash on hand, and it can focus on yield-maximizing investment strategies.

· As mentioned before, the fund’s underlying investments themselves are often illiquid. Since these assets aren’t meant to be sold constantly, their prices aren’t reevaluated at the same frequency as other products on the market. This means that the value of an interval fund’s investments is generally less correlated to the short-term trajectory of financial markets, making them a stable option for long-term investors.

INVEST FOR ACCESS, YIELD, AND STABILITY

Given their unorthodox structure, why would somebody want to put their money in an interval fund? There are a few essential reasons:

· Diversification: Spreading personal investments across a range of sectors and assets insulates wealth from random dips in different parts of the market. As mentioned above, interval funds allow access to hard-to-reach areas, providing diversity across geography, credit quality, and asset type.

· Liquidity premium: Because a lack of liquidity is a disadvantage, such investments usually carry a “premium” ­– a bump in yield to compensate for the downside of not being able to readily cash out. For interest-generating investments, like bonds or debt, this translates to higher yields and thus a greater periodic payout for investors.

· Low market correlation: As mentioned previously, the way an interval fund is structured creates insulation between their value and the movement of the market. Because of this feature, interval funds are attractive options in times of great market volatility.

COMPARISON OF FUNDS

There are hundreds of interval funds available to investors, and that number is growing. It’s useful to compare different interval funds to one another, but it’s also important to know how they compare to other types of fund.

There are many categories and sub-categories of investment fund, and the distinctions can be confusing. Here’s how interval funds stack up to some of the other funds you may encounter.

Interval Funds: The What and Why

ASK THE RIGHT QUESTIONS

As with all investments, interval funds carry risk. Here are some questions investors should ask before buying shares:

· What’s the fund’s objective? It’s important to know what the fund’s advisors are targeting so that you can make sure those goals align with your own. Common objectives include long-term value increase, short-term income, or outperforming a certain index. This information can usually be found on the fund’s website, or in their official filings.

· Who is the advisor? This is an essential consideration when entrusting your money to an investment fund. Advisors decide which investments will make up the fund, and so you should be sure of their expertise before proceeding. Look at the advisors’ past performance and how much wealth they’ve managed.

· Can my portfolio handle the illiquidity? Interval funds can be a steady source of return, but they aren’t a good place to put cash that you might need on short notice. Make sure you have enough liquidity elsewhere in your portfolio to handle the interval fund’s buyback structure.

· What are the fees? All funds charge management and operating fees, which are used to pay the advisors and cover the company’s overhead. Interval funds may charge an additional redemption fee when investors sell their shares, as well as a collection of servicing fees. Only some charge these fees, and you can compare the fee structures of different interval funds to determine which is right for you.


Next: The Top Five Advantages of Interval Funds

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