CFA Level 1 Alternative Investments: Our Cheat Sheet

Sophie Macon ∙ 21 May 2021

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Whilst a relatively smaller topic weight in the overall CFA Level 1 exams, Alternative
Investments is an important topic career-wise if you work in asset management as it is
expected to capture 49% of global asset management revenue by 2024.

I personally found this topic very interesting – a nice break from the traditional fixed
income and equity. It is the perfect topic to master to maximize your exam scores since it
is a relatively short reading for its topic weight.

Hence, we have created a quick cheat sheet to CFA Level 1 Alternative Investments to help
save you some precious study time.

Our Cheat Sheet series focuses on one specific topic area for each CFA Level.

More Cheat Sheets will be published in the coming weeks, sign up to our member’s
list to be notified first.

By referring to the CFA Learning Outcome Statements (LOS), we prioritize and highlight the
absolute key concepts and formula you need to know for each topic. Plus some topic-
specific tips at the end too!

A nice and short topic for once, let’s master this 🙂

 Contents

CFA Level 1 Alternative Investments: An Overview

Reading 50: Introduction to Alternative Investments
Hedge funds
Private equity
Real estate
Commodities
Infrastructure
CFA Level 1 Alternative Investments Tips

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CFA Level 1 Alternative Investments: An Overview

Given that this Study Session is limited to a single reading with roughly half a dozen LOS,
candidates are not expected to develop a particularly detailed understanding of this
material – at least not for the Level 1 exam. However, the readings at Levels 2 and 3 go
into greater depth, but cover the same sub-categories listed above.

CFA Level 1 Alternative Investments’ topic weighting is 5-8%, which means 9-14
questions of the 180 questions of CFA Level 1 exam is centered around this topic.

For 2021’s curriculum, it is covered in Study Session 7 , which includes Reading 50.

Here’s a summary of Alternative Investments chapter reading:

Reading
Sub-topic Description
Number

An overview to Alternative Investments asset class, such as hedge funds, private

equity, real estate, commodities and infrastructure investments.

Introduction to

50 Alternative
We look at each of their distinguishing characteristics, valuation considerations,
Investments
potential risks and benefits, whilst also comparing the similarities and
differences with stocks and bonds.

The CFA curriculum tends to categorize all assets other than equity and fixed-income as
alternative investments, so this Study Session covers a broad range of topics from
tangible assets such as gold to hedge fund strategies. Specifically, the categories of
alternative investments are:

These are not distinct assets, many hedge funds invest in stocks or bonds.

What distinguishes hedge funds as an alternative investment is the variety of strategies that
they employ.

Hedge funds

Investing in hedge funds can offer very attractive risk adjusted returns, but expect to pay
significant fees for the privilege of doing so (and don’t expect to be able to access your money
for a while).

Private ​This category includes two important sub-categories:

equity​ 1) buyout funds, which make highly-leveraged purchases of established companies, and

2) venture capital funds, which provide equity to young companies that have yet to establish
themselves in the market (or, in some cases, in an office outside of their founder’s garage)…
 ​Owning real estate is a relatively simple concept, but there are several ways to think of this as
an asset class.

Real estate
It is possible to own real estate directly, for example as many own their own home or rental
properties, or indirect through an investment vehicle such as a real estate investment trust
(REIT).

We’ve all learned how to invest in commodities by watching Trading Places (and if you haven’t,
you must), but the curriculum goes into a bit more detail.

Commodities

Commodities investing is growing at a rapid rate and this topic will play a larger role in the
curriculum at Levels 2 and 3.

In a nutshell, the various markets in which alternative investments trade are less liquid
than traditional stock and bond market, which means that there is greater potential to
exploit inefficient pricing and earn abnormal profits.

With alternative investments expected to hold 49% of global asset management revenue
and represent 17% of AuM by 2024, it is important for any financial analyst to understand
how best to utilize this asset class to improve a portfolio’s risk-return profile.

Reading 50: Introduction to Alternative Investments

Hedge funds

Hedge fund strategies:

A short-term investing strategy that seeks to exploit pricing inefficiencies before or after a major
Event- corporate event, e.g. bankruptcy, spin-off, mergers and acquisitions.

driven

Specific strategies include merger arbitrage, distressed debt, activist, special situations.

A strategy that seeks to profit from the price differential between related financial instruments such
as stocks and bonds.

Relative

value
Examples include fixed income convertible arbitrage, fixed income asset backed, fixed income
general, volatility and multi-strategy.

Uses a top-down approach to identify market trends, taking bets on the direction of a market,
Macro
currency, exchange rate, interest rate, commodity or any macroeconomic variable.

A bottom-up approach which takes long or short positions in equity or equity derivative securities.

Equity

hedge Examples include market neutral, fundamental growth, fundamental value, quantitative directional,
short bias, sector specific strategies.

Hedge fund fees:

“2 and 20” means 2% management fee (based on AuM) and 20% incentive fee
(hurdle rate or high water mark provisions may apply)
Soft hurdle rate: incentive fees are calculated on the entire return if hurdle rate is
cleared.
Hard hurdle rate: incentive fees are calculated on the return above the hurdle rate.
High water mark: incentive fees are only applies to profits after previous losses are
recovered.

Private equity

Leveraged Use borrowed funds to buy an established company. The company will be restructured to
buyouts improve operations and eventually increase cashflow and profit.

(LBOs)

2 types of LBOs:

 – management buyouts (MBOs) where current management team buys and runs the
company,

– management buy-ins (MBIs) where current management team is replaced and run by the
acquirer.

Investments in less established companies with significant growth potential.

VC investing can take place at various stages:

Venture
– Formative stage: angel investing, seed investing, early stage

capital (VC)
– Later stage financing: for expansion after commercial productions and sales but before
IPO

– Mezzanine financing: preparing for IPO.

Development Minority equity investments in established companies that require funds for
capital growth/expansion, restructuring, acquisition etc.

Distressed
Buying debt of mature companies in financial distress.
investing

Private equity exit strategies: trade sale, IPO, recapitalization, secondary sale, write
off/liquidation.
Valuation methods for portfolio company: market or comparables approach,
discounted cash flow approach, asset-based approach.

Real estate
 Investment
Residential property, commercial real estate, REITs, timberland/farmland.
categories

3 categories of index to measure real estate returns:

– Appraisal index: uses estimates rather than real transaction values, which understates
volatility.

Performance – Repeat sales index: Uses repeat sales of properties to construct the indices, but this
measurement suffers from sample selection bias since it’s unlikely the same property is available for sale
annually.

– REIT index: this is based on prices of publicly traded REITs, which accuracy depends on
how frequently the shares of the index trade.

3 methods for valuation:

Real estate
– comparable sales approach,

valuation
– income approach (direct capitalization method and discounted cash flow method),

approaches
– cost approach.

2 methods:

REIT valuation
– income based approach using funds from operations (FFO) and adjusted FFO.

approaches
– asset based approach using net asset value (NAV)

Commodities

Commodities futures price = Spot price x (1+r) + Storage costs – Convenience Yield
Contango = when commodity futures price > spot price. Happens when there is
little or no convenience yield.
Backwardation = when commodity futures price < spot price. Happens when there
is high convenience yield.
3 sources of return for a commodity futures contract:
Roll yield: Spot price – futures price
Collateral yield: interest earned on the collateral
Spot prices, which is determined by supply and demand

Infrastructure
 Investments in real, capital intensive, long-lived assets
Categories of infrastructure investments:
Economic infrastructure assets: transportation (road, railways etc) and utility
assets (water, gas, electricity distribution).
Social infrastructure assets: examples are healthcare and educational facilities.
Brownfield investments are investments in existing infrastructure assets.
Greenfield investments are investments in yet to be built infrastructure assets.

CFA Level 1 Alternative Investments Tips

​This is a heavily qualitative Study Session that will require you to use your calculators
sparingly, if at all.

The key answering questions on this topic is to understand and identify the differences
between various types of alternative investments as well as the distinguishing features
of categories within asset classes.

​For example, it is important to know the difference between direct and indirect real estate
investing. In the case of hedge funds, it is important to be able to distinguish between the
different classifications of strategies (see the sample question below).
​An exam question on alternative investments may look something like this:

Which of the following hedge fund strategies is most likely to be categorized as a

relative value strategy?

A. Merger arbitrage

B. Quantitative directional

C. Fixed income convertible arbitrage

Option C is the correct answer. Fixed income convertible arbitrage is a relative value
strategy that involves taking long and short positions in related securities with a view to
profiting from short-term pricing discrepancies.

Choice A is incorrect because merger arbitrage is an event-driven strategy. Choice B is

incorrect because quantitative directional strategies fall in the category of equity hedge
strategies.

This sample shows that, while the Level 1 curriculum covers alternative investments at a
high level, it is still necessary to develop a strong understanding of important details.

The CFA Level 1Alternative Investments may be covered from a highly qualitative
perspective, but it is not unreasonable to expect a question asking you to calculate hedge
fund fees. Such a question may look something like this:

The Axe Capital Fund begins the year with $2 billion of assets under management
(AUM). Fund manager Bobby Axelrod charges a 2% management fee (based on ending
AUM) and a 20% incentive fee, which subject to a 5% hard hurdle rate and calculated
net of the management fee. At the end of the year, the fund’s value has increased by
 17%. The total amount of fees earned by Bobby Axelrod for that year’s performance is
closest to:
 A. $85 million.

B. $95 million.

C. $105 million.

Option A is the correct answer and can be calculated as follows:

The Axe Capital Fund begins the year with $2 billion in AUM and grows by 17% to $2,340
million over the course of the year. Bobby Axelrod’s management fee is $2,340 million x
2% = $46.8 million. The 20% incentive fee is subject to a 5% hard hurdle rate, so it is only
applied on gains above $100 million ($2 billion x 5%). The incentive fee is also calculated
net of the management fee calculated above, so the relevant gain is:

$340 million – $100 million – $46.8 million = $193.2 million

20% of $193.2 million is $38.64 million, which is Axelrod’s incentive fee and brings his
total compensation for the year to $46.8 million + $38.64 million = $85.44 million.

Choice B is incorrect because this represents Axelrod’s total compensation if a soft hurdle
rate (or none at all) had been used and the incentive fee had been calculated net of the
management fee. Choice C is incorrect because this represents his total compensation if
a hard hurdle rate is used, but the incentive fee had been calculated gross of the
management fee.

More Cheat Sheet articles will be published over the coming weeks. Get ahead of other
CFA candidates by signing up to our member’s list to get notified.

Meanwhile, here are other related articles that may be of interest: 3H

CFA Level 1 Cheat Sheets series: Quant Methods | Economics | Corporate

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