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2020 Curriculum CFA Program Level I Alternative Investments

Introduction to Alternative Investments

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Introduction

Assets under management in vehicles classified as alternative investments have grown rapidly since the mid-1990s. This growth has largely occurred because of interest in these investments by institutions, such as endowment and pension funds, as well as by high-net-worth individuals seeking diversification and return opportunities. Alternative investments are perceived to behave differently from traditional investments. Investors may seek either absolute return or relative return.

Some investors hope alternative investments will provide positive returns throughout the economic cycle; this goal is an absolute return objective. Alternative investments are not free of risk, however, and their returns may be negative and/or correlated with other investments, including traditional investments, especially in periods of financial crisis. Some investors in alternative investments have a relative return objective. A relative return objective, which is often the objective of traditional investment portfolios, seeks to achieve a return relative to an equity or fixed-income benchmark.

This reading is organized as follows. Section 2 describes alternative investments’ basic characteristics and categories, general strategies of alternative investment portfolio managers, the role of alternative investments in a diversified portfolio, and investment structures used to provide access to alternative investments. Sections 3 through 7 describe features of hedge funds, private equity, real estate, commodities, and infrastructure, respectively, along with issues in calculating returns to and valuation of each. Section 8 briefly describes other alternative investments. Section 9 provides an overview of risk management, including due diligence, of alternative investments. A summary and practice problems conclude the reading. 

Learning Outcomes

The member should be able to:

  • compare alternative investments with traditional investments;
  • describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence;

  • describe potential benefits of alternative investments in the context of portfolio management;

  • describe, calculate, and interpret management and incentive fees and net-of-fees returns to hedge funds;

  • describe issues in valuing and calculating returns on hedge funds, private equity, real estate, commodities, and infrastructure;

  • describe risk management of alternative investments.

Summary

This reading has provided an overview of the characteristics, potential benefits, and risks of alternative investments. It also described features of some categories of alternative investments. Including alternative investments in an investor’s portfolio may result in a higher Sharpe ratio for the overall portfolio because of diversification benefits. However, these benefits do not come without associated risks. It is important for investors to understand these risks before including alternative investments in their portfolios. Some key points of the reading are summarized as follows:

  • Alternative investments are supplemental strategies to traditional long-only positions in stocks, bonds, and cash. Alternative investments include investments in long–short public market strategies and such less common assets as private equity, real estate, infrastructure, and commodities. Often these investments are made via limited partnerships and special purpose vehicles.

  • Alternative investment strategies are typically active, return-seeking strategies that often have different risks from those in indexed public markets.

  • Characteristics common to many alternative investments, when compared with traditional investments, include the following: lower liquidity, less regulation, lower transparency, higher fees, and limited and potentially problematic historical risk and return data.

  • Alternative investments often have complex legal and tax considerations and may be highly leveraged.

  • Alternative investments are attractive to investors because of the potential for portfolio diversification (reduced risk) and higher portfolio returns when added to a portfolio of traditional investments.

  • The risks associated with alternative investments must be factored into the investment decision-making process.

  • Many alternative investments are valued by using estimated values rather than actual market prices. These values are then reported to index providers for performance-reporting purposes. As a result, the volatility of returns and correlation of returns vis-à-vis traditional investments will tend to be underestimated. It is important to identify and understand how alternative investments are valued, particularly owing to illiquidity.

  • Indexes for alternative investments may be subject to a variety of biases, including survivorship and backfill biases.

  • Many alternative investments, such as hedge and private equity funds, use a partnership structure with a general partner that manages the business and limited partners (investors) who own fractional interests in the partnership.

  • The general partner typically receives a management fee based on assets under management or committed capital (the former is common to hedge funds and the latter is common to private equity funds) and an incentive fee based on realized profits.

  • Hurdle rates, high-water marks, lockup and notice periods, and clawback provisions are often specified in a partnership agreement.

  • The fee structure affects the returns to investors (limited partners) in such alternative investments as hedge and private equity funds.

  • Hedge funds are typically classified by strategy. One such classification includes four broad categories of strategies: event driven, relative value, macro, and equity hedge.

  • Primary private equity fund strategies include leveraged buyouts, venture capital, development capital, and distressed investing. Leveraged buyouts and venture capital are the dominant strategies.

  • Real estate investing includes direct and indirect ownership of real estate property and lending against real estate property.

  • Real estate property has some unique features, including basic indivisibility, heterogeneity (no two properties are identical), and fixed location.

  • The required amount to directly invest in real estate may be large in order to achieve adequate diversification, and the investment may be relatively illiquid. Various investment forms, such as REITs and mortgage securitizations, partially address these issues.

  • Commodity investments may involve investing in actual physical commodities or in producers of commodities, but more typically, these investments are made using commodity derivatives (futures or swaps).

  • Returns to commodity investing are based on changes in price and do not include an income stream, such as dividends, interest, or rent (apart from income earned on the collateral).

  • Infrastructure assets are capital intensive, long-lived, real assets that are intended for public use and provide essential services. Investors expect these assets to generate stable cash flows, which typically are adjusted upward with economic growth and inflation, and they may also expect capital appreciation of the infrastructure assets.

  • Category, stage of development, and geographic location of underlying assets and the form of infrastructure investment affect risks and expected returns of infrastructure investments.

  • Managing risks associated with alternative investments can be challenging because these investments are often characterized by asymmetric risk/return profiles, limited portfolio transparency, and illiquidity.

  • Traditional risk and return measures (such as mean return, standard deviation of returns, and beta) may provide an inadequate picture of alternative investments’ risk and return characteristics. Moreover, these measures may be unreliable or not representative of specific investments.

  • Operational, financial, counterparty, and liquidity risks may be key considerations for those investing in alternative investments.

  • It is critical to perform due diligence to assess whether or not (a) the manager can effectively pursue the proposed investment strategy; (b) the appropriate organizational structure and policies for managing investments, operations, risk, and compliance are in place; and (c) the fund terms appear reasonable.

  • The inclusion of alternative investments in a portfolio, including the amounts to allocate, should be considered in the context of an investor’s risk–return objectives, constraints, and preferences.