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 UWorld CFA. Forgo the dense CFA reading materials and opt for engaging, bite-sized video lessons with UWorld.

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)

UWorld 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, UWorld 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.

Key fact: Most Alternative Investments study sessions will be qualitative in nature, but you could still get a question asking you to calculate hedge fund fees. So, make sure to be prepared for those.Hint: UWorld can help you strike a balance between qualitative and quantitative study prep for this topic, so you’re not caught off guard.

Prepare for this section by understanding the four main hedge fund investment strategies (equity hedge, event-driven, relative value, and macro and CTA strategies).

Hedge Funds Investments Practice Question

Which of the following hedge fund strategies is most likely to be categorized as a relative value strategy?

1. Merger arbitrage
2. Quantitative directional
3. Fixed income convertible arbitrage

Correct answer: C

Prepare for this section by reviewing the two main sectors of real estate (residential and commercial), knowing how to measure real estate return with different indexes, and the types of real estate investing.

Real Estate Investments Practice Question

A mortgage real estate investment trust (REIT) offers the investor safety because:

1. All investment properties in a REIT portfolio have an underlying collateral agreement in the form of a mortgage.
2. The portfolio contains only mortgages and loans, which are relatively safe.
3. The trust has obtained mortgage financing from large, reputable financial institutions for use in purchasing investment properties.

Correct answer: B

5-10% of the Level II CFA exam is based on Alternative Investments, so it does have the potential to be more heavily tested than on the Level I exam. The Level II exam is a pretty evenly balanced exam, so Alternative Investments has the same weight as Quantitative Methods, Economics, Corporate Issuers, and Derivatives.At this stage, you’ve been tested on your memorization of the concepts in the Level I exam, and you will now have to demonstrate a greater conceptual understanding of Alternative Investments. This will be a big change, so know exactly what to expect by studying for the Level II exam with UWorld CFA.

Vignette-supported multiple-choice questions are introduced on the Level II CFA exam. This means the questions will need to be approached differently than on the Level I exam. In each item set, candidates will be given a brief description of an event and will then have to answer four or six multiple-choice questions related to the scenario. There will be 88 multiple-choice questions in total.

Prepare for this section by understanding commodity investments and futures and swaps.

Commodities and Commodity Derivatives Practice Question

Which of the following is least likely to be a cash crop?

1. Rice
2. Sugar
3. Coffee

A: Rice. Coffee and sugar are considered cash crops because they are grown and sold for income rather than consumed for subsistence, whereas rice is often consumed by its producers.

Prepare for this section by reviewing key investment strategies (leveraged buyouts and venture capital) and private equity exit strategies. Private capital includes funding for private equity and private debt.

Private Equity Investments Practice Question

Which of the following companies would not likely interest a buyout investor?

1. A new technology firm
2. A railroad
3. An established technology firm

A: A new technology firm. Buyout investors are generally not looking to bear the risk of a new product line and instead prefer companies with more established cash flow.

Alternative Investments makes up 5-10% of the Level III CFA exam, so it has the potential to be tested to the same degree as on the Level II exam. However, the Level III exam tests at a higher skill level and introduces constructed response questions. To make the studying process easier and to get support along your CFA journey, make sure to study with UWorld CFA.

There are still vignette-supported multiple-choice questions on the Level III exam, but you will also now have to answer vignette-supported constructed response questions. These item sets may have essay questions, or they may require another type of written response.

CFA Level III Alternative Investments Practice Questions

An investor is considering an investment in a multi-strategy fund that pays each strategy manager a performance incentive without regard to total fund return and passes this fee on to clients. The multi-strategy fund involves lock-up periods, withdrawal gates, and so forth, at the fund level only. Which of the following is an advantage of the multi-strategy fund that is not available from a fund-of-funds?

1. Fast reallocation of fund capital
2. Lower netting risk on the performance-based incentive
3. Economies of scale not available to individual investors in different funds for each category

A: Fast reallocation of fund capital. Multi-strategy funds will most likely be able to reallocate more quickly because its managers are under the same roof, and each strategy does not have its own capital controls.

Keep these key tips in mind as you study Alternative Investments for each level of the CFA exam.

Understand and Identify Different Alternative Investments

The most important thing you need to prioritize for this section is understanding and being able to identify the different Alternative Investment types (hedge funds, private capital, natural resources, real estate, and infrastructure).

Differentiate Between the Categories Within Asset Classes

As you study each of the Alternative Investment types, spend extra time differentiating between the different asset classes. For example, direct vs. indirect real estate investing and equity hedge vs. event-driven investing strategies.

Join a Study Program With Excellent Success Rates and Experienced Instructors

Alternative Investments makes up a relatively small but important portion of the CFA curriculum, so it’s helpful to study with the highest quality study materials on the market. UWorld lets you study with experienced instructors (that you can trust) that will guide you along your study journey. Plus, UWorld CFA study materials will save you time and stress by helping you target your efforts effectively on all three levels of the CFA exam.