Why Chasing the Top-Performing AIFs Can Be Risky?

In the world of Alternative Investment Funds (AIFs), most investors seek funds that outperform other asset classes and even other AIFs. Outperform only based on “Returns”, strong recent performance indicates a better investment decision. This is the reason why investors search for Top AIFs in India, focusing primarily on recent return rankings.

However, market research and experience show that choosing funds mainly based on recent outperformance can lead to unsatisfactory long-term results. The risk comes from several factors, such as changing market conditions, investors’ behaviour, or fund strategies that no longer work as before.

The most common discussion in investment analysis is whether past strategies that have given good returns will perform better in the future. Because the performance is influenced by several factors,

• Economic conductions 

• Business cycle

• Leadership

• Valuation

A strategy that gives a higher return has certain conditions under which it performs very well, because AIFs work in a concentrated manner, and if something changes in the market greater impact on performance. 

The reason for the higher return in the Top AIFs is due to the level of risk they have taken. When the market is rising, these strategies may not be clearly visible because there is untested downside protection, and the niche strategies they work on are continuing to rise.

But when the market changes, these strategies experience a sharp decline. Those investors who focus only on the returns also need to see the risk involved in these AIFs for generating those returns. 

Return-chasing Behaviour

Investors' behaviour and psychology play a crucial role in performance chasing.

Research shows that if a fund performs well, investors give more capital in the future based on performance. Still its not necessarily that past performance continues to give those returns in the future, this behaviour of the investor leads investors to enter at higher valuations and exit during weaker periods.

Investors give more importance to recent performance over other criteria; such behaviour can impact long-term outcomes because decisions are made based on short-term performance.

Not only returns, but there are many other things that investors need to focus on, like

• Fund Manager & Team Structure - The manager and team are the most critical part of the fund; their expertise decides whether the fund gives alpha. The 2 most important things are how they perform due diligence and whether they invest their own capital or not.

• Economy & Business Cycle - AIFs are cyclical; your fund’s strategy must align with where India is going. The firm must help in national building and generate returns out of it.

• Timeframe - AIF is not the short-term game; it needs "patient capital." You cannot simply leave like stocks; most closed-ended funds generally have a tenure of 5 to 10 years. In the first 2-3 years, your fund gives negative or zero returns. Gains usually come at the end of the tenure.

• Fees Structure - It follows the 2-20 rule, 2% management fee, and 20% as a performance fee (Carry). It also has the Hurdle Rate, where the investor (or Limited Partner) at minimum return on their capital. 

• Taxation - It's complex in AIFs, because it depends on the Category in which the fund operates.

Instead of selecting funds primarily based on performance. Investors may shift their focus to other things, like return consistency in different market conditions, and whether they can manage downside risk or the discipline on their investment promises, and many other things.

AIFs require research and monitoring; this is a powerful investment tool, but it demands capital, conviction, and calm from the investors. Long-term investment is generally influenced by process consistency rather than selecting top performers.