Alternative Investments — Study Notes
CFA® Level I topic weight 7–10% · structures, fees, and the quirks of illiquid assets
The landscape & fund structures
- Categories: hedge funds, private capital (private equity and private debt), real estate, infrastructure, natural resources (commodities, timberland, farmland), and digital assets. Common threads: lower liquidity, less regulation and transparency, appraisal-based or infrequent pricing, and higher fees than traditional assets.
- GP/LP structure: the general partner manages the fund and bears unlimited liability; limited partners commit capital, drawn down over time. Committed capital > invested capital early on, which drags reported returns.
- Fees — “2 and 20”: a management fee (traditionally ~2% of assets or committed capital) plus incentive/performance fee (~20% of profits). A hurdle rate makes incentive fees apply only above a minimum return (hard hurdle: only the excess; soft hurdle: the whole gain once the hurdle is cleared). A high-water mark requires recovering past losses before incentive fees resume — fee-calculation questions turn on these details.
- Hedge fund liquidity terms: lockup periods, redemption notice, and gates limiting withdrawals — the price of strategies that hold illiquid positions.
Private capital & real assets
- Private equity stages: venture capital funds early, unproven companies (minority stakes, high failure rates); buyout funds acquire control of established companies, typically with significant debt (leveraged buyouts). Exits: trade sale, IPO, secondary sale, or (worst case) write-off.
- Private debt: direct lending, mezzanine (subordinated debt, often with equity kickers), venture debt and distressed debt — higher yields for illiquidity and credit risk.
- Real estate: direct ownership vs listed REITs (liquid, dividend-driven, but more correlated with equities). Income-approach valuation: value = net operating income ÷ capitalization rate — a lower cap rate means a higher value.
- Infrastructure: long-lived cash-flow assets. Brownfield = existing, operating assets (lower risk, lower expected return); greenfield = to-be-built (construction and demand risk, higher expected return).
- Digital assets: blockchain-recorded assets with distinct custody, regulatory and valuation risks; exposure comes direct, via funds/ETPs, or through equities of related companies. No cash flows — valuation rests on supply/demand and adoption arguments.
Commodities & performance measurement
- Commodity exposure is usually via futures, so total return = spot price change + roll yield + collateral yield. Pricing follows storage costs and convenience yield rather than discounted cash flows.
- Contango vs backwardation: contango (futures above spot) produces negative roll yield as contracts are rolled; backwardation (futures below spot) produces positive roll yield. Direction-of-roll-yield questions are near-guaranteed.
- IRR-based reporting and the J-curve: private funds report money-weighted (IRR) returns; early years show negative returns as fees accrue and capital is drawn before value is realized — the J-curve. Multiples like MOIC supplement IRR.
- Index biases: hedge fund indexes suffer survivorship bias (failed funds drop out) and backfill bias (funds join with good histories), overstating returns. Appraisal-based valuations smooth reported returns, understating volatility and correlation with public markets.
- Portfolio role: alternatives are added for diversification and return enhancement, but smoothed statistics overstate the diversification benefit — interpret with care.
Common traps
- Computing incentive fees without checking the high-water mark or hurdle type — hard vs soft hurdles and loss carryforward change the answer.
- Assuming contango benefits a long futures roll — rolling in contango sells low and buys high: negative roll yield.
- Taking hedge fund index returns at face value — survivorship and backfill bias inflate them.
- Treating appraisal-smoothed volatility as real — measured risk and correlations are understated for illiquid assets.
- Confusing brownfield with greenfield infrastructure — brown = existing/lower risk, green = new-build/higher risk.
Drill 75 Alternatives practice questions
Fee-calculation and structure drills with worked explanations, plus the topic’s share of a 540-question mock bank.
For exam preparation reference only — original condensed summaries of publicly known Level I curriculum concepts. Independent study aid. CFA Institute does not endorse, promote, or warrant the accuracy or quality of this product. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
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