Don't forget the downsides of interval funds, Morningstar warns

A new analysis from Morningstar raises some red flags for advisors and investors exploring interval funds as a pathway to private market exposure.

While these vehicles have surged in popularity as an alternative to traditional mutual funds or ETFs – Morningstar’s own research found interval funds held $80 billion in AUM as of May 2024, growing almost 40 percent per year in the decade up to that point – the report warns of several embedded risks that may lurking under the hood, especially when it comes to fees and leverage.

It’s worth noting at this point that Morningstar recently announced plans to roll out a new Medalist rating system geared toward semiliquid investment products, including interval funds.

Unlike mutual funds, interval funds restrict redemptions but not inflows, allowing managers to hold less-liquid positions that may offer higher yields. That feature has helped them gain traction among income-hungry investors.

However, Morningstar points to structural incentives that could align managers’ interests more closely with fee maximization than with long-term performance for shareholders.

“Not only are interval funds more expensive and harder to redeem than exchange-traded funds or mutual funds, but some also have fees that are easy to miss and hard to understand,” the report said.

One of the key concerns involves performance fees based on income, not total return. In certain cases, managers collect a cut of income generated above a specific threshold – even if that yield is achieved using methods that introduce significant credit or liquidity risk.

According to Morningstar, “some interval funds charge performance fees on the income component of their total return, though it arguably does not take much investment skill to hit an income target.”

To meet those targets, managers may load up on lower-rated high-yield bonds or take on leverage. While such tactics can juice yields, they also amplify risks and fees.

The use of leverage can be particularly misleading to investors, as the income hurdle is typically calculated based on contributed capital, not the total assets deployed counting debt. This allows managers to boost reported yields – and their incentive fees – without necessarily improving net returns.

Even more, some interval funds apply management fees to total assets, including borrowed funds. “This can encourage managers to leverage their portfolios even if the borrowing costs are high and the expected returns of the assets they buy are low,” Morningstar noted. “They earn more fees off the larger total asset base.”

In the analysis, Morningstar modeled several scenarios showing how fee structures may eat into investor gains – similar to how hedge funds may have disappointed many investors over decades.

One example showed a fund generating a 10 percent gross yield but returning only 7.36 percent to investors after accounting for fees – an outcome comparable to what some high-yield ETFs offer at a fraction of the cost.

The risks become more pronounced in down markets. Leveraged exposure can turn modest losses into steeper drawdowns, while management and incentive fees continue to accrue. In lower-return environments, the imbalance between manager revenue and investor wealth creation may widen further.

“There is limited evidence of manager skill over long periods,” Morningstar concluded. “It seems more likely that asset managers with lofty fee structures tied to leverage will be prone to borrow capital regardless of their ability to earn excess returns with that capital.”

For advisors, the report serves as a reminder to scrutinize not just a fund’s yield, but how that yield is generated – and at what cost.