Category III Alternate Investment Funds (AIFs) will have an increasingly significant role to play in liberating the Indian High Net Worth Investor (HNWI) from the inherent volatility and lack of diversification by investing in the domestic equity markets. Given the minimum investment in these funds is set at Rs 1 crore, the option is effectively closed for the mass-market retail segment.
Alternative asset managers such as hedge funds, private equity and venture capital firms do not seek to outperform a benchmark such as a stock index. They seek an absolute return irrespective of whether the market is up or down. Often AIFs are used to protect and preserve investor capital and as such they play a key role in diversifying an investor's exposure in the wider market.
With Nifty volatility at 16 per cent and long-only funds at 20 per cent plus (source: Eurekahedge), an AIF offering double-digit absolute returns at 6 per cent volatility fills an important gap in wealth management for investors relegated to playing only in the domestic equity market or in real estate or gold.
Globally "alternative" assets represent 12 per cent of all financial assets, the equivalent of approximately $3trillion. The Indian hedge fund industry, started in late 2012, currently has Category III AIFs with total assets of Rs 3,700 crore. So, in terms of further allocation towards AIFs the scope is vast.
Taxation with representation
The largest stumbling block to the prospect of more Indian HNWIs getting access to AIFs - and hedge funds in particular - is the Indian government itself.
The taxation for Category III AIFs (i.e. hedge funds) takes place at the representative assessee level instead of being taxed at the investor level. This makes it difficult to show tax deducted at source (TDS) and for fund managers to withhold tax to show investors clear post-tax returns.
Category I and II AIFs (primarily venture capital and private equity funds) are generally eligible for tax pass-through where income is taxed in the hands of the investor rather than at the fund level. This considerably eases the tax administration burden.
Hedge funds are additionally fiscally disadvantaged as their income is classified as business income and liable to taxation at the highest marginal rate. They do not qualify for long or short-term capital gains. Potentially up to one-third of the performance gains from domestic funds could be eroded.
Benefits beyond HNWIs
In addition to HNWIs, family offices and even corporate treasuries could also benefit from exposure to alternative asset managers. From a macro-economic standpoint, increasing the number of amplifiers of GDP growth in the Indian economy requires more than just reliance on top-down infrastructure spending and encouraging FDI flows. It requires opening the investment landscape to encourage wealth creation and wealth preservation decoupled from the vicissitudes of the domestic equity market.
Until it feels comfortable with the idea of money/capital leaving the country, the scope for investing in alternative asset managers will be limited to domestic AIFs sanctioned under SEBI. Contrary to the popular misconception of hedge funds as "gamblers", they can play a key role in both portfolio diversification - as previously noted - and even in market "self-regulation" (i.e. in their ability to 'short' over-valued assets).
It is ironic that Mr Modi's recent demonetisation initiative has the stated intention of purging "black" money from the economy when opening the market to more foreign and domestic AIFs could achieve a similar goal. At once enticing money out of the shadows and into a more transparent (and taxable) investment landscape.