Interval Fund Mechanics: Using Lock-up to Limit Risks

There are several reasons portfolio managers recommend interval fund products to their investors. The biggest benefit is that interval funds offer access to higher yielding securities, while avoiding management difficulties commonly associated with daily-redemption corporate-debt funds. The lock-up feature keeps investors from making hasty withdrawals during market volatility. Portfolio managers can then assist their clients in making decisions that are best for the long term. 

What is an interval fund?

Regulated under the Investment Company Act of 1940, an interval fund is similar to a mutual fund and a fairly new product in the alternative investment arena. An investor can fund it on a daily basis if desired, redeem limited amounts at regular intervals and invest in private and public assets at the same time. All of these features offer significant advantages over traditional mutual fund products, including higher yields and non-correlation to equities.

What kinds of assets are in this type of fund? 

Regardless of the particular asset focus or strategy, interval funds often offer retail investors access to underlying investments that otherwise are for institutions only or have prohibitive minimums. Until recently, real estate and syndicated leveraged loans comprised the bulk of assets in interval funds. A new breed of interval funds is coming on the scene. Now, interval funds offering public and private corporate debt in the asset mix provide better yielding alternatives to the old standbys.

What does “lock-up” mean for investors and fund managers?

Illiquidity is generally a burden for investors, one for which they should demand a better expected return. An interval fund’s regular redemption structure represents a compromise for investors’ and the manager’s interests. For investors, it means that they are able to withdraw funds at regular intervals only, but not on demand. This feature acts to preserve the fund and its earning power for everyone’s benefit in the longer term.

For the fund manager, it ensures the fund’s long-term viability and prevents managers from becoming a forced seller if too many investors withdraw funds simultaneously. The lock-up feature successfully balances the ability to generate higher returns with limited liquidity.

Further, interval fund lock-up programs can benefit investors because they keep some discipline on the sponsor.  An interval fund cannot suspend its repurchase program without shareholder approval. This distinguishes it from the redemption programs of REITS and BDCS, which are always suspended at the worst possible times.  

How risky are the new interval funds?

Interval funds take advantage of swings in value to improve earnings and preserve the fund with lock-up periods to limit investor selloffs. As a result, they minimize the risk of having to decrease holdings to meet immediate demands for redemptions. However, it takes a high-quality manager to properly take advantage of the swings. 

What should investors be thinking about before investing in an interval fund?

Each fund will have its own goals and investment philosophy. However, consider the following before recommending an interval fund:

* Understand the type of assets in the fund and the risks associated with them.

* Inquire about which asset type(s) represents the majority position. 

* Ask about liquidity in the fund. A relatively high level of liquid assets ensures that the fund will be able to meet investors’ requests for withdrawals at the specified, regular intervals, but an allocation weighted too heavily to liquid assets may limit returns.

* Ensure that pricing transparency exists. Transparency improves with more liquidity.

* Note conflicts of interest; can the fund invest in other funds owned or managed by the same sponsor?

Interval funds were designed to minimize the risks and maximize returns to investors. Depending on the underlying strategy, they seek to balance yield, growth, asset diversity and liquidity.