Alternative investments have become an important part of the portfolio composition conversation for investors. The reason is not merely fashion or complexity. Alternatives can offer access to assets, structures and return opportunities that mutual funds are not designed to provide.
Mutual funds serve a very important purpose. They are regulated, transparent, liquid and hence suitable for a wide base. In India, mutual funds operate under regulations and a detailed rule book on portfolio construction, valuation, liquidity, disclosures, borrowing, derivatives usage and concentration limits. These rules protect investors and make mutual funds one of the most efficient vehicles for listed equity, debt and hybrid exposure. But the same rules also define the boundaries of what a mutual fund can do for you.
A mutual fund is built mainly for marketable listed securities. It cannot freely participate in many private-market, off-shore, structured or illiquid opportunities. For example – It cannot behave like a private lender, negotiate bespoke covenants, invest deeply in unlisted operating businesses, or lock capital into strategies where the real return comes from structuring. Also recently, AIF funds have helped Indian investors gain foreign exposure. Indian mutual funds operate within industry-wide overseas investment limits, and when these limits are fully utilised, fresh access to international opportunities can become constrained. In such situations, as is the case right now, alternative structures, including AIFs operating through GIFT City and other permitted routes, can provide investors with access to global markets and foreign investment opportunities that may not be readily available through mutual funds.
AIFs are governed by a separate regulatory framework from mutual funds. Their rules are more flexible because the products are meant for portfolios that need underlying assets that mutual funds cannot provide. Depending on the category and strategy, AIFs can invest in private equity, venture capital, real estate, structured credit, stressed assets, long-short strategies, derivatives-led strategies, unlisted companies and global investment opportunities.
Private equity is one such example. A mutual fund can buy listed companies after they are already available in the public market. An AIF, on the other hand, can invest in companies much earlier in their journey, including unlisted businesses, growth-stage companies, buyout opportunities and pre-IPO situations. This gives investors access to a different part of the corporate lifecycle. The return is not coming from daily market movement alone, but from business growth, operational improvement, better governance, capital structuring and eventually an exit through a sale, IPO or secondary transaction. This can be a genuine diversifier because the value creation happens outside the listed market framework. At the same time, private equity also brings illiquidity, valuation uncertainty and execution risk. So it should not be treated as a substitute for listed equity, but as a separate allocation for investors who can stay invested for longer periods.
So the first answer is clear: alternatives can genuinely diversify a portfolio when they give the investor access to a different source of return. The mistake is to think that anything called “alternative” automatically diversifies. It does not. The real test is whether the underlying risk is different from what the investor already owns.
Performing credit is another good example. In mutual funds, credit risk funds are often assumed to be a way of accessing private credit or performing credit. In reality, they are usually portfolios of tradable corporate bonds that take exposure to lower-rated papers within a daily-liquidity fund structure. That is not the same as performing credit in the true sense. Performing credit is generally better suited to an AIF structure. Here, the manager can directly underwrite a borrower, study cash flows, negotiate collateral, build covenants, structure repayment terms and hold the exposure to maturity. The investor is not just buying a lower-rated bond from the market. The investor is participating in a lending strategy where underwriting, structuring, and monitoring create the return. Of course, this does not make it risk-free. It simply means the risk is different and must be evaluated differently.
Global diversification with unique and targeted themes is another area where alternatives are becoming more relevant. Indian investors have historically used international mutual funds and fund of funds to get foreign exposure. However, industry limits on overseas mutual fund investments have constrained fresh flows into several such products. As a result, GIFT City structures, including AIFs and other IFSC-based vehicles, are becoming important routes for investors who want access to foreign markets, offshore funds and global opportunities.
Therefore, alternatives should be judged by the role they play in the portfolio. Are they adding private equity, private credit, global exposure, market-neutral returns, real assets, venture capital or a genuinely different source of cash flow? Or are they simply repackaging equity, credit or currency risk in a more complex form?
The right conclusion is balanced. Alternatives are not a replacement for mutual funds. Mutual funds remain the core vehicle for most listed-market exposure. But alternatives can complement them by giving access to areas that mutual funds cannot enter efficiently.
Used well, alternatives can improve diversification. Used poorly, they can merely add complexity, illiquidity, and cost. The label does not matter. The underlying asset, structure, and risk do.
(The article has been authored by Ankit Patel, Co-founder & Partner – Arunasset Investment Services)
Disclaimer: The views expressed in this article are those of the author/authors and do not necessarily reflect the views of ET Edge Insights, its management, or its members.