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Are Interval Funds the Next Big Thing?

Close cousins of CEFs, interval funds offer a unique set of pros and cons. 

Cara Esser and Brian Grow, 03/20/2017

Interval funds are close cousins of closed-end funds, or CEFs, but they offer a unique set of pros and cons for investors. PIMCO made headlines last month when it launched an interval fund (PIMCO Flexible Credit Income) and registered to raise $1 billion in assets. The last CEF to raise more than $1 billion in assets was Goldman Sachs MLP and Energy Renaissance Fund GER in the fall of 2014. Interval funds have gained popularity in recent months as investors continue to search for income and are increasingly willing to invest in riskier fare to gain a bit more yield. These funds have some distinct advantages over CEFs, though there are plenty of reasons to avoid them.

Some in the financial press have asserted that, with all the challenges facing CEFs, particularly the potential imposition of the fiduciary standard on advisors and brokers, interval funds could be the next big thing. Asset managers seem to think so, too. As of the end of February, there were about 20 interval funds in registration, which would almost double the number of interval funds available. For comparison, just nine new CEFs launched in 2016, raising a paltry $3 billion in total; for the year to date through February 2017, there were two CEF IPOs, raising just $375 million in assets.

While growing in popularity, interval funds remain a very small part of the overall market. As of February 2017, there were about 30 interval funds in existence, accounting for a total of around $9 billion in assets. By comparison, there are around 530 CEFs with nearly $400 billion in gross assets ($250 billion in net assets) in existence.

What Is an Interval Fund?
Interval funds are a type of CEF but with one important distinction: Shares are not traded on an exchange in the secondary market. Instead, shareholders can participate in periodic (quarterly, for example) repurchase offers by the fund (the amount repurchased must be at least 5% but no more than 25% of assets each period). The funds can continuously offer shares to the public based on current net asset value, though not all interval funds strike a daily NAV (most CEFs do). By contrast, shareholders in CEFs buy and sell shares on the secondary market, which creates both a NAV (the value of the fund’s underlying holdings) and a share price (the price at which investors transact); this gives rise to discounts and premiums. More on this later.

Interval funds’ unique redemption process requires a bit more detail. Investors are only able to withdraw money during predetermined redemption periods, which usually occur once per quarter but could be as infrequently as semiannually or annually. During this “redemption window” (which usually lasts two or three weeks), investors submit requests to sell shares back to the fund company, but orders are not processed immediately. Rather, once the redemption window closes, the fund has additional time (typically around one week) to sell assets to raise cash to meet the redemptions.

Investors should also note that sell orders will not be processed using the fund’s NAV on the day the order is submitted. Rather, depending on the length of the redemption window and when the order was submitted, sales might not be processed until two, three, or even four weeks after submission, which means investors do not know the NAV at which shares will be repurchased. This give rise to a considerable downside for interval funds over CEFs: the inability to sell shares immediately and the risk that the market will turn south between order placement and fulfillment, leaving investors with a lot less cash than expected.

Finally, because interval fund managers do not have to worry about meeting daily investor outflows, they tend to invest in very illiquid securities. While CEFs can and do invest in illiquid securities, some interval funds invest in highly illiquid assets, including hedge funds, catastrophe bonds, real estate securities, and small business loans. Traditional CEFs tend to shy away from hedge funds and those exotic asset classes, even though, in theory, the structure does allow them to purchase similarly illiquid investments. In fact, since traditional CEFs don't have to meet regular redemptions, those products arguably have a greater ability to own illiquid securities.

From a fund firm or management perspective, an interval fund is an appealing investment wrapper. The managers can invest without too much concern about meeting outflows except during specified time periods, which provides them the freedom to invest in more esoteric and illiquid fare. From the fund company's perspective, the ability for investors to purchase shares at any time allows for the prospect of growing assets in the fund and increasing management fees. With CEFs, an asset manager would need to launch another fund in order to significantly increase assets under management for a specific strategy.

Cara Esser is a closed-end fund analyst at Morningstar.

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