It seems like every year some new and complicated type of investment appears to tempt investors. Interval funds came on the scene a few years ago, and they boast the likelihood of comparatively high returns -- yet they also come with some significant drawbacks that may cancel out the benefits.
What is an interval fund?
An interval fund is a type of closed-end fund, meaning that the fund is not required to buy back shares whenever shareholders wish to sell. Interval funds typically offer to redeem shares on a set schedule -- it could be once a year, once a quarter, or some other interval as disclosed in the fund's prospectus. These guaranteed opportunities to sell back shares make interval funds a bit more accessible than many closed-end funds. However, unlike most closed-end funds, interval funds are generally not traded on the public exchanges, such as the New York Stock Exchange. As a result, it's much harder to sell those shares to anyone other than the fund itself.Fund shares are offered at a price determined by the fund's net asset value divided by the number of outstanding shares.
The good news about interval funds
As a type of closed-end fund, interval funds are allowed to choose less liquid investments than a standard mutual fund. As a result, interval funds on average enjoy notably higher returns than open-ended funds. Because interval fund managers have a wider range of investment options, these funds don't usually move up or down in sync with the stock market as a whole, so they can make a great diversification option for someone with a lot of stock holdings. And holding shares in an interval fund can give you access to investments that would normally only be available to institutional investors.
The bad news about interval funds
The high returns that interval funds often enjoy go along with comparatively high fees. Because interval funds can invest in a wide array of assets, their managers possess unique and valuable skill sets -- and thus they command a higher salary. Taking advantage of those unusual investment opportunities can also be expensive, generating yet more fees as those costs are passed on to shareholders. Interval funds have expense ratios (the cost of running the fund compared to its value) as high as 3%. By comparison, the typical expense ratio for an actively managed open-ended mutual fund is 1.5%, and the typical expense ratio for an index fund is 0.25%. And when an interval fund buys back your shares, it can tack on a redemption fee of up to 2% of the proceeds. All those extra fees can eat up the extra returns you're making and then some. Also, since you have to wait to sell your shares until the fund agrees to buy them, an interval fund is a lot less liquid than a stock investment. If you need to sell some shares in a hurry, you're out of luck. Minimum investment requirements for interval funds are usually higher than those of standard mutual funds -- sometimes much higher.
The bottom line
An interval fund may be a good investment for you if you're looking for a way to diversify your holdings and don't require high liquidity. However, before you buy into such a fund, you should really dig into the fee information and compare it to the returns you can expect to make (remember that past performance is no guarantee of future results). Since fees can vary widely across different funds, one fund might be a great deal, while another might turn out to be an expensive ripoff. If you're not sure what to look for, show the fund prospectus to a trusted financial advisor. And if you're still unsure what fees you'll be charged or what the investor requirements are, walk away. Investing in something you don't understand is a surefire way to lose your shirt.
The Motley Fool has a disclosure policy.