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Rekenthaler Report

Do Interval Funds Have a Future?

If so, some things need to change.

Silver Anniversary
Interval funds turned 25 years old this year.

They had a proper birth, being conceived several months before their delivery. With 1992 being an election year, the presidential candidates were eager to demonstrate their concern for small businesses. Accordingly, the Bush administration directed the SEC to consider how registered U.S. funds could broaden their mandates, so that they could invest more in private-placement securities issued by companies that weren't large enough for the public markets.

(Theoretically, the benefit would extend far down the corporate ladder. Mom's Diner wouldn't be issuing equity anytime soon, but its bank loan might be bundled and resold. The point being, the more monies that funds invested in private placements, the lower the financing costs for America's small business. Or at least, so was the pitch.)

The SEC responded by stating that because closed-end funds never faced redemptions, they could invest in such less-liquid investments. In contrast, open-end funds, obligated to meet redemptions each business day, were bound by the Investment Company Act of 1940 to invest primarily in public issues. The SEC loosened--not eliminated--that requirement, permitting mutual funds to place up to 15% in private placements.

The commission then authorized the creation of a third species: interval funds, which were authorized the following year. As the SEC explained, the interval fund would meet a need unfulfilled by the two existing fund types. Without the interval fund, investors who wished to hold illiquid securities would either confront mutual funds' 15% restriction or be forced to trade their closed-end shares at the market price. Neither situation was ideal.  

Best of Both Worlds?
The interval fund was to be Goldilocks' chair. Like the mutual fund, it could be redeemed at net asset value. Not daily--because then it would just be a mutual fund--but instead monthly, or perhaps quarterly. Meanwhile, limiting the redemption window to occasional periods, rather than permitting daily exchanges, would permit interval funds to invest freely in less-liquid issues. Voila! The problem was fixed.

Well, yes … but a new one appeared. Although closed-end funds do not accept redemption requests, they can nevertheless be traded for cash during market hours. The price might not be great, but the availability is reliable. Not so for interval funds. Absent the development of a secondary market (which has not occurred), interval funds can only be converted to cash a few times each year.

Trouble Spots
In addition, interval funds have faced two other problems.

One is that they are costly. Among the 65 interval funds with five-year histories, 56 have annual expense ratios that exceed 1.2%. The median expense ratio among that group is 1.7%. These days, when indexers and institutional share classes reign, funds that are burdened with high costs languish. Rare indeed is the fund (of any stripe) that has positive cash flows with expense ratios that are well above 1.0%.

The other related difficulty is that interval fund sponsors are almost all boutiques. Capstone offers an interval fund, as do CION, City National, CLA, Corsair, Crestwood, Cross Shore, and Crow Point. Purchased any funds from those companies lately? Meanwhile, Vanguard, Fidelity, and Schwab offer hundreds of registered funds, none of which are intervals.

No surprise, then, that interval funds have gathered very few assets. They cost too much and are promoted by little-known firms that have modest marketing budgets. Morningstar's data base indicates that interval funds possess only a collective $13 billion, which accounts for 0.06% of the U.S. fund industry. Suffice it to say that if the SEC chose to end interval funds' 25-year lives by ordering that they be disbanded, the obituary could fit comfortably onto a tweet.

Future Possibilities
Perhaps that should occur. It is not clear to me--and I suspect as well to interval fund marketers--whether the handicap of interval funds' redemption provisions can be overcome. Hedge funds, it is true, face similar restrictions; they typically can be redeemed only monthly or quarterly. However, hedge funds enjoy greater investment freedom. They can leverage, or engage in short-term trading, in a way that registered interval funds cannot.

It may be, therefore, that interval funds are not Goldilocks' chair, but rather an invention that landed betwixt and between. They aren't adventurous enough to warrant the attention of hedge fund buyers, and they aren't glamorous enough to draw retail investors away from their liquid alternatives funds. Plus, those liquid alternatives funds are, well, liquid.

Recommendations
Let us assume, though that, that interval funds can be saved. If so, this is what they need to change:

1) Cost
The obvious item. I realize that boutique firms can't price their wares as aggressively as can the giants. Their interval funds won't be subsidized by fees collected on hundreds of billions of other dollars. There can, however, be a compromise--expense ratios that make sponsors uncomfortable, and that won't generate a profit under current conditions, but which would be lucrative if the funds were to achieve significant scale.

Yes, that is a business gamble. But what is there to lose, a quarter century's worth of failure?

2) Visibility
Nothing much is written about interval funds except for the occasional introductory article, such as this one. If there is a trade organization that represents the group, I am not aware of it. Somehow, in some way, the word needs to be spread, such that interval funds are not nigh-on invisible.

Obviously, the activities of a trade group could help. Better yet, though, would be if one of the largest mutual fund firms launched an interval fund and were to put its brand behind the effort. There's nothing like an industry leader to legitimize a strategy.

3) Luck
All right, luck isn't a power. It happens, or it does not. For interval funds, however, it needs to happen. As alternatives--most interval funds holding bank loans or real estate--they will trail when conventional investments thrive. And conventional investments have very much thrived.

The top-performing interval fund over the trailing five years has gained 7.7% annually. There are times when such a return looks appealing. Today, however, is not one of those occasions. 

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.