How to Size Up a Semiliquid Fund

Bryan Armour, Director of ETF and Semiliquid Research at Morningstar, covers the funds built to hold private market assets. That access works because the money cannot leave on demand, which makes the redemption terms worth as much attention as the exposure.

We sat down with Armour to talk through which clients these funds suit, what separates the best managers, and how to compare costs when leverage is involved.

Q: What can a semiliquid fund do in a client portfolio that a liquid wrapper can’t?

A: Semiliquid funds are designed to manage illiquid assets. A mutual fund or ETF receives inflows or outflows daily but they can’t quickly buy or sell illiquid holdings. Those assets can end up dictating portfolios more than the manager during heavy inflows or outflows. Semiliquid funds are designed to limit rapid outflows by only offering periodic redemptions up to a capped amount. The most common structure is quarterly redemptions for up to 5% of the fund’s assets. If investors collectively request more than 5%, then redemptions would be prorated.

For example, Baron First Principles ETF RONB is currently saddled with a 41% stake in SpaceX. Offering SpaceX exposure pre-IPO began as a selling point, and as investors rushed in they were able to purchase more. Once hit with outflows, the ETF has become highly concentrated because it can’t sell its SpaceX shares that are locked up after its IPO. All outflows must be paid by selling other holdings, causing SpaceX’s weight to swell.

Q: What kind of client is a good fit for a semiliquid fund?

A: Most types of investors have the option to invest in semiliquid funds. Clients that can hold the investment for years are ideal because there’s no guarantee they can get all their money back quickly.

Investor objectives play a large role in whether a semiliquid fund fits in their portfolio. They tend to be more expensive than mutual funds and ETFs, potentially much more so, but they offer different exposures. For example, direct lending private credit funds offer floating rate loans with high credit spreads relative to traditional corporate bond exposures. Floating rate exposure is great when interest rates are rising, and wider credit spreads can add a significant increment of income for investors seeking it. These funds often use leverage, which enhances income in stable markets. The tradeoff is high risk during down markets. 

Likewise, private equity give investors access to different companies or strategies than exist in public markets. For example, AI companies like Anthropic and OpenAI have created significant wealth in private markets and have yet to go public.

That said, the diversification benefits are overstated. Direct loans and private companies are subject to many of the same macroeconomic risks as corporate bonds and public companies.

Q: What’s the first thing you look at when evaluating a semiliquid fund?

A: Understanding the strategy and whether it aligns with your objectives are step number one. Step two is kicking the tires on their redemption program and how they manage liquidity in the fund.

Q: What do the best semiliquid managers do that others don’t?

A: They master the tricky art of balancing risk and reward. Handling liquidity risks is key to investor outcomes, yet no one wins awards for it. At the same time, you want a semiliquid fund that makes full use of the fund’s structure by using leverage that fits the underlying strategy and aligning its aggressiveness with appropriate levels of liquidity for investors.

Certain managers also have top-tier connections to build better deal pipelines than peers and deep resources to maximize performance, like well-staffed workout teams with deep expertise to optimize recovery of defaulting loans.

Q: Expense ratios in this space aren’t always comparable between funds. What should an advisor look at to get a true read on cost?

A: Understanding the fee structure is key. Incentive fees, in particular, can impact costs significantly, though they can be (but not always) aligned with investors such that fees go up when the fund performs well.

Prospectus expense ratios are less likely to tell the whole story than in mutual funds and ETFs. In response, Morningstar created new Semiliquid Fund Cost Estimates that add standardized assumptions to give investors a more reliable expectation of the long-term costs of owning the fund. This standardization also makes funds easily comparable, and investors can get a clear idea of the hurdle those fees set to outperforming public market alternatives available in mutual funds and ETFs.

Q: Leverage can complicate any cost comparison. How do you weigh fees against structure when two funds use it differently?

A: Leverage comes at a cost referred to as ‘interest expense’ in SEC filings. Simply removing interest expense from the expense ratio allows investors to compare fund fees with varying levels of leverage. Morningstar’s Semiliquid Adjusted Cost Estimates strip out interest expenses to make comparisons readily available among funds with differing leverage profiles.

Q: How should an advisor set client expectations around liquidity from the start?

A: Advisors need to clearly state the fund’s limitations on liquidity, why those limitations exist (e.g., because they can’t easily sell holdings to meet redemptions), and what benefit a semiliquid fund confers to make that liquidity tradeoff worthwhile for the client. Morningstar’s Direct Advisory Suite offers advisors the data and analysis to measure the liquidity of funds and talking points on how to have constructive conversations with their clients.