Assessing the benefits of open-end alternative investments

Comparing characteristics of open-end and closed-end funds

Alternatives investments have evolved from optional to essential allocations in a portfolio. Asset managers are meeting this growing demand from a wider range of investors with an increasing variety of fund offerings.

For individuals or investors who are new to alternatives, open-end funds—also known as “evergreen” or “perpetual life” funds—offer characteristics they may find attractive, especially compared to closed-end funds.

In closed-end funds:

• Investors commit capital that is called in installments by the fund as the managers make investments over the coming years.
• As value is created in the portfolio and positions are sold, the fund eventually begins to distribute capital back to investors until the fund is closed.
• Investments tend to be in non-core assets, such as private equity, that offer a high risk/reward opportunity; minimum commitments are relatively high.
• During the lifecycle of the fund, capital is locked up and investors must hold capital that is waiting to be called in highly liquid investments.
• Strategies with a primary goal of capital appreciation, such as private equity, are a good fit because general partners have time to make necessary operational improvements before a position is exited.

In open-end funds:

• Strategies can continuously take in and invest capital—the funds do not have fundraising cycles and predetermined end dates—which generally eliminates the “J curve” effect¹ observed in closed-end funds.
• Capital is immediately invested at the current net asset value (NAV) of the companies in the fund and may be invested across vintages; closed-end funds invest in just one vintage.
• When positions are exited, the proceeds are reinvested in the fund; clients are fully invested at all times, a key distinction vs. closed-end funds.
• The terms for investor redemptions vary, but generally the funds are considered more liquid than closed-end funds and investors can request redemptions during predetermined windows.
• Investments tend to be core assets, such as private credit, or core-plus assets, like core real estate, infrastructure, transportation, that provide greater liquidity and a more balanced risk-reward approach than closed end funds. Some managers are beginning to offer access to other strategies, such as private equity, through these vehicles.
• Strategies with income-driven returns, which often invest in higher-quality, yield-oriented, stabilized assets (such as core real estate, infrastructure and transportation), tend to be a good fit.
• Minimum investments are generally lower and investors pay performance fees on a regular basis. This different from closed-end funds, where performance fees are only paid once gains are realized.

The characteristics of these funds, particularly around cash flows, lead to some important differences in how investors should assess open-end funds and how they can meaningfully compare them to closed-end options.

Choosing appropriate performance metrics

Investors may quickly notice that alternatives vehicles use different metrics to measure performance: closed-end funds typically use an internal rate of return (IRR) while open-end funds use time-weighted returns (TWR)—essentially the same way open-end mutual fund performance is calculated. While the metrics are appropriate for each type of vehicle, they cannot be used to compare the funds to each other in absolute terms. A quick look at how each metric is calculated helps explain why this is the case. However, a useful metric, net multiple of invested capital (MOIC), is a solution for comparing performance across different types of funds.

IRR, also known as money-weighted return, is the standard measure of performance for most closed-end alternative funds. IRR calculates the performance of a fund by taking into account the size and timing of cash flows into and out of a fund (capital calls and distributions) and the current value of the assets (net asset value).

For closed-end, vintage funds that typically invest in non-core assets, such as private equity, IRR is a relevant metric because of the importance of cash flows during the fund’s lifecycle and some ability of the general partner to manage the timing of capital calls and distributions.

TWR is used to measure performance in open-end alternative funds that invest in core and core-plus assets. TWR assumes all cash flows are invested at the beginning of the period and then calculates the compound rate of growth over a specified period. This method is appropriate for open-end funds, where managers have less control over the cash inflows and outflows, which are also less significant to assessing the underlying performance of the fund.

MOIC presents a solution for comparing closed-end and open-end funds by looking at the ending value of the investments in a fund (including any asset sales or distributions) relative to how much was invested over a given time period. MOIC resolves the issue of how to consider cash flows by simply comparing total capital invested over a defined period of time to the value of the investment at the end of that period.

Exhibit 1 shows how three investments can have the same MOIC over a 10-year period but very different rates of return, due to variation in the timing and calculation of cash flows.

• Scenario 1: A closed-end fund deploys capital slowly in the first few years but then distributes capital relatively quickly, leading to a 19% IRR.
• Scenario 2: A closed-end fund has the exact opposite pattern of cash flows as Scenario 1; it deploys capital relatively quickly with distributions skewed toward the later years, resulting in a meaningfully lower IRR of 11%.
• Scenario 3: An open-end fund accounts for the capital invested up front and then calculates the increase in NAV over 10 years, resulting in a TWR of just 7%.

Yet, at the end of the 10-year period, investors would have achieved the same result: a net MOIC of 2.0x, doubling their money.

This result brings up a related question: Is it possible to approximate the level of IRR vs. TWR to yield the same MOIC? We leveraged a relatively standard cash flow pattern for closed-end funds to build a multi-vintage program where distributions from previous vintages get reinvested in later vintages over a 10-year period and found a rule of thumb: IRR = 2*TWR (Exhibit 2). The differential is largely attributable to the importance of the timing of cash flows and the J-curve effect in closed-end funds.

A closer look at returns across funds

A first step toward understanding open-end funds is to be able to compare their performance vs. closed-end funds and net MOIC makes this possible. A closer look at the way open-end funds operate vs. closed-end funds exposes more potential performance benefits, particularly the ability to invest capital immediately and perpetually.

The continuous investment in open-end funds allows returns to compound over time, which is important for generating long-term sustainable returns in core and core-plus funds. Being as fully invested as possible, including through actively reinvesting income distributions, can have a meaningful impact on outcomes; it can potentially generate higher long-term returns and can be used to actively re-position the portfolio to capture high-conviction views.

Once again, net MOIC can be useful, this time to show how reinvesting income, rather than distributing it, may lead to higher compounded returns—and by a widening margin—over time (Exhibit 3).

The benefit of being fully invested is also implied in this analysis, which brings up an important comparison with closed-end funds and the use of IRR. While investors commit capital to a closed-end fund during the fundraising process, that capital is not immediately invested; it is called and deployed in stages as the fund finds attractive investments.

This process means that the fund is not always fully invested, which has a couple of implications for investors comparing returns across funds. First, the closed-end fund will lose out on some potential compounding of returns. Secondly, a well-known flaw in the IRR calculation is that it does not account for the fact that capital not yet called is not earning the fund’s IRR but is typically parked in lower-returning, safe investments.

Measuring volatility is also challenging

In addition to the challenge of measuring performance in alternative investments, investors may also find it hard to get a true picture of volatility. Private investments have an inherent “smoothing effect” because returns are often calculated based on appraisals of valuations and with a time lag. To better approximate “true” volatility, investors need an approach that mitigates the impact of prior valuations on current valuations.

Calendar year data may better capture economic volatility, given that the data includes at least one appraisal per year on each of the assets in the underlying portfolios. Alternatively, using a forward-looking approach that adjusts for appraisal smoothing, which is the approach used in J.P. Morgan Asset Management’s Long-Term Capital Market Assumptions (LTCMAs), may be more appropriate in constructing multi-asset portfolios.

When adjusting for the non-normal return distribution of alternative assets, using an approach that incorporates downside volatility can be helpful.²

Making a well-informed decision

Closed-end and open-end funds both have a place in an investor’s portfolio. They offer access to different types of investment opportunities across alternatives (non-core vs. core and core-plus) and have different risk/return profiles (higher for closed-end). The increasing number of open-end alternatives funds will offer a wider pool of investors easier access, greater potential to be fully invested and more liquidity than closed-end funds.

However, it’s critical to remember these funds do not operate in the same way, which also impacts performance measurement. Simple comparisons of IRR to TWR can range from misleading to meaningless. However, converting both measures into net MOIC offers a useful solution to compare performance across alternatives funds.

¹ The J-curve effect refers to the typical pattern of returns in closed-end funds, where returns appear negative in the early years a capital is invested and then turn positive in later years as value is created and distributions begin.

² Approaches include the Sorting ratio, defined as excess portfolio expected return over portfolio downside volatility; value at risk, which measures the potential investment loss at a given confidence level; and conditional value at risk, which measures the amount of tail risk at a given confidence level.