Use of AIFs for portfolio diversification to beat down-cycles

“Diversification is the only free lunch," Nobel Prize-winning economist Harry Markowitz has said.

A diversified portfolio (across asset classes) is critical in making sure your investment portfolio can protect itself when there is a down cycle in any single asset class. On the other hand, a single asset class-focused portfolio can see sharp drawdowns as its performance is linked to highs and lows of one asset class. 

Alternative Investment Funds (AIFs) as an investment vehicle provide an investor multiple options to consider for portfolio diversification. They could be debt-oriented, equity oriented or hybrid.

Real Estate Funds: These are typically Category II AIFs that invest into real estate assets – Commercial Real Estate (properties, office spaces, warehouses) or residential real estate projects. Real Estate tends to provide a hedge against equity market volatility and these AIFs also offer a steady income stream through rental yields / interest coupon on project loans / developer repayments. These funds make investments either through equity or debt. 

Performing Credit Funds: Within the Debt category too, there is a range of options available, including Credit Risk AIFs, Distressed Assets AIFs. Performing Credit Funds invest into companies that run steady business with a long term track-record and are profitable at EBITDA-level (Earnings before interest, taxes, depreciation and amortization). However, these companies could be in temporary stress due to business cycle or might require funds for a specific purpose like acquisition – in such cases, bank-funding is not available, which is where these funds step in to provide credit to the company. These funds get classified under Category II of AIFs. 

Infrastructure Funds: Infrastructure AIFs are another option for investors looking to diversify their AIF portfolio. As environmental issues become more critical, infrastructure AIFs are likely to fund more projects around climate change. Hence, more green energy or renewables-focused AIFs are likely to be launched over the coming years. These funds typically fall under Category I AIFs. 

Hedge Funds / Absolute Return Funds: These AIFs follow an Absolute return approach irrespective of equity market cycles. The strategies can be executed across equity positions and derivative instruments such as futures and options, using both long and short side to hedge. These funds typically fall under Category III AIFs. Such funds can help investors optimise returns, especially in periods of heightened equity market volatility.

Venture Capital funds: These AIFs offer investors, a chance to participate in India's entrepreneurial spirit through venture capital-oriented investments. These funds invest in early-stage, start-up companies, meeting their funding requirements as well as in some cases, offer mentorship. These funds are classified as Category I AIFs. 

Such AIFs offer investors the opportunity to invest in highly-innovative companies, which hold the potential to disrupt well-established players in their industry or create a new industry by themselves. While the risk here is higher, the return could also be potentially higher. 

A new category of Funds called Venture Debt Funds have also sprung up in the last few years. They offer Venture debt investment to start-up / early stage companies, typically with an additional equity warrant that allows some growth participation.

Private Equity Funds: These AIFs offer investors, a chance to participate into unlisted companies. The companies are typically in growth phase (where business model is established but the company could be some time away from profitability). These funds can also invest into pre-IPO companies (many of these companies could be already profitable) that are a few quarters away from listing on the exchanges. These funds are classified as Category II AIFs. 

Fund of funds (FoF): This AIF invests in various other AIFs, instead of directly holding any investments. Using the FoF structure, investors can build an AIF portfolio with broader diversification, across different underlying AIFs.