Alternative investment funds: Dispelling myths and unlocking potential

Read this | AIFs face risk of large investors moving away as Sebi tightens rules

Compared to Mutual Funds (MFs) with assets under management (AUM) worth around ₹67 trillion, AIFs clearly have a long way to go. However, the sector’s growth is hindered by myths that often stem from anecdotal evidence, oversimplification, or misrepresentation. 

Let’s debunk these misconceptions:

Myth #1: Alternatives are only for the wealthy or institutions

While alternatives like private equity and venture capital were once exclusive to institutional investors, this has changed. Today, individual investors can participate in AIFs through staggered investment plans over two to three years or direct investments in startups. 

Factors such as India’s rising number of millionaires, innovative business ideas, and the need for portfolio diversification with better risk-adjusted returns are driving AIF adoption. Professional fund management, regulatory reforms, and enhanced transparency further bolster this trend.

Myth #2: Alternatives are inherently risky

All investments carry risk, but many alternative assets can offer stability, particularly against market volatility or inflation. For instance, absolute return strategies aim to deliver consistent returns regardless of market direction. 

Read this | Are alternative investments worth the risks involved?

AIFs with exposure to derivatives or real estate often have low correlation with traditional stocks and bonds, making them valuable hedges during economic turbulence.

Myth #3: Alternatives lack liquidity

Liquidity in alternative investments depends on the fund’s strategy. 

Category III AIFs, for example, provide liquidity on a fortnightly, monthly, or quarterly basis. Most AIFs focused on capital appreciation or regular cash flows, such as those investing in private equity, credit, or real estate, typically have a fund tenure of three to seven years. Within this period, transfers are permitted, subject to the investment manager’s approval. 

Read this | RBI and Sebi must redo its overseas investment policy for AIFs

Additionally, regulatory changes mandating the dematerialization of AIF units now allow investors to leverage these investments for financing needs.

Myth #4: AIFs lack transparency

AIFs are designed to be transparent, with frequent investor updates, monthly newsletters, NAV statements, portfolio disclosures, and annual audited accounts. These measures ensure investors are well-informed about strategies, portfolios, and associated risks.

Myth #5: Fees are charged regardless of performance

Unlike traditional asset management firms that charge fixed fees as a percentage of AUM, many AIFs adopt performance-linked fees. These fees are levied only in cases of outperformance, ensuring fund managers have “skin in the game” and remain incentivized to deliver strong results.

Myth #6: Investing in one AIF provides diversification

True diversification requires categorizing AIFs into liquid, illiquid, and beta-plus strategies. Investors can then allocate across these categories to align with objectives like capital appreciation, regular cash flows, or a favourable risk-return matrix.

Myth #7: Higher tax rates apply to AIF income

Tax treatment varies across AIF categories. 

For Categories I and II, income is taxed in the hands of the investor as these are pass-through vehicles. This includes capital gains or income, excluding business income. For Category III AIFs, taxes are applied at the fund level at maximum marginal rates, meaning investors do not face additional taxation on returns.

Since the Securities and Exchange Board of India introduced AIF guidelines in 2013, the regulatory framework has strengthened considerably. Measures like independent audits, valuation norms, benchmarking, mandatory dematerialization, custodianship, liquidation norms, and compliance filings have enhanced investor confidence.

Also read | Banks versus AIFs: Govt enters the picture

By dispelling these myths, AIFs emerge as a promising avenue for asset diversification and wealth creation. Exploring this asset class could redefine your investment strategy and unlock opportunities for financial growth.

Amit Kothari is COO at Alpha Alternatives.