Ask Your Advisor These Questions Before Investing in Semiliquid Funds

Key Takeaways

• A semiliquid fund is a fund that doesn’t offer daily liquidity like you would get in a mutual fund or an ETF, but also doesn’t require you to lock up your money for years at a time.
• Typically, 5% of the fund’s assets will be available for redemption quarterly.
• Private credit is most popular with advisors right now for semiliquid funds.
• Liquidity crunches could be a challenge with semiliquid funds. Leverage is also a risk.
• Semiliquid funds cost more than mutual funds or ETFs, especially if there’s a lot more incentive fees.
• In general, ones that are more equity-focused haven’t kept up with the S&P 500, but the credit ones have done a pretty good job of delivering higher income.
• In our ratings, we put extra weight on the parent company because we think there is a degree of extra trust that you need with these vehicles.
• Funds that didn’t rate well tended to have poor track records and high fees.
• One of the key questions to ask your advisor about semiliquid funds is about the plan to rebalance.

Susan Dziubinski: I’m Susan Dziubinski with Morningstar. There’s been a lot of talk in the financial media lately about the convergence of public and private markets. And as a result, interest and investment in semiliquid funds—which make less liquid private assets more accessible to individual investors—is on the rise. Should you consider adding semiliquid funds to your portfolio? How do they work ? And what are their risks? Joining me to discuss these and other questions investors should ask their advisors about semiliquid funds before investing in them is Jason Kephart. Jason is a senior principal with Morningstar’s multi-strategy asset ratings team. Great to see you.

Jason Kephart: Thanks for having me.

What Are Semiliquid Funds?

Dziubinski: All right, let’s start at the beginning. What are semiliquid funds?

Kephart: Semiliquid funds go by a lot of different names. Some people call them evergreen, some people call them perpetual. There’s a few different vehicle types that fall under this. But in general, what we’re talking about is a fund that doesn’t offer daily liquidity like you would get in a mutual fund or an ETF, but also doesn’t require you to lock up your money for years at a time, like traditional drawdown funds, which were the most common way people access private markets in the past.

Interval Funds vs. Semiliquid Funds

Dziubinski: OK, so you mentioned that they’re called a bunch of different things, semiliquid funds. And you know, I’ve also heard about interval funds. So are interval phones funds and semiliquid funds the same thing? Are there different types of semiliquid funds? Explain that?

Kephart: Yeah, there are four, there are basically four main types of funds we think of as semiliquid. And when we’re talking about semiliquid, in this context, we’re talking about the semiliquid funds that are available to nonqualified purchasers. We’re thinking about like the democratization of private markets, which it gets called often. And that means your interval funds, which are generally available to anyone through a financial advisor, tender offer funds, which are also generally available through a financial advisor, nontraded REITs and nontraded BDCs, which are not funds but essentially function as a fund. Non-traded REITs focus, as you would guess, on real estate investments. And BDCs are business development companies. This is kind of the direct lending, the private credit that everyone’s talking about. There’s like a requirement that 70% of the portfolio has to be loans to middle market companies to qualify for the tax status of a BDC, which gives some advantages to the shareholders.

Types of Liquidity for Semiliquid Funds

Dziubinski: Got it. So let’s talk a little bit about liquidity. And what are the types of liquidity related questions an investor should be asking their advisor? If the advisor is approaching him or her about considering semiliquid funds.

Kephart: Yeah, it’s like one, I think, big picture, how much liquidity do you need in your portfolio? It’s probably true that 100% of people don’t need 100% of their portfolio to be 100% liquid 100% of the time. But you really need to think about how much illiquidity can I really bear? Longer-term goals, you probably can bear more. Shorter-term goals, you probably should be as liquid as you can. But in general what we see with these funds is they’ll typically be like 5% of the fund’s assets will be available for redemption quarterly. That’s the most common thing we see.

Why Advisors Are Loving Private Credit

Dziubinski: So now, as you sort of alluded to, semiliquid funds are really a wrapper that give investors access to some sort of portfolio of less liquid securities. So you talked a little bit about some of the types of investments that are held in these funds. Are there particular pockets of that that are more or less popular right now with advisors?

Kephart: Right now, private credit is getting all the buzz. We’re seeing a lot of flows that way. Funds like Cliffwater, Blackstone Private Credit are really taking in a lot of money. And it really is the high income you can get from private credit right now relative to where yields are, particularly as we enter what most believe will be a rate-cutting cycle.

How Liquidity Crunches Could Be a Challenge With Semiliquid Funds

Dziubinski: Right. So, staying on the liquidity topic for a minute, have we seen any liquidity crunches with any semiliquid funds—what can investors expect if, say, they want to get out and some other people want to get out at the same time, too?

Kephart: Yeah, I think that’s the challenge is if everyone wants to get out at once, you’re not going to be able to get your full redemption probably. What’s likely going to happen is you’re going to get prorated. And so say both of us, as for $10, we might both get $5 back. And then we have to reapply the next month. We have seen some liquidity stress in real estate. Some firms have managed that much better than others. Blackstone Real Estate Income made a lot of headlines, but they managed their liquidity very well. They met their 5% redemptions quarterly as promised, and they made it through the other side, and they’re no longer in a proration period.

Other real estate investment trusts like Starwood have had to cut their 5% quarterly redemptions to 1%, which is not a really good investor outcome. Then we’ve seen interval funds like Bluerock Total Income Real Estate, that is now trying to list as a listed closed-end fund, which means investors will no longer be able to transact at NAV. They’ll have to transact the shares on the open market. And again, if everyone’s trying to get out at once, that could be a lot of downward pressure on those prices. So again, that’s not really the investor outcomes. we’re hoping to see in these funds.

How Advisors Are Talking About Semiliquid Funds to Their Clients

Dziubinski: Now, obviously, investors need to understand what their semiliquid fund is investing in. They need to understand when they can tap into it, what amount they can take out when they can tap into it. But then let’s talk a little bit about how they fit into a broader portfolio.

Now, are advisors, when they’re talking about semiliquid funds with clients, are they generally talking about them as completely separate asset classes, or if you’re talking about a semiliquid fund that focuses on private credit, are they talking about it in context of the client’s bond sleeve? How are they communicating about these?

Kephart: I think it varies a lot. I think generally a bucket term here is like alternative, though really credit is credit. Private equity is an equity. These are companies that are subject to the same economic risks as their public counterparts. So we don’t think you should think of them as like true diversification in that sense, though the volatility can be a little understated, which can, may give you an appearance of diversification. But I think there’s definitely a lot of different ways to do it. But you really want to think about like, what are you adding to the portfolio, and how are you managing the overall risks? Because everything’s going to have trade-offs.

Are Semiliquid Funds More Expensive?

Dziubinski: So let’s unpack costs here, Jason. Are semi—I would assume that—semiliquid funds might be more expensive than, say, the standard mutual fund or ETF. What might be sort of a typical range?

Kephart: Yeah, what we’ve seen is like around 2% or higher, especially there’s a lot more incentive fees, which are extra fees paid to the managers if they hit certain return targets. Like in an income fund, it’s very popular to see a 12.5% incentive fee. And that’s what you should expect to pay, because income is kind of pretty predictable. So you should kind of expect that. And those fees can weigh. They also use a lot of leverage, though, which can kind of make up for it. But I think if you’re used to the fees we’re seeing in mutual funds and ETFs, particularly with all the downside pressure we’ve seen, we have not seen that yet in alternatives, the semiliquid funds., but I think it’s very early days. And I think for these things to really gain traction, we’re going to start to see some fee pressure. But I think that it’s not going to happen tomorrow.

Risks of Semiliquid Funds

Dziubinski: Now, you mentioned leverage. So let’s talk a little bit. What are some of the other risks besides, of course, liquidity risk, that an investor might encounter with a semiliquid fund?

Kephart: Yeah, there’s definitely leverage, which magnifies returns and magnifies losses. So you need to be aware of that. But I think the liquidity is really the key risk because the real challenge would be if you have everyone trying to get out at once and the managers aren’t able to manage through that liquidity, they might have to transact some really illiquid securities at prices that are much lower than what’s marked on the balance book. And that’s kind of what’s going on with like what we’re seeing with the Bluerock fund that’s trying to list as a closed-end fund to avoid having to force those transactions. So the real risk is that once you have all this stampede of the exits, it kind of becomes like a downward spiral. So that’s kind of what I would really be concerned about. And that’s the hardest thing to predict is: How is everyone else in the fund going to behave?

Performance of Semiliquid Funds

Dziubinski: Right. So let’s talk a little bit about performance. Can you talk a little bit about how semiliquid funds in general have performed? Have they historically compensated for that liquidity risk and leverage and any other risks that they might have?

Kephart: I’d say a lot of it’s really new, but in general, the funds we’ve seen that have longer track records, it varies, as you’d imagine, the ones that are more equity-focused haven’t kept up with the S&P 500, but the credit ones have done a pretty good job of delivering higher income. We haven’t really seen the issues there that we’ve seen in real estate, but then again, it’s been kind of a golden period for private credit. They are floating-rate. So rates going up was actually a good benefit for them. And default risks in credit have been really low. So you haven’t really seen the same kind of shocks to the private credit market in the most recent period. So it’s been a great time for them, and they have done a pretty good job on average.

Morningstar’s Methodology for Rating Semiliquid Funds

Dziubinski: Morningstar recently began rating some semiliquid funds. Talk a little bit about the methodology that Morningstar uses for these ratings. It differs a little bit from how our Medalist Rating works for mutual funds and ETFs, right?

Kephart: A little bit. I’d say the key difference is we’re putting extra weight on the parent company because we think there is a degree of extra trust that you need with these vehicles given the illiquidity, the lack of transparency. You really need to make sure the fund firm behind it is well-resourced and able to manage through things. The thing that really helped Blackstone’s real estate. is that the company behind them is a pretty strong company, and they were able to manage through this volatility in a way that a lot of others wouldn’t be able to. So that’s key. So the Parent rating is higher, it’s 25%. The People rating is 25%. And then our Process rating is 50%. And that’s where we consider things like liquidity management, which we think is really the key thing to the success of these funds.

Morningstar’s Top-Rated Semiliquid Funds

Dziubinski: So Jason, of the six or so semi-liquid funds that Morningstar has rated so far, are there any sort of standouts in the bunch?

Kephart: Yeah, I’d say Pimco Flexible Credit Income is one that kind of stood out to us. What we really felt comfortable there is it has a decent track record. It launched in 2017. So we’ve been able to see it managed through multiple market environments, both how they use leverage and how they manage liquidity. And that kind of gave us a little bit more comfort. It’s also managed by Dan Ivascyn, who we think is a really skilled fixed-income manager. And Pimco, we think is a really good steward of investor capital. So we felt just a little bit more comfortable there.

What Traits Lowered Semiliquid Funds’ Rating

Dziubinski: Now for the semiliquid funds who maybe didn’t get such great Medalist Ratings from Morningstar, is there anything that sort of united them, any traits they had in common that maybe made us a little bit more nervous about them as investments?

Kephart: Yeah, I would say a common thread was either they had very short track records, and so we really haven’t seen that management through multiple market cycles. And when you have a new fund, it’s hard to know exactly what you’re going to get, even when the manager says all these great things, we need to see it in action first, before we’re really going to have confidence. I’d say that was a common theme. And then also, we talked about the fees can be very high. Some of the funds we looked at, the fees were a bit prohibitive, and that kind of held us back, too.

Ask Your Advisor These Questions Before Investing in Semiliquid Funds

Dziubinski: So then lastly, Jason, are there any other questions that if an investor is being approached by his or her advisor, “Hey, let’s talk about how some of the liquid funds might work in your portfolio.” Any other questions to really sort of get your arms around besides what’s the liquidity look like? What’s it invested in? Is there leverage? Anything else we’re not looking at? Oh, and what does it cost?

Kephart: Yeah, I think the other key thing is what’s the plan to rebalance? Liquidity doesn’t just mean getting your money back for withdrawal. But if there’s a period where public stocks and bonds have a drawdown, your semiliquid fund is going to grow bigger, but you probably want to be able to pull from that to invest in what’s gone down, buy low, sell high. But with these funds and the limited redemption periods, that might not always be very easy. So I do think having a rebalancing plan and how you’re going to think about that is paramount because what we’ve seen is whatever your starting allocation is, it’s very easy to go up from there. It’s not very easy to go down. So whatever your starting allocation is, you’re kind of married to that. So if you’re thinking about dipping a toe in, if you’re alts-curious, maybe start with a small allocation, get comfortable with those redemption windows, and build up comp, build up to your full allocation over time.

Dziubinski: Well, thanks for your time today. This was really interesting, Jason.

Kephart: Thanks for having me.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch Ask Your Advisor These Questions Before Investing in Derivative Income ETFs for more from Jason Kephart and Susan Dziubinski.