The Hot New Thing in Funds Is Higher Fees and More Restrictions

(Bloomberg Businessweek) -- The hottest thing in investing for the past decade has been low-cost exchange-traded funds, which investors can hop in and out of any time the market is open. So here’s a strange proposition: How about buying a fund with higher fees and restrictions on when you can take out your money?

Some big asset managers think investors are ready to take that offer. Pacific Investment Management Co., Blackstone Group, Ares Management, and even BlackRock—the ETF giant—have all introduced “interval funds” in the past two years. Interval funds restrict total withdrawals to a range of 5% to 25% of fund assets in a specified period, such as once a quarter. James Seyffart, a Bloomberg Intelligence analyst, likens them to the Hotel California—with a twist: “You can only sometimes leave.”

What’s in it for investors? Fund companies say interval funds have a chance to deliver higher returns by capturing what’s known as the illiquidity premium. Because they don’t have to be able to redeem shares on a moment’s notice, interval funds can build their portfolios on thinly traded commercial mortgages, loans, private equity debt, and other high-yielding, high-risk assets usually available only to wealthy individuals and institutional investors. Conventional mutual funds can also buy some of the assets interval funds hold, but they have limits on how far they can go. “Our goal has been to democratize access to alternative strategies,” Eric Mogelof, Pimco’s head of wealth management, says about interval funds.

That access doesn’t come cheap. For example, the Pimco Flexible Credit Income interval fund has an expense ratio of more than 3% of assets per year, or about three to four times as much as the firm’s most popular bond mutual fund, Pimco Income, depending on the share class. Interval funds’ costs are steeper because it’s expensive to pick and trade the assets they buy, according to Mogelof.

There were 56 interval funds with a total of $25 billion in assets as of May 31—that’s twice as many funds and twice as many dollars as there were in the category two years ago. Investors have been drawn to the funds in part because low interest rates have dragged down the return on more conventional investments. Pimco Flexible Credit Income, whose portfolio includes mortgage-backed securities, Italian bank debt, distressed utility debt, and consumer and student loans, has earned an annualized 8.4% since its launch in February 2017. That compares with 5.4% for the liquid Pimco Income fund over the same period.

Other interval funds include one from Pimco that specializes in junk-grade municipal bonds and a new BlackRock fund that invests in corporate debt. Interval funds are mainly sold through intermediaries such as advisers. “Retail investors without financial advisers that are point-and-clicking to buy may not understand what they’re getting,” says Evan Stoff, a senior research analyst with Vivaldi Asset Management in Chicago, which uses interval funds. He says the funds’ main value is to add diversification to a broader portfolio.

While restricting redemptions can reduce volatility, interval funds can still lose money. The largest interval fund is the $4.8 billion Stone Ridge Reinsurance Risk Premium Interval Fund, which invests in insurance-related assets. It lost almost 9% in the fourth quarter of last year after insurers were forced to cover damages from California’s wildfires, according to Interval Fund Tracker, a website that follows the funds. Stone Ridge President Ross Stevens didn’t respond to requests for comment.

Some of the assets interval funds tend to buy may be getting riskier. One example is leveraged loans—or loans to businesses with less-than-stellar credit. They’ve expanded in recent years to a $1.2 trillion market, and terms on the loans have gotten looser as yield-hungry investors have poured in. Federal Reserve Chairman Jerome Powell recently said he doesn’t think these loans pose a threat to the financial system, but he is concerned that a chunk of them are held by regular mutual funds that have to meet investors’ demand for liquidity. “Widespread redemptions by investors, in turn, could lead to widespread price pressures,” Powell said in a May 20 speech, “which could affect all holders of loans.” Including, presumably, some interval funds.

Then again, such disruptions can also create opportunities. Michael Arougheti, chief executive officer of Ares Management Corp., says his firm’s interval fund bought discounted assets in 2018’s volatile fourth quarter, when managers of more liquid funds had to sell to cover outflows. “As the old expression goes, liquidity’s always there when you don’t need it,” says Arougheti. “And then, when you need it, it’s never there at the price you want.” Interval funds are designed to depend less on liquidity but only work for those investors who can afford to give some of it up.

To contact the editor responsible for this story: Pat Regnier at pregnier3@bloomberg.net

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