Going where ETFs can't: Illiquid interval funds draw investors

This analysis is by Bloomberg Intelligence analysts James Seyffart and Eric Balchunas. It appeared first on the Bloomberg Terminal. 

Interval funds have exploded to $19 billion in assets by going where ETFs and mutual funds can’t. The closed-end funds offer retail investors access to illiquid and typically high-yielding assets, such as real estate, catastrophe bonds and direct lending. Yet they come with high costs and infrequent redemptions.

Broadening access to illiquid assets
Interval funds can give the broader investing public access to illiquid investments, typically reserved for accredited or institutional investors via hedge funds and other private structures. While high minimum investments are required by the largest interval funds, many have share classes with retail-level minimums. Strategies available via these funds include direct real estate, specialized fixed-income investments such as catastrophe bonds or direct lending, and long-dated derivatives.

These types of assets can offer return streams with low correlations to traditional investments. Additional differentiation comes from a closed-end funds’ ability to use and create leverage via preferred stock, loans and credit facilities. All of this comes with differentiated risks.

Assets surge to $19 billion since 2012
More than 40 interval funds with 94 different share classes hold a total of $19 billion in assets — up from $1 billion in 2012. Growth should persist so long as investors seek alternatives for their portfolios and ETF issuers are unable to figure out ways to offer these less-liquid holdings in the superior ETF structure. Many funds are launching multiple share classes that offer the same strategies, with different structures in loads, expense ratios and minimum investments.

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A closed-end fund without daily redemptions
Interval funds are a type of closed-end fund registered under the Investment Company Act of 1940, with a few key differences. They aren’t traded on exchanges and act like mutual funds because they are bought and sold at net asset value. Like mutual funds, they also continuously offer subscriptions. The closed-end aspect comes from the funds not offering daily redemptions. Scheduled redemptions range from quarterly to annually, and investors must elect in advance to have their shares redeemed to leave a fund.

There is typically a limit on the percentage of shares redeemed each period. If enough shares are elected to be redeemed, investors may not be able to reduce or close their positions when desired. This liquidity risk is matched with this fund type’s ability to earn a liquidity premium.

Mediocre returns, high yield, low correlation
Like hedge funds, interval funds come with low volatility, as well as little correlation to the S&P 500 Index. The funds, while expensive, offer diversification benefits alongside potentially higher yields. The returns, yields and Sharpe ratios of interval funds are all over the map. Looking at the five biggest funds, the yields range from 0.1-15%. It’s very important for investors to do due diligence.

The relatively disparity in yields for interval funds vs. traditional equity and fixed-income markets likely comes from two areas: the types of underlying investments and the structure’s ability to use leverage to pump up yields and returns.

No access to private equity? Check out these ETFs
Private equity is one of the last frontiers that has yet to be democratized by ETFs. However, there are some surrogate and indirect ways to attempt to capture these returns, albeit minus the illiquidity premium. These include microcap ETFs and small-cap value ETFs, as well as those that track publicly traded private-equity companies.

Microcaps ETFs are private equity-esque
One way for ETF investors to capture something close to private equity is through microcap ETFs. Microcap stocks share similar characteristics with companies a private-equity fund would invest in, namely that they’re in their early stages of growth, have less financial strength and have much less research coverage. However, unlike private-equity funds that have lockups — creating an illiquidity premium — microcap ETFs and the stocks they hold trade all day, every day. Private-equity funds also tend to charge much higher fees than an ETF.

ETFs holding private equity another way to benefit
Another way to play private equity with ETFs is to invest in publicly listed private-equity companies such as Blackstone, KKR and the Carlyle Group. Doing this won’t imitate the return stream of a private-equity fund like a microcap ETF, but it does let investors participate in the growth and success of private equity investing via the companies that offer the funds. That hasn’t been a good bet so far, as the biggest product on the market, the PowerShares Global Listed Private Equity Portfolio (PSP), has underperformed the S&P 500 by 118% since launching.

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