The Pros And Cons Of Cat 3 AIF’s

With equity returns seemingly trapped in a narrow band, and a complex set of global and local risk factors raising questions about the future returns of a lot of debt funds, we’re likely to see Mutual Fund houses launching Alternative Investment Funds or AIF’s in the times to come.

AIF’s are aimed at savvy, high net worth investors who understand the risks associated with such investments. Probably keeping this in mind, SEBI has fixed the minimum ticket size for an AIF investment at Rs. 1 crore, in effect keeping retail investors at bay. SEBI also stipulates that an AIF cannot have any more than 1,000 investors at one time, further underscoring the fact that the product is not a retail-base oriented one.

Within AIF’s, a specific category known as “Category 3”, are Indian equivalents of hedge funds, in a way. With a few AMC’s already having launched Cat 3 AIF’s and another couple in the immediate pipeline, you may be curious about the pros and cons of these products. Here they are, in a nutshell.

Pros
The most obvious plus point of a Cat 3 AIF is its ability to take multi directional calls on the market. While Mutual Funds and PMS products are basically “long only” (meaning that they only stand to benefit when stock prices go up), AIF’s can employ both long and short strategies, which means that they can “bet” on an index or a stock price going down, and cash in on them if their calls go right. In range bound or bearish markets, AIF’s have the potential to continue generating real returns while their long only counterparts flounder. AIF’s also enjoy the flexibility to employ a wide variety of hedging strategies, such as buying call or put options, thereby allowing fund managers to cap their maximum losses if they should choose to do so.

Cons
The biggest drawback of an AIF would surely be the high level of “fund manager risk” attached to it. Since an AIF takes multi directional calls, it’ll need to look beyond traditional valuation models or buy and hold strategies while making investment or trading decisions. While this opens up windows of opportunity, it also exposes investors to the fund management team getting things wrong that many more times, and incurring losses in the process. In the absence of robust stop-loss strategies or hedging strategies, this itself can increase the risks associated with a Cat 3 AIF to absurdly high levels. Besides this, AIF’s also have very high minimum ticket sizes, high fees (typically with a profit sharing clause beyond a certain threshold annualised return), and very low tax efficiency. In fact, the difference between gross returns and net (post fees and taxes) returns in an AIF could be as high as 40% to 50%, meaning that a 20% gross return may actually translate to a net return of just about 10%-12%. AIF’s are also not as transparent as Mutual Funds, and do not declare NAV’s or portfolios as frequently – this may lead to discomfort for some investors.

End Note
Most Cat 3 AIF’s are open ended, and so you can always wait for a year or two to see first-hand if their strategies actually work outside of their paper-testing models. A wait and watch approach is advised.