What’s in the blog?
In this blog, we break down everything you need to know about Alternative Investment Funds (AIFs) — what they are, how they work, and how they differ from mutual funds and PMS. You’ll understand their categories, fee structures, risks, and real return potential. We also discuss on who they’re best suited for and why AIFs have been trending among investors in recent years. By the end, you’ll have the clarity to decide whether AIFs truly deserve a place in your portfolio.
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During one of our recent client review meetings, a client pulled out his phone and showed me a WhatsApp forward. The message claimed that AIFs are giving far better returns than mutual funds. He smiled and asked, “Varad, is there any substance in this, or does AIF actually mean Another Investment Fraud?”
We both laughed at the joke. But what I appreciated most was that he didn’t blindly believe what he saw online. Instead, he came to me for clarity. That’s exactly the kind of dialogue I value because the world of investments today is full of noise… half-baked forwards, bold claims, and product pitches disguised as ‘advice’.
So let’s clear the air. In this blog, I’ll walk you through what AIFs really are, how they work, what kind of returns they can generate, and most importantly, whether they might make sense for you.
So, What Exactly is an AIF?
To make you understand in the simplest terms, I can say that an Alternative Investment Fund (AIF) is like an exclusive investment club. It pools money from a small group of sophisticated investors and invests in strategies that go beyond traditional mutual funds — private equity, venture capital, structured debt, real estate, or even long–short trading.
Unlike mutual funds, which are designed for retail investors, AIFs are meant only for those who meet SEBI’s eligibility criteria. The minimum ticket size starts at ₹1 crore. This automatically filters who can invest — usually HNIs and ultra-HNIs with larger net worths.
How are AIFs Different from Mutual Funds (MFs) or Portfolio Management Services (PMS)
If we dig into the details, there are a number of differences between these three investment tools. For a simple understanding, you can see these as layers of sophistication in investment:
- Mutual Funds – These are democratised, i.e. open to everyone, and so are highly regulated, transparent, and liquid.
- PMS (Portfolio Management Services) – These are more personalized with larger ticket sizes. They still focus mostly on listed equities.
- AIFs – This is the advanced layer, where strategies can get complex and exposure is not just to listed markets but also to unlisted companies, private equity, real estate, or derivatives.
The Three Categories of AIFs
As we discussed earlier, AIFs can invest in a wide range of opportunities — from listed stocks and unlisted companies to real estate and structured debt. However, not all AIFs work the same way.
To bring structure and investor protection, SEBI classifies them into three categories, based on where and how they invest, and the kind of risk they take.
Let’s understand each one in simple terms.
Category I AIFs
These funds primarily invest in sectors that contribute to economic development — startups, small and medium enterprises (SMEs), infrastructure, and social ventures.
In simple words, they put money into businesses that are in their early or growth stage. This can include venture capital funds or funds that back infrastructure projects.
Pros:
- It can offer high growth potential if the underlying businesses scale successfully.
- Often receive favorable regulatory treatment, as they support innovation and job creation.
Cons / Risks:
- High business and execution risk, since many investments are in early-stage ventures or projects.
- Longer investment horizon, typically 8–10 years, before meaningful returns are realized.
Category I AIF is best suited for Investors with a high-risk appetite and long-term outlook. If you have high risk-appetite and are okay to give time to your investment to grow, you can think of investing.
Category II AIFs
This is the most popular category among Indian investors today. These funds invest in unlisted companies, private equity deals, structured debt, or even real estate development.
Unlike Category III, they don’t use leverage (borrowed money) except for day-to-day operations, making them relatively more stable.
Pros:
- Exposure to private market opportunities not available in mutual funds or PMS.
- Can generate consistent mid-to-high-teen returns (14–20%), depending on the strategy.
- Offers diversification beyond listed equity markets.
Cons / Risks:
- Illiquid — you can’t exit midway; capital stays locked for 7–10 years.
- Returns depend heavily on the fund manager’s ability to identify and exit investments successfully.
This category is best suited for investors with substantial net worth and patience, looking for long-term capital growth through private equity or debt opportunities.
Category III AIFs
These funds are the most active and flexible among all categories. They can invest in listed and unlisted securities, use derivatives, and take both long and short positions — similar to hedge funds.
The goal is to generate returns in both rising and falling markets, though that also means higher complexity and risk.
Pros:
- Potential for higher, market-beating returns when managed well.
- Flexibility to hedge positions and adapt quickly to market trends.
Cons / Risks:
- High volatility due to the use of leverage and derivatives.
- Returns can vary significantly across managers and market cycles.
- Generally taxed at the fund level, unlike Category I & II (which enjoy pass-through benefits).
Category III AIF is best suited to experienced investors who understand market risks, derivatives, and are comfortable with short-term volatility for potential higher returns.
What is the Typical Tenure of an AIF?
One of the first things you should know before investing in an AIF is that it’s not a short-term product. Unlike mutual funds, which you can enter or exit anytime, AIFs usually come with a lock-in period — meaning your money stays invested until the fund completes its lifecycle.
The tenure varies depending on the type of AIF:
- Category I & II AIFs (like venture capital, private equity, or real estate funds) generally have a 7–10 year tenure, sometimes extendable by a couple of years. This is because investments in unlisted or project-based opportunities take time to mature and generate returns.
- Category III AIFs, which deal more with listed securities and market strategies, tend to have shorter durations or even open-ended structures, allowing periodic redemptions.
In short, if you invest in AIFs, be prepared to stay committed for the long haul. These are not products you can ‘time’ or ‘trade’. They’re meant for investors who can give their capital time to work.
Understanding the Fee Structure — What Are You Really Paying For?
Whenever I explain AIFs to clients, this is usually the point where eyebrows go up. Because, unlike mutual funds, where expenses are baked into the NAV, AIFs come with multiple layers of fees, and it’s important to understand them before investing.
Typically, there are two kinds of charges:
- Fund Management Fee – This is the annual fee charged by the fund house to manage your money. It generally ranges between 1.5% to 2.5% of your invested capital.
- Performance Fee (or Carry) – This is a profit-sharing fee charged only when the fund crosses a pre-decided return threshold, known as the hurdle rate.
Let’s simplify this with an example:
Suppose your AIF has a hurdle rate of 10%, and the fund ends up generating 26% CAGR over four years. The excess return is 16% (26 – 10). Now, the fund manager takes 20% of that excess as the performance fee — that’s 3.2%. After accounting for this, along with management charges and taxes, your net return might settle around 23–24%.
That’s still a strong performance, but it shows why investors should always look at net returns, not just the headline numbers.
Also, not every fund charges the same way. Some have a “high-water mark” clause, meaning the manager can only charge performance fees if the fund’s value exceeds its previous peak. It’s a smart feature that ensures fairness to investors.
How Do AIFs Actually Invest?
AIFs differ not only in structure but also in how they deploy your capital. Depending on their focus area and investment style, different AIFs operate with very different objectives and risk-return profiles. Let’s break down the three most common approaches you’ll come across:
1. Equity AIFs
Equity AIFs primarily invest in shares of companies, both listed and unlisted. The idea is to build a concentrated, high-conviction portfolio with potential for superior long-term growth.
Fund managers typically start with a broad universe like the Nifty 500 and narrow it down using strict filters such as:
- ROE (Return on Equity) above 20%
- ROCE (Return on Capital Employed) above 15%
- Consistent revenue and profit growth over the past few years
- Strong management and governance quality
Because these portfolios usually hold 35–45 stocks, they are more focused than mutual funds, which means potentially higher returns, but also higher volatility.
Equity AIFs are ideal for investors who already have some experience in market-linked instruments and want to aim for higher alpha generation over a long-term horizon.
2. Debt & Real Estate AIFs
Debt AIFs typically lend to corporates or projects through structured credit instruments. These could include last-mile financing, mezzanine debt, or project-based loans that banks might not cover.
Real Estate AIFs, on the other hand, invest in property-related ventures. For instance, they may provide funding for commercial or residential projects, which later earn returns through rentals or property sales.
These AIFs are designed for investors looking for steady income or lower volatility, though they still carry credit and liquidity risk.
Expected returns from these funds usually range between 12 and 18%, depending on the risk profile and project timeline. They can add a fixed-income-like component to your portfolio but remain illiquid until project completion or fund maturity.
3. Hybrid or Multi-Asset AIFs
Now, this is where things get interesting. Hybrid AIFs combine different asset classes, which are usually a mix of equity, debt, and sometimes real estate or alternatives, to balance risk and reward.
You can think of them as diversified wealth-creation vehicles within the AIF framework. For example, a hybrid AIF might allocate:
- 50% to listed equities for growth,
- 30% to private debt for a steady income, and
- 20% to real estate or special situations for diversification.
The idea is to smoothen returns while still offering better upside than traditional fixed-income products. These are often categorized under Category II but can vary based on structure.
Hybrid AIFs work best for investors who don’t want to take extreme positions in either equity or debt and prefer a balanced, long-term compounding approach.
Why Have AIFs Been Trending Lately?
If you’ve been hearing about AIFs more often over the last few years, it’s because this has been a trending name in the last 3-4 years. The growth of this segment in India has been remarkable, and there are a few reasons behind it.
- Booming equity markets: A strong run-up in Indian equities has boosted investor confidence in alternative and higher-return products.
- Growing investor base: As more Indians move into higher income brackets, the demand for sophisticated investment options like AIFs has naturally grown.
- Liquidity in the system: With increased liquidity and wealth creation post-2020, investors are more willing to allocate capital to long-term vehicles.
- Wealth creation mindset: Many investors today are thinking beyond short-term returns. They’re looking to build intergenerational wealth. AIFs, with their structure and flexibility, fit that aspiration well.
- Regulatory clarity: SEBI’s structured classification and stronger disclosure norms have built trust in this category, making it easier for investors and advisors to explore it confidently.
Who Should (and Shouldn’t) Invest in AIFs
Now comes the question to which you would have wanted me to jump in the very beginning. A lot of clients want a straight ‘one-word’ answer to whether they should or should not invest in a particular instrument. But, I always say, understand the why behind any ‘yes’ or ‘no’. That’s the way to take informed decisions.
Coming back to AIF… I would say it upfront, AIFs aren’t for everyone.
If you want to get into Alternative Investments, you need to have both financial capacity and mental discipline.
If you’re an investor who checks portfolio values every week or gets anxious during market swings, this is not an investment for you. These instruments are designed for long-term investors with a higher risk appetite who understand that capital can remain locked for years.
Here’s a quick way to gauge suitability:
Suitable for:
- Investors with ₹5 crore+ net worth
- Long-term horizon of 4–10 years
- Ability to take on higher volatility for potential alpha returns
- Desire for diversification beyond listed markets
Not suitable for:
- Conservative investors seeking capital safety or liquidity
- Those who need regular access to their funds
- Investors are uncomfortable with complex products or market-linked risks
In my experience, AIFs work best when you invest a smaller portion of your overall portfolio in AIFs, complementing your core mutual fund and PMS holdings.
What to Check Before You Choose an AIF
After reading everything till here, if you’re considering an AIF, I would like to give you a word of caution. Don’t get swayed by return charts or glossy presentations. Get answers to 5 key questions before you invest your capital in any category of AIFs.
- Where and how does the fund invest? Is it equity, debt, or hybrid? (The strategy)
- Has the fund manager navigated both bull and bear markets successfully? (Fund manager’s track record)
- Are all fees (management, performance, expenses) clearly disclosed? (Fee transparency)
- What’s the lock-in period? Are there partial exit options? (liquidity and exit)
- What tax burden will you attract with your investment? (Tax implication)
[Note: Category I & II AIFs enjoy “pass-through” taxation (you pay tax based on your income type), while Category III funds are taxed at the fund level.]
If you can confidently answer these five, you’re already ahead of most investors who enter AIFs purely on word-of-mouth.
The Reality Check – Returns vs Expectations
I started the blog by telling you that my client wanted to know if it’s true that AIFs give better returns as compared to MFs. So, it’s my responsibility to give you the answer before wrapping up.
It is true that several AIFs have delivered 20%+ CAGR over the last few years, especially those that caught the right market cycles. But not all have done so consistently.
AIF performance depends heavily on fund quality, timing, and manager skill. A good AIF can compound wealth impressively over the long term. A poorly managed one can lock up capital for years with mediocre returns.
That’s why due diligence, both on the product and the people managing it, is non-negotiable.
My Take
AIFs are a sophisticated way to access opportunities beyond traditional markets, but they come with higher complexity, higher minimums, and longer lock-ins.
For the right investor, they can be a powerful wealth creation tool. For the wrong one, an illiquid mistake.
As always, your best bet is to align your investments with your goals, risk appetite, and time horizon, not with WhatsApp forwards or dinner-table trend talks. And whenever in doubt, do what my client did – ask the experts.
Frequently asked questions (FAQ)
Not necessarily. Both serve different purposes. Mutual funds are designed for retail investors seeking liquidity and diversification, while AIFs cater to high-net-worth investors looking for higher, risk-adjusted returns through private equity, debt, or alternative strategies.
Yes, NRIs and OCIs can invest in Indian AIFs, subject to compliance with FEMA regulations and fund-specific guidelines. However, certain AIFs may have restrictions or additional documentation requirements, so it’s best to check before investing.
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