CFA Alternative Investments

Alternate Investments is covered in a relatively short reading, so mastering this topic is an efficient way of boosting your exam score.

• Alternative Investments is tied for the least heavily weighted topic on the Level I exam (tied with Portfolio Management and Derivatives).
• Alternative Investments makes up 5-8% of the Level I exam.
• 9-14 of the 180 questions on the Level I CFA exam will be dedicated to Alternative Investments.
• Alternative Investment questions make up 5-10% of the Level II and Level III exams.
• Alternative Investments include five main investment categories: hedge funds, private capital, natural resources, real estate, and infrastructure

Getting an understanding of the key concepts of Alternative Investments early will help with your studies as you progress through the CFA exam. You can depend on the CFA Curriculum reading materials to prepare you for this topic, but it’s much easier to understand these concepts with a study program like Wiley CFA. Forgo the dense CFA reading materials and opt for engaging, bite-sized video lessons with Wiley.

CFA Institute defines Alternative Investments as a disparate group of investments that are distinguished from long-only, publicly traded investments in stocks, bonds, and cash (often referred to as traditional investments).

The five main Alternative Investment categories are:

• Hedge funds
• Private capital
• Natural resources
• Real estate
• Infrastructure

Hedge Funds Explained

Hedge funds are actively managed investment funds that are designed to return the highest possible absolute return. There are four main hedge fund strategies:

• Equity hedge (e.g., market neutral)
• Event-driven (e.g., merger arbitrage)
• Relative value (e.g., convertible bond arbitrage)
• Macro and CTA strategies (e.g., commodity trading advisers)

Private Capital Explained

Private capital includes funding for private equity and private debt.

Private equity can be categorized by three key investment strategies:

• Leveraged buyouts (e.g., MBOs and MBIs)
  • The two types of leveraged buyouts are management buyouts and management buy-ins.
• Venture capital
  • Venture capital investing can take place during the formative stage or after. Later stage financing can be used for expansion, and mezzanine financing occurs in preparation for IPO.

Trade sale, IPO, recapitalization, secondary sale, and write off/liquidation are the primary private equity exit strategies.

Private debt is different forms of debt offered to private entities by investors.

Private debt can be categorized into four key strategies:

• Direct lending
• Mezzanine debt
• Venture debt
• Other specialized strategies (CLOs, unitranche debt, real estate debt, and infrastructure debt)

Real Estate Explained

The two main sectors of real estate are:

• Residential (largest sector, 75% of global market)
• Commercial (office buildings, shopping centers, warehouses, etc.)

You can measure real estate return via:

• Appraisal index
• Repeat sales index
• REIT index

The two types of real estate investing are:

• Private
• Public

Natural Resources: Commodities and Timberland and Farmland Explained

Natural resources are investments in commodities or timberland and farmland.

CFA Institute notes commodity investments typically involve investments using commodity derivatives (futures or swaps). Returns are based on price changes and don’t include an income stream.

Timberland does however offer an income stream (from trees, wood, and other product sales) and includes both the factory and warehouse. Farmland is similar and generates income based on harvest quantities and agricultural commodity prices.

Infrastructure Explained

Infrastructure investments are real, capital intensive, long-lived assets.

Infrastructure can be organized into four main categories:

• Economic infrastructure assets
• Social infrastructure assets
• Brownfield investments
• Greenfield investments

As part of Alternate Investments, one of your learning outcomes is to be able to describe the characteristics of different investment methods.

The three investment methods are:

• Direct investment (no intermediary is used and an investor makes a direct investment)
• Co-investment (a mixture of direct and indirect investing and investment alongside a fund)
• Fund investment (where a fund makes an investment for the investor)

Wiley study materials go over these methods in detail with video lectures, practice questions, and practice exams.

In investment and compensation structures there are partnership structures and compensation structures.

Partnership Structures Explained

Partnership structures usually have two parties:

• General Partners (fund manager with unlimited liability)
• Limited Partners (accredited investor with investments risks)

Compensation Structures Explained

Compensation structures involve management fees, performance fees, and hurdle rates.

• Management fees (usually received by GP, based on committed capital not invested capital)
• Performance fees (additional incentive based on achieving return based on hurdle rates)
• Hurdle rates
  • hard hurdle rate (rate calculated when annual return is in excess of the hurdle rate)
  • soft hurdle rate (rate calculated when annual gross return is in excess of the hurdle rate)

There are four common investment clauses and provisions.

• Catch-up clause (makes GP’s incentive fee based on the total return, not just the return in excess of the preferred return)
• High-water mark (this is the highest value a fund has reached, net of fees)
• Waterfall (this decides the order in which distributions are made to LPs and GPs)
• Clawback (this allows VPs to recover performance fees from GPs)

Alternative Investments makes up 5-8% of the Level I CFA exam, so it’s tied for the least heavily weighted topic on the Level I exam (tied with Portfolio Management and Derivatives). Its importance does increase slightly as you move through the exam levels, with it accounting for up to 10% of the Level II and Level III exams.

The Level I CFA Program exam consists of 180 standalone, multiple-choice questions, so 9-14 of the questions on the Level I CFA exam will be dedicated to Alternative Investments. To help you prepare for these questions, Wiley CFA exam prep courses break the information down into engaging, bite-sized lessons so you can learn everything you need to know without getting overwhelmed. To make sure you’ve really grasped the core concepts, you’ll want to make time for lots of practice questions.