July 28, 2017
Some of the best performing investments of the last twenty years have been private funds, alternative investment classes like real estate or natural resource development programs, and hedge funds. Many top portfolio managers are attracted to these asset classes and structures for their flexibility and the opportunity to participate with fund performance fees. Private funds are not available to the public, however, due to restrictions under the Investment Company Act limiting hedge and private funds to accredited and qualified investors, determined by income and net worth.
Closed end interval funds are a relatively new structure that can make these investment structures available to a wider group of investors. From an investment standpoint, alternative investments that contain relatively illiquid assets, such as real estate, private debt securities, development programs and other private or hedge funds, daily liquidity is not an option. Traditional mutual funds require daily liquidity.
Closed end interval funds are a hybrid. New shareholders and new investment are accepted continuously, but redemptions are limited to once per month or once per quarter, depending upon how the prospectus is written.
Who Can Invest in Hedge Funds and Interval Funds
Private or hedge funds are limited to accredited and qualified investors. In the United States, this means a net worth of $1 million excluding personal residence, or $200,000 in income ($300,000 if married filing jointly). Interval funds by contrast are usually open to all investors. There are exceptions to this rule, but typically an interval fund makes previously just about anybody that wants to invest in them. Even with relatively large minimum investments for some funds ($10,000 or more), interval funds are still far more accessible to the public than hedge funds.
Minimum Net Worth
To become an accredited investor that can legally invest in a hedge fund an individual must have an annual income of at least $200,000 which is well above the average income in the US. They can also qualify as an accredited investor if their assets exceed $1 million, aside from their home. The reason for this is that the Securities Commission views this type of investor as having the means to mitigate the risk that comes with investing in a hedge fund. The bottom line is that most investors can’t join a hedge fund even if they want to, but they can get involved in an interval fund.
Hedge Funds Require a Long-Term Commitment
Interval funds also much more flexibility than hedge funds do. When an investor first joins a hedge fund they must accept a “lock in” period that guarantees they’ll leave their money in the fund for at least one year. After that they may leave the fund at set intervals – 6-month intervals are common.
Compared to hedge funds, interval funds are much more liquid. Investors can’t opt out whenever they want, but they aren’t “locked in” for extensive periods either. Investors can buy into the fund whenever they like and they can leave at set intervals that are predefined. These intervals may be as little as one month or as much as six months.
Risk and Reward
One of the great attractions of the hedge fund for those that qualify is the possibility of above average returns. Mutual funds are limited in use of leverage (purchasing securities on margin). Hedge funds are not. Mutual funds are limited in the level of short selling that can take place in the fund. Hedge funds are not. Mutual funds are limited to publicly listed securities for typically 90% or more of the mutual fund portfolio. Hedge funds can purchase unlisted securities. With additional opportunity comes additional risk, and there’s a chance the funds may be hit with substantial losses instead of large returns. This high degree of risk is one of the main reasons that these funds are only open to accredited investors that can potentially absorb any losses. If the fund managers explain their investment strategy to its investors ahead of time they can manage it as they see fit.
Interval funds can hold these alternative, riskier investments, and engage in more aggressive investment techniques, but must maintain more diversity among the underlying investments than a pure private or hedge fund. Illiquid investments such as real estate may be held, but the percentage of the portfolio in any one investment is restricted, and the interval fund must demonstrate its ability to create liquidity on the redemption cycles stated in the prospectus. So, in many ways the structure is a hybrid. The returns may not be as great, but the diversity of securities and requirement to offer liquidity makes them more secure.
How Hedge Funs Use Leverage
One of the most popular strategies used by hedge fund managers is the use of leverage to achieve significant gains. This means that the manager will borrow money to increase the holdings of the fund to invest in things that offer a high rate of return that will not only cover the borrowed money, but also offer a substantial return as well. This strategy risky is because if the investment does not go as planned the fund may not have the money to pay back the cash it borrowed, causing the fund to fail.
Interval funds do not use leverage as a major investment strategy. Instead the managers of these funds look for strong investment opportunities with a great deal of long term potential. For the average investor that doesn’t want to take a risk on their life savings, interval funds are a much better choice.
Contrasting the Fee Structures of Hedge Funds and Interval Funds
The structures of fees of each are another significant difference between interval funds and hedge funds. Hedge funds commonly have what’s known as a 2 and 20 fee structure. The fund manager receives 2% of the assets of the fund each year as well as 20% of the profits. Yes, these fees are as high as they sound. Investors are willing to pay these high fees because of the large returns they can realize from a well-managed hedge fund. High risk in this case can result in high rewards.
Interval funds can also have high fees when compared to open end mutual funds, but not anything like a hedge fund. On average, these funds charge their investors between 2 and 4% annually and require you to pay a sales charge when you sell.
Interval Funds are Lower Risk
Is one fund better than the other? It really comes down to what you’re trying to achieve. A relatively wealthy investor who’s not afraid of a little risk can do very well investing in hedge funds. Interval funds offer more modest returns, but are open to just about anyone and are lower-risk.
This is the second installment of Kip’s interval fund series, read the original article here.