Alternative investment funds (AIFs) vs mutual funds

You must have heard a lot about pooled investment funds. Mutual funds, hedge funds, alternative Investment funds, etc., are some examples of pooled funds. But today, we will read about mutual funds and alternative investment funds (AIFs) in particular. How do they differ from one another? Is one better than the other?

Well, both mutual funds and alternative investment funds operate on the same principle of investing money collected through a pooled fund - deposited by several individuals working towards the same objective. Before making any investment, you should be aware of the key distinctions between the two. Let's understand what mutual funds and alternative investment funds are and how they differ from one another.

What are alternative investment funds?
An alternative investment is a financial asset that does not fall into one of the conventional investment categories. Conventional categories include securities like stocks, bonds, and cash. Alternative investment funds pool capital from private investors and invest in line with the investment policy. These funds are illiquid as these investments are open only to limited investors. They also have lower transaction costs than traditional investments due to their lower turnover. However, entry requirements and fees are higher than traditional investments.

The SEBI has divided AIFs into three major categories. Each of the categories has different investment policies as per their broad definition:

• Category I includes funds with strategies to invest in start-ups, early-stage ventures, social ventures, SMEs (small and medium-sized enterprises), infrastructure or other sectors or areas that the government or regulators consider as socially or economically desirable.
• Category II includes funds that do not undertake leverage or borrowing other than to meet day-to-day operational requirements and as permitted in the Regulations. The funds that cannot be categorised as Category I or Category III.
• Category III includes funds that employ complex or diverse trading strategies and may employ leverage through investment in listed or unlisted derivatives.

What are mutual funds?
Mutual funds are a similar kind of pooled investment, but here professional fund managers invest the collected funds in stock and debt securities. The manager invests in a systematic and planned way so that investors generate wealth. Learn more about mutual funds.

Difference between mutual funds and alternative investment funds (AIFs)
1. Minimum investment amount: The minimum investment threshold for a person looking to invest in an AIF is set to be Rs 1 crore. This cap is set at Rs 25 lakh for an AIF employee, management, or director. Mutual funds, on the other hand, allow investments for as low as Rs 500.
2. Volatility: While some AIFs (Hedge Funds and Equity Funds) are linked with the market, which makes these investments volatile. There are other AIF products such as Private Equity funds that are unrelated to the stock market, making the returns unaffected by the market's movements.
In contrast, the returns from equity-oriented mutual funds are tied to the stock market. Because of this, they are volatile, but it also gives investors a chance to make more money if the market rises (higher returns on investments). Non-equity-oriented funds, however, are not as risky because they contain some debt component.
3. Lock-in period: The majority of alternative investment funds have a lock-in term of three years. Some mutual funds, like ELSS, have a lock-in of three years. Other mutual funds don't have any such lock-in period.

How are they taxed?

AIFs
Category I and II AIFs have a pass-through status, which means any income (other than business income) generated by the fund will be taxed at the hand of the investor and not by the fund house - even if the investor didn't redeem the investment. Unlike Category I and II, there is no pass-through status for Category III. This category is taxable at the fund level. The highest rate of tax (as per the current tax slab) is charged on the profit made by this fund.

It is to be noted that in Category I and II, the investor is obliged to pay advance tax during the year. A freshly created AIF that keeps its money in a short-term asset while it waits to make investments - any revenue this "short-term asset" generates is not included in the investor's calculations of income. So even if the NAV may not indicate appreciation, the investor may therefore end up paying tax, either directly in the case of categories I and II or through the fund in the case of category III.

Mutual funds
As far as mutual funds are concerned. The NAV is net of all expenses including fund management expenses; hence, effectively deducted from gains on exit. The investor pays the tax only on redemption. Once the investor invests in a mutual fund, till he exits or redeems, there is no tax compliance and payment of taxes. Learn how mutual funds are taxed.

What should you choose?
Despite the distinctions and complications between these two avenues, the AIFs' minimum investment requirement is out of reach for the average investor. Therefore, mutual funds are a preferred mode of investment because they are cost-effective and allow one to start with as little as Rs 500; which also doesn't come with a lock-in period. While AIFs aim to increase the wealth of the financially sound (HNIs or high net-worth individuals), mutual funds let everyday investors try their hand at investing.

For HNIs who are looking to diversify their portfolios and increase long-term returns on their investments while willing to take considerable risk, AIFs seem like decent investment alternatives. But for those who can take low to high risk, mutual funds are the way to go. The decision between alternative investment funds and mutual funds should be based on your investment objectives, available capital, and long-term intentions.