Alternative Investment Funds (AIFs) have become increasingly attractive to high-net-worth individuals and institutional investors in India. Positioning themselves as more diverse than equity or fixed income, AIF Investment Returns provide investors with exposure to asset classes such as private equity, venture capital, real estate, hedge funds, and structured credit that they otherwise might not add to a conventional portfolio. Notably, AIFs tend to try and outperform traditional market returns, and are typically unable to remain immune from the significant economic forces driving traditional market behavior’s. Arguably, the greatest of these forces propelling market behavior’s is volatility.
Naturally, volatility tends to be negative in terms of price movement, and can emerge from multiple factors: geopolitical conflict, economic data releases, inflation, interest rate volatility, or systemic financial crisis. For AIFs, valuation volatility presents both risk and opportunity. An AIF will either benefit or detract from valuation volatility depending on the fund’s investment process, underlying asset classes, and the manager’s trading process.
Market Volatility Understanding in the AIF Context
Market volatility is generally measured with indicators like VIX (Volatility Index) and the standard deviation of asset prices; it expresses the degree of uncertainty or risk within financial markets. However, for AIFs that often invest in illiquid or non-public assets, the impact of volatility is less direct than it is for public equity markets.
Although their daily valuation may still be distant from a mark-to-market approach of mutual funds, AIFs also face impacts from volatility changes in their underlying assets. Volatility causes action in valuations, sentiment of investors, deal trails and exit opportunities, all which impact AIF returns.
Category-Wise Impact of Volatility on AIFs
India’s AIF Investment Returns ecosystem is made up of certain categories, as stated by SEBI:
Category I AIFs
As these funds are allocated mainly to early-stage or growth-stage ventures, their investments are usually long-term and illiquid. The market’s volatility affects them by:
- Raising the hurdle for fundraising, as risk-averse capital tends to retreat
- Affecting the potential for IPO or acquisition exits
- Leading to markdowns in valuations of private investment
- Leading to issues surrounding sector-specific growth (e.g., tech issues, or slowdown in real estate)
On the flip side of that, volatility can give rise to attractive entry valuations, which means that Category I can be negotiated with more flexible terms in down-markets.
Category II AIFs
These funds do not use leverage or more complex derivatives. Their returns may be impacted by market volatility in the following ways:
- The rise in interest rates (which is frequently correlated with volatility) can compress fixed income returns
- Credit spreads widen and increase default risk for debt-focused AIFs
- PE funds may be able to acquire acquisition targets and companies at discounted valuations, but exit opportunities are reduced
- Fundraising cycles lengthen, which limits the capital available for deployment
Category II funds with a flexible investment strategy and strong due diligence can take advantage of dislocations in the market.
Category III AIFs
These are hedge funds that use complexities such as long-short equity, complex derivatives, exchange-traded variables and/or arbitrage:
- Volatility provides risk and return. We’ll describe why
- Complex strategies (volatility arbitrage, for instance) may benefit from sharp market moves.
- Market mismatch may lead to volatility and undersized strategy contracts moving against a hedge.
- In a turbulent market, margins can go up. Markets can expose fund liquidity constrictions.
A category III AIF investment options will win or lose based on its skill to measure and react to volatility in real-time.
Key Mechanisms of Volatility Impact
Liquidity Crunch
When markets are extremely volatile, liquidity dries up in both the public and private markets. AIFs, especially those relying on the timely entry and exit of their positions, can struggle to deploy or liquidate capital. This is particularly acute for PE and real estate AIFs.
Valuation Risks
For AIFs that invest in unlisted assets, they must evaluate either internally, or through a third party. During times of volatility, it becomes much more difficult to evaluate properly, which can lead to markdowns and subsequently delayed payouts to investors.
Portfolio Rebalancing
When markets are volatile, portfolio rebalancing becomes imperative for institutional investors. If the alternative investment funds are part of their allocation, re-balancing means either redemption pressures are placed on the funds, or they don’t make new investments until rebalancing of the portfolio is complete.
Correlation to Public Markets
Even if an AIF is marketed as a diversified aspect of overall portfolio diversification, many of the underlying assets are still correlated with broader market sentiment. As noted above, if there is a sharp correction in public equities/markets, this often extends to reduced investor appetite for illiquid assets managed at similar time frames, and investment in AIFs.
Behavioral Factors
Market volatility does affect investor psychology. In a fearful environment, investors are often not making rational or long-term-decision based investment decisions. This can lead to redemptions, or indecision on committing long-term to illiquid ‘external’ funds. This will affect the ability of AIFs to fundraise and, depending on their strategy or investor base, maybe negatively affect NAV.
Bottom Line
Market volatility is an inevitable part of the investment landscape. For AIF Investment Returns investors, the key lies not in avoiding volatility but in understanding how it influences their portfolio and selecting fund managers who can navigate it wisely. Different AIF categories respond differently to market dynamics — some may struggle during downturns, while others may seize the moment to deliver superior returns.
For those seeking to optimize their exposure to alternative assets amid uncertain markets, Gravitas Investments offers expert management, carefully curated AIF opportunities, and deep market insights. With a commitment to transparency, performance, and risk management, we help investors access the power of AIFs with confidence and clarity.
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