AIFs can enrich portfolios but are not very tax-efficient
Investors’ search for a buffer against economic uncertainties and mixed stock and bond market returns over the past few years has pushed them towards the high yield strategies offered by alternative investment funds (AIFs). As a result, the assets under management (AUM) of these funds reached more than ₹4,500 billion in March 2021 against ₹360 crore as of December 2012, according to data available from the Securities and Exchange Board of India (Sebi).
Experts say the alternatives are meant to increase investors’ current portfolio.
“Typically, AIF fund managers bring more experience and an entrepreneurial bent compared to regular mutual fund managers. As a result, AIF managers bring better management and innovation to investors, ”said Nitin Rao, CEO of InCred Wealth.
Multiple factors are driving demand for AIF. First, AIFs offer a non-traditional investment avenue, as they allow investors to explore a variety of strategies other than long-only, such as long-short, hybrid or other high yield strategies.
The second factor is differentiation, as AIFs are designed more for more sophisticated investors looking for certain differentiated strategies. The third factor is concentrated solutions, because unlike mutual funds, AIFs offer concentrated solutions and typically have a basket of 25 to 30 stocks in the portfolio.
There are three categories of AIF. Category I AIFs invest in startups or social venture capital funds, infrastructure funds, and SME (small and medium-sized enterprises) funds, among others. Category II funds are generally private equity funds and debt funds.
Category III funds employ diverse or complex trading strategies and may use leverage, including investing in listed or unlisted derivatives.
In terms of investment, all categories of AIFs except angel funds require a minimum investment of ₹1 crore. In terms of taxation, investors should keep in mind that AIFs are not as tax efficient as mutual funds. The tax rules also differ for the three categories.
Category I and II AIFs are pass-through vehicles, which means investors have to pay tax on their income and the fund pays no tax.
In the case of Category III funds, the income is taxed as business income, which means that the tax paid is generally the highest tax rate, including a surcharge of 42.7%.
When it comes to costs, AIFs tend to be more expensive because there is no regulatory limit here, unlike mutual funds.
Investors should keep in mind that, by nature, AIFs carry more risk, can have foreclosure, and require more time for the strategy to unfold. They are suitable for those whose risk profiles match the expectations that they are willing to wait for the theme to play out and take the risk until then.
“When looking at the overall asset allocation, in the case of AIFs, the overall allocation of the portfolio to the underlying asset is what needs to be taken into account, however, it would be prudent not to not exceed 5% exposure in a single non-traditional AIF name. “said Rao.
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