Refresher Reading
Performance Calculation and Appraisal of Alternative Investments
2023 Curriculum CFA Program Level I Alternative Investments
Introduction
Investors frequently look to alternative investments for diversification and a chance to earn relatively high returns on a risk-adjusted basis. Investors also value low correlation and a more risk-neutral source of alpha.
Evaluating an alternative investment can be a subtle, qualitative exercise—one that depends on the initial objectives of the investor—as opposed to a purely quantitative, one-size-fits-all exercise. Much of the nuance revolves around not only the total net return created by an alternative investment but also the path and volatility (drawdown risk) required to create the total return as well as how an alternative investment fits into and benefits a larger portfolio of assets—in other words, its portfolio-level correlation benefit.
The attraction to alternative investments is often focused on their expected returns, but investors often neglect to consider the atypical risks they present—risks we can examine on both a standalone and portfolio basis:
- limited transparency
- low portfolio liquidity
- high leverage and use of derivatives
- high product complexity
- mark-to-market issues, especially for specialized products
- limited redemption availability
- difficulty in manager selection and diversification
- high fees, which can have a nontrivial impact on performance
Learning Outcomes
The member should be able to:
- describe issues in performance appraisal of alternative investments, and
- calculate and interpret returns of alternative investments both before and after fees.
Summary
- Conducting performance appraisal on alternative investments can be challenging because these investments are often characterized by asymmetric risk–return profiles, limited portfolio transparency, illiquidity, product complexity, and complex fee structures.
- 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.
- A variety of ratios can be calculated to review the performance of alternative investments, including the Sharpe ratio, Sortino ratio, Calmar ratio, and mean adequacy ratio (MAR). The internal rate of return (IRR) and multiple on invested capital (MOIC) calculations are often used to evaluate private equity investments, and the cap rate is often used to evaluate real estate investments.
- Redemption rules, lockup periods, and timing differences in reporting can bring special challenges to performance appraisal of alternative investments.