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Rekenthaler Report

Interval Funds: A Dissenting Opinion

A reader disputes Wednesday’s column.

Mentioned:

Taking Exception 
Sometimes, my articles can’t be reasonably rebutted. That  PIMCO Total Return (PTTRX) survived Bill Gross’ departure, or that target-date funds were inspired by academic research, is not up for debate. Other times, though, there is room for disagreement.

Such was the case with Wednesday’s installment on interval funds. It was pessimistic, but the optimists have their claims, too. Today’s column presents a dissenting opinion, courtesy of a reader’s note. (Now would be a good time to peruse Wednesday’s column, if you have not already.) I give his comments below in italics, while my responses are in plain font.

Limited Redemptions
You write, “Absent the development of a secondary market (which has not occurred), interval funds can only be converted to cash a few times each year.” 

This is exactly what they are designed to do, for multiple reasons.

Indeed. On this point we agree. The issue is if possessing only a few redemption periods per year significantly damages interval funds’ marketability. Interval funds have not sold well since their 1993 inception, but whether those struggles owe to their restricted redemption rights, or to other factors, remains an open question.

(Another reader suggests that the bigger problem is operational. Being neither the fish of registered mutual funds nor the fowl of unregistered alternatives, interval funds do not fit seamlessly into existing “platforms”--the technology systems that oversee client accounts. In addition, he writes, redemption requests require “careful communication between the distributor and financial advisor.”

In short, investing in interval funds involves additional wrinkles, which can dissuade those who might otherwise own them.)

Corrected Figures
You write, “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.” 

Total interval fund net assets equaled $23.3 billion as of the most recent public filings available at the end of this June, up 48% compared to the prior year.

Thank you for the additional information. Morningstar’s numbers are comprehensive for the major investment types, such as open-end mutual funds, exchange-traded funds, and common stocks, but are not always so for less-common structures. My wording reflected that caution: I spoke to what Morningstar’s data base held.

Of course, the point remains: Interval-fund assets are small potatoes, as the U.S. fund industry goes.

About Leverage
You write, “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 funds cannot.” 

Most interval funds use leverage to manage the risk of the assets they invest in and potentially meet investor redemptions, depending upon the circumstances of the fund at any given quarterly tender date.

That type of leverage is quite different from that used by more-aggressive hedge funds. As an extreme example, before its demise Long-Term Capital Management invested in assets worth more than $100 billion, supported by $5 billion of equity capital.

Mind you, I am not convinced that this ability should be a selling point for hedge funds! There is much to be said for the protections provided by the Investment Act of 1940. Long-Term Capital Management lost 84% of its value in a single calendar year. It would surprise me if an interval fund were to match that less-than-admirable feat.

Brand Management
You write, “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.” 

Ever heard of PIMCO? It runs an interval fund.

Fair enough; I asked for that. Yes, I have heard of PIMCO. I am also acquainted with an even-larger New York company called BlackRock, which manages its own interval fund. A few of the giants have indeed participated. (Although not Vanguard, Fidelity, or Schwab, as Wednesday’s article stated, nor American Funds, nor T. Rowe Price.) However, they haven’t pushed them very hard.

However, this is an item where reasonable people can disagree. In my judgment, the industry leaders haven’t promoted interval funds as aggressively as they might. Others may see the matter differently.

A Bargain, Or Not?
In terms of the costs of interval funds, you are correct that the average expense ratio is much higher than the typical active open-end fund or passive ETF. However, interval funds are actually helping to bring down the costs of investing in illiquid assets that have historically only been able to be accessed via hedge funds that charge 2% management fees and 20% performance fees.

There are two ways to view interval funds, or, for that matter, liquid-alternative mutual funds: 1) as cheap hedge funds, or 2) as pricey mutual funds. Morningstar believes that the latter approach makes the most sense. After all, interval funds and liquid-alternative mutual funds are sold to retail investors and therefore compete for shelf (and portfolio) space against mutual funds and ETFs.

It is certainly acceptable to regard interval funds as low-cost challengers to hedge funds. But, ultimately, I am not the one who needs convincing. The potential investors are those who must be persuaded. And to judge by the redemptions that have hit liquid-alternatives funds, they have some qualms. The appetite for higher-cost registered funds is limited.

However, these comments are based on today’s conditions. Should the great bull market cease and interval funds prove one of the pockets of resistance, they could quickly become popular. There hasn’t been much benefit in recent years from swimming against the current.

To conclude: My views have not changed since Wednesday. I still believe that, although interval funds have investment merit, their high costs (when compared with other registered funds) and relative obscurity work against them so that they are unlikely to become large potatoes. But ... I could be wrong.

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.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.