Factors for big investors to consider before picking AIFs to diversify portfolio

Market Outlook

Vishal Chandramani

Alternative Investment Funds (AIFs) are privately pooled investment vehicles that are mainly intended for investments from HNIs (high networth investors) and institutional investors.

The Securities Exchange Board of India (Sebi) introduced AIFs in 2012 to boost asset classes such as angel, venture capital, private equity and hedge funds.

AIFs complement traditional long-only investment strategies by offering investors avenues to invest in long-short, hybrid, arbitrage, or other high yield strategies.

There are three categories of AIFs. Category I AIFs invest in venture capital funds (including angel funds), social impact funds, SME (small and medium enterprise) funds and infrastructure funds.

Category II funds are typically real estate funds, private equity funds, distressed asset funds, structured credit, and venture debt funds. They do not leverage or borrow, except to meet temporary requirements.

Category III AIFs employ different trading strategies like long-short, arbitrage, fixed income, and derivatives trading. These funds can invest in both unlisted and listed derivatives through leverage.

Given the various strategies available under AIFs, these products have become popular among HNIs. The funds raised under AIFs have increased from a little under INR 39,000 Cr. in March 2016 to approximately INR 4.51 Lac Cr. in March, 2021, a CAGR of over 63%!

Portfolio diversification is a key advantage of AIFs. HNIs can invest in a portfolio of start-ups or companies which are at an early stage of fund raise through angel/private equity funds.

Again, a portfolio approach in such cases is preferable as one is investing in several companies which increases the probability of success rather than investing the same amount directly in a single or handful of companies.

Similarly, one can invest in a portfolio of real estate assets through real estate funds or in high yield strategies that make distributions to investors at periodic intervals.

Venture debt funds are a relatively new but increasingly popular investment strategy. Hedge funds can adopt market-neutral strategies or take positions that benefit during market downturns, both of which complement the traditional long-only portfolios of investors.

Investors must however keep in mind that AIFs are typically closed-ended funds (except in the case of some Category III AIFs) and the fund tenure may vary anywhere between three to at times even ten years in the case of some funds.

Also, the fee structure in most AIFs tends to be on the higher side as compared to mutual funds given that these funds typically charge both a fixed management fee as well as a performance fee.

One needs to also consider the aspect of taxation while investing in AIFs. While Category I and II AIFs are pass-through vehicles (investors have to pay tax on the income from the fund), in the case of Category III funds, the income is taxed at the fund level which in many cases is at the highest rate and this may be disadvantageous for investors/entities that are in a lower tax bracket.

Thus, HNIs should restrict the overall investment in AIFs keeping in mind their risk tolerance level, liquidity requirements and investment time horizon.

Depending on one’s investment objective (income vs. growth), an investor can choose a fund that makes regular distributions or in a fund that invests in companies from a long-term growth perspective.

Again under each of these categories, one can diversify between funds which invest into different sectors.

(The author is Managing Partner- Products & COO at TrustPlutus Wealth (India))

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