New Kid on the Block: Interval Funds

By Cameron Norris
For years, advisors have looked for new opportunities to bring clients increased returns while simultaneously reducing risk. This journey has led to numerous new financial products, and one of the newest players in this space – the Interval Fund. What is an Interval Fund and what prompted their introduction? What liability might they impose upon a Fiduciary/RIA? Finally, how might the E&O insurance contract treat such an exposure?

What is an Interval Fund – and What has prompted their introduction?
Interval Funds we established in the early 1990s but until very recently have been relatively few and far between. Aggregated information is limited on Interval Funds, but there are currently about 30-40 different Interval Funds to choose from. As of February 2017, Interval Funds had close to $9 billion in total assets; compared to traditional CEFs which have more than $400 billion. Some advisors in the industry believe that growth of Interval Funds has been because they are a quality replacement to traditional CEFs as advisors are preparing for the Fiduciary Rule to come down the pipeline.

CEFs have come under increased scrutiny for a few reasons; traditionally they have traded under IPO prices within a few months of inception, have high commission fees, and fees associated with launching CEFs typically get passed on the investor. If a new Fiduciary rule is established, it will have large implications around high fees, which likely will not mesh will with the traditional CEF IPO process. It is hard to say, if any, how the fiduciary rule will affect traditional CEFs but in 2016 20 new Interval Funds were launched, compared to only 9 CEFs . And in the first part of 2017, PIMCO made headlines launching their first Interval Fund, PIMCO Flexible Credit Income.

What is the Liability?
With the increase in the Interval Fund space in the last few years, what do these investments mean for risk? First, the limited liquidity of redemption windows can be problematic. Depending on the Fund, redemption windows can range from three months to annually, and last 2-3 weeks on average. During the redemption window sell orders are not calculated off the NAV of the day the order was placed. Rather, they are calculated after the redemption window closes. Since you cannot control the execution price, Interval Funds can have a significant downside risk as compared to traditional CEFs and other liquid funds. There are also often fees associated redeeming shares which can vary in cost and be as much as 2%. The redemption structure of Interval Funds also allows fund managers the flexibility to invest in more alternative strategies since they do not need to meet daily outflow demands of a traditional 40 Act fund.

Is the Interval Fund exposure covered by E&O/Professional Liability?
If a claim arises, how does the E&O insurance policy (contract language) treat the exposures created by an Interval Fund? Short answer, and the most important E&O educational key for an advisor… it depends.

Coverage applicability depends upon a respective underwriter’s contract language and/or how that language has been appropriately modified. Some E&O insurance contracts contain problematic exclusionary or limitation language within their insuring agreements that directly affect Interval Fund coverage applicability. While other underwriters, unknowingly, are insuring the exposure simply because their terminology is currently “silent” with no applicable exclusions.

Generally, Interval Funds are currently unknown to most underwriters. From an E&O underwriting perspective, since an Interval Fund is industry defined as a “40 Act” security, most underwriters, once enlightened, will view the exposure positively. That said, as Interval Funds possess limited liquidity and seem to be managed with more an alternative investment philosophy, down the road insurers may seek to modify their underwriting positions. As Interval Fund popularity grows, so may grow underwriters’ negative underwriting viewpoint/position.

The introduction of Interval Funds into an advisor’s asset model creates an imperative to proactively seek counsel from an experienced insurance broker dedicated to the RIA space. Remember, there are no “boiler-plate” insurance contract standards. Unlike most commercial forms of insurance that are governed by the Insurance Services Office, not so for Investment Management Errors & Omissions. Each underwriter issues their own, unique form with various terms, conditions, exclusions, limitations, definitions, etc. Buyer beware!

Resources:
http://www.morningstar.com/advisor/t/115148626/the-future-of-cefs-gets-dimmer-with-dol-ruling.htm
https://www.morganlewis.com/events/~/media/a09a6da1977d4e9abafa4c6b836e58bb.ashx
https://www.morganlewis.com/~/media/files/publication/outside%20publication/article/til-interval-funds-alternative-to-liquid-alternative-funds-part1-sept2015.ashx?la=en
http://www.morningstar.com/advisor/t/118783094/are-interval-funds-the-next-big-thing.htm


Golsan Scruggs is an insurance brokerage firm operating throughout the United States specializing in investment advisor E&O errors & omissions insurance (aka professional liability insurance) for RIA registered investment advisors. As one of the largest insurers of RIA firms in the U.S., we have a dedicated staff that understands the risks of the financial services industry and delivers superior results.  We make the underwriting process painless.