What Advisors Need to Know About Interval Funds

Since the global financial crisis, fund managers have explored new vehicles to tap into the private markets. A new wrapper aims to offer diversified opportunities.

But no investment opportunity comes without risk. These complicated wrappers pull from new opportunity sets and structures that might be unfamiliar to many advisors. When are interval funds right for a client?

Christian Clayton, PIMCO’s executive vice president of global wealth alternatives, joined the Big Picture in Practice to discuss interval funds.

“The idea behind these vehicles is to marry the flexibility to invest in private assets with retail distribution and a vehicle that is easy for advisors to use and clients to access,” he explains.

In this episode, Christian and our hosts delve into the potential benefits and drawbacks of the interval fund wrapper.

You can listen to this and other episodes of the Big Picture in Practice podcast by Morningstar on all major streaming platforms. You can keep up with the latest episodes by subscribing to our Big Picture in Practice Newsletter.

Apple Podcasts | Google Podcasts | Spotify | Amazon Music | Stitcher

Interval funds are unlisted closed-end funds with controlled liquidity. Like mutual funds and ETFs, investors can buy shares of interval funds on an ongoing basis. But unlike traditional funds, shareholders can only sell shares at fixed intervals—usually every three, six, or twelve months.

“By limiting liquidity on the redemption side, fund managers can access more private, illiquid opportunities than what they might be able to offer in a day-liquid mutual fund,” Christian explains.

Today, 94 US interval funds manage about $48.9 billion in assets, according to Morningstar data.

And they still have room to tap into private-market interest. Private equity firms manage $11.4 trillion in assets, while hedge funds hold another $3.6 trillion in assets, Cerulli Associates reports.

Non-traded REITs invest in real estate-related assets. Most focus on owning physical assets. They typically offer capped monthly liquidity. Unlike listed REITs, they won’t appear on an exchange, so they don’t have the same market price volatility.

Business development corporations focus on corporate loans to small- and mid-sized businesses. They are required by law to distribute at least 90% of their taxable income as dividends to shareholders.

Tender offer funds offer periodic repurchases of shares, like interval funds. However, this vehicle gives fund managers more discretion over how often they do tenders and at what amounts. Tender offer funds can also cancel repurchase events if they so choose.

Christian breaks down some of the risks and benefits of interval funds.

While some investors have always been able to access higher yields, these opportunities were limited to qualified purchasers. Private funds often come with higher expenses, high minimum investments, and complicated tax structures that rule out many investors.

Through interval funds, investors can tap into opportunities with different risk and return profiles than traditional investments. Fund managers can expand their options to mitigate downside risk, enhance income, or diversify revenue streams.

“The flexibility to source opportunities across that public and private spectrum can be a real benefit over a longer turn, given that ability to opportunistic to go to where we’re seeing the most attractive relative value,” Christian says.

Through interval funds, more investors can also access veteran private managers in niche asset classes or sectors. That means investors can outsource due diligence to experts with experience in the less-transparent private markets.

Interval funds began to grow in popularity in 2017 after the 10-year yields had fallen below 2%. Investors who were trying to generate yield or retirement income faced severe headwinds. They turned to interval funds for a potential source of higher yields against a low-yield backdrop.

Christian points to bank retrenchment as an emerging opportunity for interval funds.

“Our view is that the best way to generate income return over time is to play into a longer-term secular theme, with an opportunity set that we think persists,” Christian says.

However, most of the interval funds on the market are five years old or younger. We haven’t seen them through a full market cycle to understand how funds might perform in a recession.

Interval fund investors can only sell their shares at fixed times. They receive notice ahead of time with information on the pricing (at net asset value) and decision deadline. The repurchase offer amount is also set between 5% and 25% of the fund’s outstanding shares.

What happens when a fund can’t cover requested redemptions?

Most interval funds take a pro rata approach. If too many investors request redemptions, exceeding the limit, shareholders will only be able to sell some of their holdings in an interval.

With a gating approach, a fund might eliminate those repurchase activities completely. While most interval funds don’t take this tactic, periodic liquidity has become more common.

Christian notes that interval funds do come with a steep learning curve. Advisors and investors need access to educational content to understand the diverse strategies coming to market.

“There’s a lot more to come in testing this market and seeing how things play out,” he says.

Christian counsels advisors to partner closely with clients. He recommends reviewing portfolios and assessing where they need daily liquidity and where they could explore other options.

“What you'll tend to see is that when markets get tough and folks want liquidity, it’s the toughest to get because everyone else wants the same,” he says.

Education is essential. Firms are building out richer educational materials to support the decision-making process.

Today, most interval funds invest in private credit, whether in real estate or private loans. Christian believes that in the next few years, firms will build out more differentiated strategies across the private markets.

As lineups grow more complicated and harder to choose from, Christian thinks that the simplest private-market vehicles will drive the most growth.

“I think there’s a lot more room to run over the coming year,” Clayton said. “We’ll continue to see innovation and compelling solutions come to market.”