Three things that make AIFs way more complex than mutual funds

In their quest for higher commissions, which have been rationalized for mutual funds, more and more distributors have sharpened their sales pitch for alternative investment funds (AIFs) in the past year or so.

The problem arises because most HNIs have been investors in mutual funds, which are far simpler products than AIFs. The complexity and the high commissions make AIFs prone to mis-selling. “There has been a shift towards AIFs among HNIs after the Securities and Exchange Board of India (Sebi)-mandated reductions in total expense ratio in 2018. This prompted some distributors to push higher-commission products like AIFs to this segment," said Amol Joshi, founder, Plan Rupee Investment Services. “A key factor in the sales pitch is the exclusivity of the product given its minimum ticket size (typically, ₹1 crore)," he added.

Here are a few things to keep in mind before buying AIFs.

What are AIFs?

AIFs are high-risk investment vehicles meant for HNIs, with a potential for high returns.

AIFs come in three varieties, according to the Securities and Exchange Board of India (Sebi) categorization. The first type (category I AIFs) consists of venture capital, SME, infrastructure and social venture funds. The second type (category II AIFs) invests in any type of asset class such as equity or debt, but does not leverage or borrow money to invest in stocks or other risky assets. The third type (category III AIFs) can indulge in leverage or short selling to generate returns (read What is short selling?).

“AIFs give an option of investing in different asset classes that the investor may not have, directly or through mutual funds. Asset classes like venture capital, private equity pre-IPO, private credit and hedge funds can only be accessed through AIFs. Smaller-sized listed equity strategies may also allow the fund manager more flexibility to generate alpha compared to the popular mutual funds which have grown large over time," said Gaurav Awasthi, senior partner, IIFL Wealth Management. Alpha is the outperformance of a fund compared to its benchmark index.

Category I and II AIFs are closed-end funds with a time horizon of at least seven years, in most cases. Category III AIFs can be open-ended or closed-end. The time horizon of closed-end category III AIFs can be as short as three-and-a-half years.

What to keep in mind

There are certain things you should keep in mind before investing in AIFs, especially if you are new to the product. Understand that AIFs are different from MFs in all these aspects.

Strategy: Understand the nature of the AIF you are investing in. This includes finding out which category (I, II or III) it falls under. For instance, category III AIFs can borrow to invest, which makes them riskier.

“While selecting an AIF, you should first look at its theme or investment objective," said Daniel G.M., founder, PMS Bazaar, an online information portal for PMS and AIFs. For instance, an AIF investing in real estate debt will have a different type of risk-reward outlook compared to an AIF following a long-short strategy (which tries to benefit from both rise and fall in stock prices).

One way to evaluate the strategy is to look at past performance, but there are some limitations on this aspect. “Typically, the AIF provider will give you past returns on its own performance. However, unlike mutual funds, past returns on peer funds is not available," said Awasthi. Sebi has mandated benchmarking of AIFs which will entail the display of a fund’s performance against the category average. But it may be difficult to get the details of other AIFs in the peer set and their returns, which is possible in case of MFs. Identifying a peer set itself is a major challenge because AIFs adopt a medley of strategies to generate returns. It is possible to identify a peer group along broad parameters but this is much less precise than the peer comparison in mutual funds.

Costs: It’s important to know the costs involved. There is no regulatory limit on costs in AIFs unlike the limits on total expense ratio (TER) in mutual funds.

Complex profit sharing arrangements are also common. You may have to pay a 2% management fee on the total value of your AIF investment every year and a 20% share in the profits that the AIF generates. Some AIFs may not take any management fee and only charge a profit share. For instance, True Beacon AIF One, managed by Zerodha co-founders Nithin and Nikhil Kamath, only charges a 10% profit share.

However, there are further nuances to tackle. What if an AIF delivers 20% returns in the first year, -20% in the next and 8% in the third? In this case you would’ve paid the manager a profit share in the first and third years, even though the actual net asset value (NAV) of the fund will be lower than the value it hit in the first year because of the second-year loss.

Some funds have a concept known as “high water mark" in place to avoid such double payment of performance fees. A high water mark means that if a fund declines after hitting a high, fees cannot be charged until the previous high (high watermark) is crossed. For example, assume that a fund goes from ₹100 crore to ₹110 crore in year one and you pay a performance fee of 20% on the gain of ₹10 crore, which is ₹2 crore. If the fund declines to ₹105 crore in year two, you pay no performance fee since there is no gain. Further, if it rises back to ₹110 crore in year three, you pay no performance fee despite the gain because it touched the high watermark of ₹110 crore in year one.

Taxation: AIFs are not as tax-efficient as mutual funds. Also, the taxation rules of the three categories of AIFs are different.

Category I and II AIFs are pass-through vehicles. In other words, the fund does not pay any tax but the investor does on the earnings of the fund. However, this tax becomes due even if the fund has not paid out cash to investors. So if the fund has received interest income of ₹5 lakh but has distributed only ₹3 lakh to investors (retaining the balance to invest in its portfolio), you will have to pay tax at your slab rate on the entire ₹5 lakh. Similarly, if the fund has realized capital gains on stocks, you will be liable to pay tax on those gains at 15% or 10%, depending on the holding period, even if you haven’t received the gains. Though mutual funds are also pass-through vehicles, you pay tax only when you redeem them units.

Category III AIFs are not considered pass-through vehicles. As a result, the fund has to pay tax when the AIF realises its gains or gets other income such as interest. The income of a category III AIF is usually taxed as business income, although there can also be a capital gains component. As a result, the tax paid is, typically, at the highest tax slab, including surcharge of 42.7%, and is deducted before the returns are paid out. This high deduction can lead to higher tax than the investor’s own tax bracket.

Merely having ₹1 crore to invest should not be a reason for you to invest in AIFs as they are highly risky products meant for sophisticated investors. Even such investors should evaluate AIFs carefully.

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