Know Why Alternative Investments Are Growing Among Indian Investors

India is a nation on the move as the country witnesses change across its length and breadth. This change is being precipitated by a host of factors including government stability, enabling regulation, a thriving financial and entrepreneurial ecosystem, and the changing contours of its vast and diverse population. At the same time, it is engendering a host of opportunities for wealth creation. These opportunities are no longer limited to traditional asset classes – they have now come to encompass the growing asset class known as alternative investments.

The nuts & bolts of alternative funds

Alternative investments are any investments that do not fall under the purview of traditional investments like plain equity and fixed income. Globally, the alternative assets industry is set to reach USD 24 trillion by 2028 with private credit and venture capital leading from the front.

Exhibit: Global Alternative asset industry AUM (USD Tn)

In India, alternatives are now gaining traction with allocations to alternative investments increasing in investor portfolios. An ideal way to access alternative investments is Alternative Investment Funds (AIFs) – these are privately pooled investment vehicles that raise funds from both Indian as well as foreign investors with an intent to invest in wide range of alternative assets including private equity, venture capital, venture debt, private credit, long-short strategies, etc. More specifically, AIFs in India are divided into three categories, each offering different investment strategies and objectives.

• Category I AIFs: These funds invest in areas that are considered socially or economically beneficial. Examples of funds in this category include venture capital funds, angel funds, SME funds, social venture funds, and infrastructure funds.

• Category II AIFs: This is a broad and versatile category as it comprises any strategy or objective that does not come under the purview of CAT I or CAT III. It can include private equity, private credit, real estate funds, distressed assets funds, fund of funds, etc. Currently, this category also commands the largest share of industry AUM

• Category III AIFs: Funds in this category invest in both listed and unlisted securities and can deploy complex trading strategies with the potential for leverage. Long only funds, long-short funds, hedge funds, etc., fall under this category.

Growing interest in alternatives is exemplified by the sharp rise in both industry Assets Under Management (AUM) and the number of schemes being launched by AIFs. Over the last 5-year, industry AUM has witnessed a CAGR of ~32%, growing from INR 2.9 trillion (as of June 2019) to INR 11.8 trillion (as of June 2024). Correspondingly, the number of funds launched over the years has also increased significantly, increasing from 467 funds in 2019 to 1266 in 2024.

Exhibit: Growth in AUM under AIFs

Why are AIFs finding favour amongst India’s HNIs, UHNIs, and Family Offices?

There are several factors that contribute to the unique appeal of alternatives. These include:

1. Enhanced risk-adjusted returns: AIFs can deploy multiple strategies across different asset classes. This enhances their ability to manage risks and deliver superior risk-adjusted returns. Additionally, their ability to take leverage (in select category). Further supports their ability to double down on compelling opportunities and generate alpha.

2. Un-correlated market exposure: Due to their ability to invest across asset classes, AIFs are well positioned to create diverse portfolios that have low to zero correlation with traditional markets. In this scenario, they can act as an excellent portfolio diversifier and offer protection during turmoil in select markets or asset classes.

3. Access to reputed fund managers: AIFs are the best display of fund manager expertise. As a result, they offer investors access to niche strategies with concentrated exposure across debt & equity/sectors/securities.

4. Partake in the India growth story: AIFs seamlessly allows investors to partake in the India growth story. Through CAT 3 long-only funds, investors can gain exposure to listed equities and invest in sectors that are key catalysts of the India growth story. Similarly, through CAT 1 and CAT 2 funds, they can invest in private companies and start-ups that are playing a key role in the growth of the country.

5. Flexibility of investment avenues: Underlying assets within AIF universe can invest in securities of listed or unlisted investee companies, derivatives, units of other AIFs or complex or structured products.

6. Access to private and public markets: One of the biggest benefits of AIFs is the flexibility to access public as well as private markets. This is unique to AIFs as access to private markets is not available through the mutual fund vehicle.

The overall objective of any robust portfolio is to provide the desired exposure, optimally harness prevailing opportunities, and generate the required returns within the risk boundaries of the investor. To achieve this, portfolio diversification, across different asset classes, and even geographies, becomes almost table stakes. In the background of such a landscape, alternative investments are well poised to play a critical role in investor portfolios.