The commercial from years ago, “you got chocolate in my peanut butter”, with the response, “you got peanut butter on my chocolate” has always stood out as an example of how two completely separate concepts, each perfectly good in their own right, can become better when combined.
Interval funds are a bit like that.
Background on types of funds, how interval funds came to be
Understanding how an interval fund works is best in context of how other types of funds are structured.
Open end mutual funds
Open end mutual funds have an operating history dating back to the 1940s. “Open end” means that the shares in the fund are offered continuously, on each business day the stock exchange is open, and can be redeemed by shareholders selling those shares back to the fund on each business day as well.
The advantage to having an open end fund is that there is no limitation on new shareholder investment coming into a fund. The disadvantage is really the same issue – there is no limit on when shareholders can redeem their shares. Investment advisors managing open end funds must plan for the possibility of redemptions on each business day, which may limit fully enacting the investment advisors investment policies and strategy. Most funds choose to keep a certain level of assets in cash to meet redemptions, which dilutes investment return in “up markets”.
Open end funds issue new shares and redeem existing shares at net asset value. Net asset value is the value of all of the assets held by the open end fund, plus accrued interest and dividends less any accrued liabilities (operating expenses accrued but not yet paid).
Closed end mutual funds
Closed end funds are basically the opposite of open end funds in structure. A closed end fund raises assets in an initial offering. After the fund is established and operational, shareholders wishing to redeem must sell their shares to another buyer, through an open market sale just like selling common stock on the stock exchanges. The fund itself does not provide any liquidity for investors. The open market system of bid by a potential purchaser of shares and ask by a potential seller of shares is negotiated.
The advantage to a closed end fund is the investment advisor to the fund knows what assets are in the fund, and there is not a dilutive necessity to maintain cash positions for the sole purpose of meeting redemptions.
There are two primary disadvantages to closed end funds. The fund can only grow in size with secondary (and third and fourth or more) offerings. Any investor that did not purchase shares on the initial offering must either purchase shares on the open market or wait for a secondary offering. Since investment managers are paid as a percentage of assets, if the initial offering is not as successfully as desired, the fund may linger for quite some time at a smaller than optimal level.
The second big disadvantage is that closed end funds are not priced at NAV (net asset value, calculated based on the securities held by the fund less accrued liabilities), but are priced at a bid ask market price set by a market maker on the exchange. In order to “hedge” the valuation, and take into account the transaction costs of purchasing closed end funds on an exchange, just like any equity, the market makers almost always offers or “asks” a price that is less than or equal to the most recent estimated NAV of the fund. Since the underlying investment activity of the closed end fund is not known by the market, the bid ask is therefore typically below the actual liquidated value of the closed end fund. As a result, the measurement of performance is always below the actual investment activity.
Due to these negatives, closed end funds typically are not the most popular option for starting a new fund.
Best of both worlds?
Back when commercials on television were more fact based (or claim based), there were a lot of products claiming “new and improved”. Whether they actually were, of course, was up for debate. In the case of an Interval Fund, the structure and attributes is clearly better for the right situation.
An Interval Fund is able to continually offer shares for purchase to new shareholders, but limits redemptions typically to monthly or quarterly. The advantages to this structure are:
- Able to continuously offer new shares, so fund can grow
- Fund is priced at NAV, so performance is accurate at all times, and shareholders know that their transactions will be at fair value, not a value set by a market maker (which can happen with a closed end fund or ETF)
- Fund liquidations are limited to known periods, so investment manager has fewer issues with liquidity concerns in having to meet daily redemptions
There are also some disadvantages to Interval Funds. Some platforms do not hold interval funds, with the stated reason being that there is a liability for the platform to track redemption requests. If a client of a platform firm requests a redemption for effective the end of the month, and the platform somehow missed processing that request at the appropriate time, there is liability for a gain or loss to correct the trade at the next available trade period. Most platforms do not feel there is enough “upside” in holding interval funds to justify that risk of loss that the platform would be excepted to cover.
While there is no such thing as a perfect mousetrap, Interval Funds can be a “perfect compromise” when an investment style is best managed limiting the need for liquidity or frequent valuation of difficult to value securities, with the option to accommodate demand for new shareholders with open ability to purchase new shares.