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2021 Curriculum CFA Program Level III Portfolio Management and Wealth Planning


Asset allocation is a critical decision in the investment process. The mathematical and analytical processes inherent in contemporary asset allocation techniques are complicated by the idiosyncrasies of alternative investments. Approaches to incorporating alternative assets into the strategic asset allocation have developed rapidly as allocations to assets other than stocks and bonds have accelerated in the aftermath of the 2008 Global Financial Crisis. The term “alternative” understates the prominence of alternative investment allocations in many investment programs, because institutional and private clients have been increasingly turning to these investments not just to supplement traditional long-only stocks and bonds but also sometimes to replace them altogether. For example, the Yale Endowment and the Canada Pension Plan Investment Board both have close to 50% of their assets allocated to alternatives. Although these two funds are admittedly outliers, between 2008 and 2017 most of the pension funds around the world substantially expanded their allocations to alternative asset classes. On average, pension funds in developed markets increased their allocation from 7.2% to 11.8% of assets under management (AUM) in 2017, a 63% increase.

“Alternative” investment has no universally accepted definition. For the purposes of this reading, alternative investments include private equity, hedge funds, real assets (including energy and commodity investments), commercial real estate, and private credit.

The reading begins with a discussion of the role alternative assets play in a multi-asset portfolio and explores how alternatives may serve to mitigate long-only equity risk, a role traditionally held by bonds. We then consider different ways investors may define the opportunity set—through the traditional asset class lens or, more recently, using a risk- or factor-based lens. An allocation to alternatives is not for all investors, so the reading describes issues that should be addressed when considering an allocation to alternatives. We then discuss approaches to asset allocation when incorporating alternatives in the opportunity set and the need for liquidity planning in private investment alternatives. Finally, the reading discusses the unique monitoring requirements for an alternatives portfolio.

Learning Outcomes

The member should be able to:

  1. explain the roles that alternative investments play in multi-asset portfolios;

  2. compare alternative investments and bonds as risk mitigators in relation to a long equity position;

  3. compare traditional and risk-based approaches to defining the investment opportunity set, including alternative investments;

  4. discuss investment considerations that are important in allocating to different types of alternative investments;

  5. discuss suitability considerations in allocating to alternative investments;

  6. discuss approaches to asset allocation to alternative investments;

  7. discuss the importance of liquidity planning in allocating to alternative investments;

  8. discuss considerations in monitoring alternative investment programs.


  • Allocations to alternatives are believed to increase a portfolio’s risk-adjusted return. An investment in alternatives typically fulfills one or more of four roles in an investor’s portfolio: capital growth, income generation, risk diversification, and/or safety.

  • Private equity investments are generally viewed as return enhancers in a portfolio of traditional assets.

  • Long/short equity strategies are generally believed to deliver equity-like returns with less than full exposure to the equity premium. Short-biased equity strategies are expected to lower a portfolio’s overall equity beta while producing some measure of alpha. Arbitrage and event-driven strategies are expected to provide equity-like returns with little to no correlation with traditional asset classes.

  • Real assets (e.g., commodities, farmland, timber, energy, and infrastructure assets) are generally perceived to provide a hedge against inflation.

  • Timber investments provide both growth and inflation-hedging properties.

  • Commodities (e.g., metals, energy, livestock, and agricultural commodities) serve as a hedge against inflation and provide a differentiated source of alpha. Certain commodity investments serve as safe havens in times of crisis.

  • Farmland investing may have a commodity-like profile or a commercial real-estate-like profile.

  • Energy investments are generally considered a real asset as the investor owns the mineral rights to commodities that are correlated with inflation factors.

  • Infrastructure investments tend to generate stable/modestly growing income and to have high correlation with overall inflation.

  • Real estate strategies range from core to opportunistic and are believed to provide protection against unanticipated increases in inflation. Core real estate strategies are more income-oriented, while opportunistic strategies rely more heavily on capital appreciation.

  • Bonds have been a more effective volatility mitigator than alternatives over shorter time horizons.

  • The traditional approaches to defining asset classes are easy to communicate and implement. However, they tend to over-estimate portfolio diversification and obscure primary drivers of risk.

  • Typical risk factors applied to alternative investments include equity, size, value, liquidity, duration, inflation, credit spread, and currency. A benefit of the risk factor approach is that every asset class can be described using the same framework.

  • Risk factor-based approaches have certain limitations. A framework with too many factors is difficult to administer and interpret, but too small a set of risk factors may not accurately describe the characteristics of alternative asset classes. Risk factor sensitivities are highly sensitive to the historical look-back period.

  • Investors with less than a 15-year investment horizon should generally avoid investments in private real estate, private real asset, and private equity funds.

  • Investors must consider whether they have the necessary skills, expertise, and resources to build an alternative investment program internally. Investors without a strong governance program are less likely to develop a successful alternative investment program.

  • Reporting for alternative funds is often less transparent than investors are accustomed to seeing on their stock and bond portfolios. For many illiquid strategies, reporting is often received well past typical monthly or quarter-end deadlines. Full, position-level transparency is rare in many alternative strategies.

  • Three primary approaches are used to determine the desired allocation to the alternative asset classes:

    • Monte Carlo simulation may be used to generate return scenarios that relax the assumption of normally distributed returns.

    • Optimization techniques, which incorporate downside risk or take into account skew, may be used to enhance the asset allocation process.

    • Risk factor-based approaches to alternative asset allocation can be applied to develop more robust asset allocation proposals.

  • Two key analytical challenges in modelling allocations to alternatives include stale and/or artificially smoothed returns and return distributions that exhibit significant skewness and fat tails (or excess kurtosis).

  • Artificially smoothed returns can be detected by testing the return stream for serial correlation. The analyst needs to unsmooth the returns to get a more accurate representation of the risk and return characteristics of the asset class.

  • Skewness and kurtosis can be dealt with by using empirically observed asset returns because they incorporate the actual distribution. Advanced mathematical or statistical models can also be used to capture the true behavior of alternative asset classes.

  • Applications of Monte Carlo simulation in allocating to alternative investments include:

    1. simulating skewed and fat-tailed financial variables by estimating the behavior of factors and/or assets in low-volatility regimes and high-volatility regimes, then generating scenarios using the different means and covariances estimated under the different regimes; and

    2. simulating portfolio outcomes (+/− 1 standard deviation) to estimate the likelihood of falling short of the investment objectives.

  • Unconstrained mean–variance optimization (MVO) often leads to portfolios dominated by cash and fixed income at the low-risk end of the spectrum and by private equity at the high-risk end of the spectrum. Some investors impose minimum and maximum constraints on asset classes. Slight changes in the input variables could lead to substantial changes in the asset allocations.

  • Mean–CVaR optimization may be used to identify allocations that minimize downside risk rather than simply volatility.

  • Investors may choose to optimize allocations to risk factors rather than asset classes. These allocations, however, must be implemented using asset classes. Portfolios with similar risk factor exposures can have vastly different asset allocations.

  • Some caveats with respect to risk factor-based allocations are that investors may hold different definitions for a given risk factor, correlations among risk factors may shift under changing market conditions, and some factor sensitivities are very unstable.

  • Cash flow and commitment-pacing models enable investors in private alternatives to better manage their portfolio liquidity and set realistic annual commitment targets to reach the desired asset allocation.

  • An alternative investment program should be monitored relative to the goals established for the alternative investment program, not simply relative to a benchmark. The investor must monitor developments in the relevant markets to ensure that the fundamental thesis underlying the decision to invest remains intact.

  • Two common benchmarking approaches to benchmarking alternative investments—custom index proxies and peer group comparisons—have significant limitations.

  • IRRs are sensitive to the timing of cash flows into and out of the fund: Two managers may have similar portfolios but different return profiles depending on their capital call and distribution schedule.

  • Pricing issues can distort reported returns and the associated risk metrics, such as betas, correlations, and Sharpe ratios.

  • Monitoring of the firm and the investment process are particularly important in alternative investment structures where the manager cannot be terminated easily. Key elements to monitor include key person risk, alignment of interests, style drift, risk management, client/asset turnover, client profile, and service providers.

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