Interval Funds are Proving a Hit With Advisors
Bond fund manager Pimco has launched an interval fund that’s proving to be a hit with institutional fixed income investors. Categorized by regulators as a cousin to closed-end funds, the new offering has registered to raise $1 billion.
That level of asset gathering hasn’t happened in the CEF universe since 2014, according to analysts.
“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,” says Morningstar’s Cara Esser and Brian Moriarty in a recent research note.
Indeed, another 20 or so interval funds are in registration, they estimate – nearly doubling the fledgling market in terms of sheer numbers. Some pundits are suggesting these alternative investment vehicles “could be the next big thing,” Morningstar notes.
What’s attracting institutional buzz in such alternatives is a fund structure that chief investment officers see as different than most closed-end competitors. Interval funds don’t trade on exchanges and allow investors to periodically buy and sell shares.
By contrast, CEFs typically issue IPOs through public markets and then close access to shares. Interval funds are also attracting money from big endowments, foundations and pension fund managers due to perceived advantages in using greater portfolio freedom in managing money flows to take investors into particularly illiquid markets.
These include catastrophic bonds, commercial real estate deals usually only open to large institutions, commercial business loans and a variety of niche hedging strategies.
But veteran alts advisors who are investing in the field tell FA-IQ that caveats do exist.
“They’re usually fairly expensive in terms of fees and they tend to invest in less tax-efficient asset classes that represent relatively tiny corners of global liquidity markets,” says Mark Armbruster, president of Pittsford, N.Y.-based Armbruster Capital Management, which manages about $325 million.
Even though such funds present “a lot of investment friction – real warts – to be concerned about,” the indie advisor is devoting anywhere from 5% to 10% of overall client portfolios to these managers.
The managers he’s hiring are charging between 1.5% to 2% in annual expense ratios. But those fees are still cheaper than rival hedge funds or private equity deals, according to Armbruster.
“Interval funds are providing access for our clients to participate in some unique areas of the market that might otherwise be difficult to access without directly holding a large private pool of assets,” he says.
Opening the doors to investors to get in or out can also be compelling to clients compared to PE and hedge funds, which can require lengthy lock-up periods to access their money, says Sasan Faiz, co-chief investment officer at Morton Capital Management.
While interval funds don’t offer daily purchases and redemptions like traditional open-end funds, he finds that most managers allow at least some amount of liquidity on a monthly or quarterly basis.
“These are often grouped in the closed-end funds and private placements marketplace, but interval funds act more like open-end mutual funds,” says Faiz, whose suburban Los Angeles-based employer manages about $1.6 billion.
Managers usually limit redemptions, however, to 5% to 25% of a fund’s total assets. “So there are limits on how much of a fund can be sold at any given time,” Faiz says. On the other hand, enough flexibility is built in to such funds so that “there are more risk management tools available to fund managers,” he adds.
Faiz is turning to interval funds to gain exposure for his clients to reinsurance markets, peer-to-peer lending and collateralized loan obligations.
With interest rates on the rise, he finds interval fixed income-oriented funds attractive now since “they’ve got structural protections built in that can buffer against rising loan defaults” in coming years. “Some of these funds can be good vehicles since they let managers control redemptions – they’re not forced to sell at periods of market stress and heightened illiquidity,” Faiz says.
For clients with moderate risk profiles, he might allocate a total of 14% to these types of funds. At the same time, his review process includes sticking to larger funds and managers his staff feels “very comfortable” with from past experiences with their investment teams. Also, he lets clients know interval funds aren’t opening their coffers to just anyone – advisors are most often required by managers to get approval on a firm-by-firm basis.
“Even though these funds might have a ticker like an open-end fund, you’ve got to get individual approval for your firm’s clients to gain access,” Faiz says. “That’s to ensure that your investment strategy is long-term oriented – interval managers usually don’t want to open their funds to short-term traders.”
Generally, interval funds are marketed to larger RIA firms that “can invest significant amounts,” he adds. In the past, minimums to bring clients into such funds usually required firms to bring at least a total of $5 million into the mix. But those levels have been dropping, Faiz observes, as interval funds become more popular.
“While we’re generally finding that these types of funds can be useful,” he says, “as interval funds become more popular there is a danger that these funds will become overpopulated with managers who don’t understand all of the risks involved with the illiquid markets they’re trying to tap.”