CFA® Alternative Investments
Summary, Syllabus, Topics, and Sample Questions (L1, L2, L3)
The CFA® curriculum categorizes assets other than equity, fixed-income, and derivatives as Alternative Investments, covering a wide range of topics from tangible assets like gold to hedge fund strategies. Alternative investments are supplemental strategies to traditional long-only positions and are not necessarily uncommon or recent additions to the investment universe.
Common categories of Alternative Investments include:
- Hedge funds, which use various strategies to aim for positive returns.
- Private capital, including private equity (e.g., leverage buyout, venture capital) and private debt (e.g., direct lending, mezzanine loans).
- Real estate, comprising residential and commercial sectors.
- Natural resources, like commodities, timberland, and farmland.
- Infrastructure, which encompasses buildings, bridges, roads, etc.
Alternative investments may involve non-traditional approaches, allowing flexibility with derivatives, leverage, illiquid assets, and short positions, encompassing traditional and less traditional assets. Active management is typical in Alternative Investments, exploring hedge funds, private equity, real estate, commodities, and infrastructure, emphasizing their common characteristics and role in diversification and potentially higher returns.
The CFAI® Alternative Investments curriculum is an important topic if you work in asset management, as it is expected to capture 49% of global asset management revenue by 2024.
What to Expect in CFA Level 1 Alternative Investments?
This topic explores Alternative Investments, including hedge funds, private equity, real estate, commodities, and infrastructure. In this curriculum, CFAI defines Alternative Investments, the characteristics they have in common, and their usefulness in creating diversification and higher returns.
Exam Weighting
The CFA Level I Alternative Investment weighs 7-10% of the total exam content, so approximately 13-18 CFA Level I exam questions focus on this topic.
| Topic Weight | No. of Learning Modules | No. of Formulas | No. of Questions |
|---|---|---|---|
| 7-10% | 7 | Nearly 15 | 13-18 |
Level 1 Alternative Investments 2024 Syllabus, Readings, and Changes
The CFA Level 1 exam includes 7 total learning modules for 2024. Numerous new texts have been added to the curriculum at all three levels, substantially expanding the focus on the topic area of Alternative Investments. One other change for 2024 is the Introduction to Digital Assets.
| No. of Learning Modules – 7 | No. of LOS – 22 | |
|---|---|---|
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Summary
This reading provides a comprehensive introduction to Alternative Investments. Alternative investments are asset classes or investment vehicles that supplement traditional long-only positions in stocks, bonds, and cash. Alternative investments include five main categories: hedge funds, private capital, natural resources, real estate, and infrastructure.
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This significant change expands the discussion of alternatives and gives more information on how to use them in an investment strategy. In-depth exploration of alternative asset classes, risk management, and alternative investment structures are combined with fundamental knowledge to produce a simplified learning experience.
Alternative Investment Features, Methods, Structures, Performance, and Returns
This topic focuses on understanding the features and categories of alternative investments. It delves into the distinctions between direct investment, co-investment, and fund investment methods within alternative investments.
Additionally, the discussion explores prevalent investment ownership and compensation structures commonly employed in alternative investments.
Investments in Private Capital: Equity and Debt
Since they may be infrequently and/or privately traded, pricing, valuation, and performance can be much more difficult to assess for alternative investments. This learning module explores the factors, models, and circumstances that impact performance evaluation.
Private Capital, Real Estate, Infrastructure, Natural Resources, and Hedge Funds
This learning module looks at the various categories of alternative investments and their specific characteristics, risks, and returns.
Introduction to Digital Assets
This topic explores the financial applications of distributed ledger technology. It encompasses an explanation of the investment features of digital assets and provides a comparative analysis with other asset classes. Furthermore, the discussion covers various investment forms and vehicles utilized in digital asset investments. Additionally, it involves the analysis of sources of risk, return, and diversification within the landscape of digital asset investments.
CFA Alternative Investments Level 1 Sample Questions and Answers
The sample questions are typical of the probing multiple-choice questions on the L1 exam. During the exam, you have about 90 seconds to read and answer each question, carefully designed to test knowledge from the CFA Curriculum. UWorld’s question bank is built to expose you to exam-like questions and illustrate and explain the concepts tested thoroughly.
At the end of 20X4, a hedge fund had $25 million in assets under management (AUM). The fund has the following fee structure, high-water mark, and 20X5 results:
| Selected Data | |
|---|---|
| Management fee (average assets) | 1% |
| Incentive fee (net of management fee) | 10% |
| Soft hurdle rate | 6% |
| High-water mark (millions) | $27 |
| Year-end fund assets 20X5 (millions) | $30 |
Assuming no inflows or outflows, the incentive fee (in $) earned by this hedge fund for 20X5 is closest to:
- 109,000
- 272,500
- 300,000
A hedge fund manager wants the power to liquidate positions in a well-organized way whenever necessary and plans to impose restrictions on investors’ ability to redeem capital. Which of the following restrictions would be most appropriate?
- Notice period
- Lockup period
- Redemption fee
For the general partner in a private equity or venture capital fund, which of the following waterfall distribution methods is most advantageous compared to the others?
- Clawback
- Deal-by-deal
- Whole-of-fund
What to Expect in CFA Level 2 Alternative Investments?
These readings focus on real estate, private equity, and commodities. The readings describe real estate investments, both private and public, and methods for analysis and evaluation. Private equity, including venture capital and leveraged buyouts, is examined from the perspectives of both a private equity firm evaluating equity portfolio investments and an investor considering participation in a private equity fund. Strategies involving commodity hedging are also discussed.
The CFA Level 2 Alternative Investment (AI) is not only fundamental to passing CFA Level 2 but to succeeding in the CFA overall.
Exam Weighting
CFA Alternative Investment has a weighting of 5-10% of the total exam content, such that approximately 4-8 questions or 1-2 item sets focus on this topic.
| Topic Weight | No. of Learning Modules | No. of Formulas | No. of Questions |
|---|---|---|---|
| 5-10% | 4 | Around 20 | 4-8 |
Level 2 Alternative Investments 2024 Syllabus, Readings, and Changes
The 2024 CFA Level 2 exam comprises four learning modules. Notably, Private Equity Investments has been removed from the readings, and Hedge Fund Strategies has been introduced into the curriculum.
| No. of Learning Modules – 4 | No. of LOS – 29 | |
|---|---|---|
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Summary
These learning modules focus on the following categories of Alternative Investments: real estate, private equity, and commodities. Real estate investments, both private and public, are described, and methods for analysis and evaluation are presented. Private equity, including venture capital and leveraged buyouts, is examined from both the perspectives of a private equity firm evaluating equity portfolio investments and of an investor considering participation in a private equity fund. |
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Although it is commonly known that real estate contributes significantly to a balanced portfolio’s diversification, applicants should be aware of how significantly the risk profile of real estate investments varies depending on the type of asset. The “Real Estate Investments” material describes the risk profile of real estate debt vs equity (as a lender or owner of mortgage-backed securities), primarily focusing on commercial real estate.
Overview of Types of Real Estate Investments
Real estate property holds substantial importance within investment portfolios, offering an appealing source of current income.
This learning module provides a comprehensive comparison of the features, classifications, primary risks, and fundamental structures of both public and private real estate investments. It also delves into the roles real estate plays in portfolios and the factors determining its economic value.
Furthermore, the module explores various commercial property types, shedding light on their unique investment traits. It covers the due diligence procedures applicable to both private and public equity real estate investments. Additionally, it addresses real estate investment indexes, including their construction methods and potential biases
Investments in Real Estate through Publicly Traded Securities
These learning modules compare various characteristics, classifications, and risks for public and private real estate investments. They also describe the valuation principles and approaches for pricing alternative assets along with discussion on the advantages and disadvantages of investing in real estate through publicly traded securities compared to private vehicles.
Introduction to Commodities and Commodity Derivatives
This reading provides a discussion of commodities and commodity futures, including scenarios of contango and backwardation for futures prices.
Hedge Fund Strategies
This topic focuses on classifying hedge fund strategies, including equity-related, event-driven, relative value, opportunistic, specialist, and multi-manager strategies. It delves into the investment characteristics, strategy implementation, and the role each plays in a portfolio.Additionally, the discussion encompasses how factor models can be utilized to comprehend hedge fund risk exposures and evaluates the impact of allocating to a hedge fund strategy within a traditional investment portfolio.
CFA Alternative Investments Level 2 Sample Questions and Answers
The provided sample questions exemplify the level of complexity and depth encountered in the Level 2 exam. They are presented as item sets, each accompanied by a vignette that creates a scenario designed to assess your understanding of the CFA Level 2 Curriculum. It’s worth noting that on the actual exam, each vignette applies to four questions, but we’ve included a few extra questions to enhance your learning experience. We strongly recommend reviewing the detailed explanations provided for each question. UWorld’s question bank is specifically designed to familiarize you with exam-style questions and provide comprehensive explanations to help you grasp the tested concepts thoroughly.
Passage
Chao Li is a vice president at Tailwind Capital, a private equity (PE) firm. He is currently raising £100 million for Tailwind Fund A. Li meets with An Heng, an associate at Insular Insurance Co., a potential institutional investor. In their meeting, Li explains the general structure of PE funds to Heng:
- Statement 1: The limited partners (LPs) and the general partner (GP) in a private equity fund participate in managing the fund.
- Statement 2: The GP is entitled to carried interest, which is typically a percentage of the fund’s profits after management fees.
- Statement 3: PE funds are closed-end funds, so LPs can redeem their investments only at specified times.
Heng says, “I understand there are costs associated with investing in PE, such as significant performance fees, dilution costs whenever the PE firm starts new funds, and annual audit costs. And I know that there are some agency risks involved with investing in a PE fund. Is there a governance provision that would address GP gross negligence?”
Subsequently, Li raises the full £100 million for Fund A. One of the fund’s investments is ModernWare, an online services company. The initial investment is £20 million: £13 million in debt, £2 million in preferred equity, and £5 million in the PE fund’s equity. Tailwind plans to sell ModernWare 5 years from now and plans to reduce the debt balance by £10 million by the time of exit. The promised return for the preferred equity holders is 15%.
Several years after the fund’s inception, Tailwind exits two investments: StoneWare and BronzeWare (Exhibit 1). Carried interest to the GP is accrued on a deal-by-deal basis and equals 20% of the profits from each exit. The hurdle rate is 10%. When a deal’s IRR is above the hurdle rate, carried interest is accrued; when a deal’s IRR is below the hurdle rate, a clawback penalty amount is accrued if there is a loss.
| Exhibit 1 Investment Exits | |||
|---|---|---|---|
| Company | Initialinvestment (at T = 0) | Profit from exit (£ millions) | Exit year |
| StoneWare | 8 | 3 | T = 3 |
| BronzeWare | 5 | -1 | T = 4 |
Twelve years after the fund’s inception, Li meets with Heng again to review Fund A’s performance, shown in Exhibit 2.
| Exhibit 2 Tailwind Fund A Performance | ||||||
|---|---|---|---|---|---|---|
| Committed capital (£ millions) | Paid-in capital | Net IRR(%) | Distributions to paid-in capital | Residual value to paid-in capital | Total value to paid-in capital | Maturity |
| 200 | 190 | 25.0% | 1.40 | 1.45 | 2.85 | 12 years |
Which of Li’s statements on Tailwind’s fund structure is incorrect ?
- Statement 1
- Statement 2
- Statement 3
Which governance provision most likely addresses GP gross negligence?
- No-fault divorce
- Key man clause
- Removal for cause
When speaking about costs associated with investing in private equity, Heng is incorrect with regard to:
- annual audit costs
- significant performance fees
- dilution costs when the firm starts new funds
What to Expect in CFA Level 3 Alternative Investments?
CFA Level 3 Alternative Investments delves into the unique regulatory and investment characteristics of major hedge fund strategy categories. It also delves into the role of alternative assets within a multi-asset portfolio and how they can help mitigate the risk associated with long-only equity investments. The curriculum explores various approaches to asset allocation when incorporating alternatives, whether through traditional methods or using risk- or factor-based approaches. Notably, there are two out of the 35 (5.7%) Level 3 readings dedicated to Alternative Investments.
Candidates will explore these concepts and principles in greater depth compared to the broader coverage in the CFA Institute Level 2 Alternative Investments curriculum.
Exam weighting
The CFA Alternative Investment curriculum has a weighting of 5-10% of the total exam content so approximately 1-2 item sets and 4-8 essay questions will focus on this topic.
| Topic Weight | No. of Readings | No. of Formulas | No. of Questions |
|---|---|---|---|
| 5-10% | 2 | Around 5 | 8-13 |
Level 3 Alternative Investments 2024 Syllabus, Readings, & Changes
The CFA Level 3 exam allocates approximately 5.7% of its content to Alternative Investments, featuring two readings. While there were 17 Learning Outcome Statements (LOS) in 2023, the 2024 curriculum streamlines this to 16 LOS in the Alternative Investments section.
| No. of Readings – 2 | No. of LOS – 16 |
|---|---|
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Summary
Presents distinctive regulatory and investment characteristics of the major categories of hedge fund strategies. Discuss the role alternative assets play in a multi-asset portfolio and explore how alternatives may mitigate long-only equity risk. Discusses approaches to asset allocation when incorporating Alternatives in the opportunity set whether using the traditional asset class approach or risk or factor-based investing. |
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Hedge Fund Strategies
This reading discusses important hedge fund categories as well as the investment characteristics of six main hedge fund strategies: equity-related, event-driven, relative value, opportunistic, specialist, and multi-manager strategies.
Asset Allocation to Alternative Investments
This study discusses the potential benefits of adding Alternative Investments to a portfolio of traditional investments that typically include debt and equity. Characteristics of Alternative Investments that impact asset allocation decisions are discussed. Factor-based optimization versus mean-variance optimization is compared along with a discussion of liquidity concerns and time horizon regarding Alternative Investments’ suitability.
Study Tips for CFA Alternative Investments
Besides the typical long-only investments in stocks, bonds, and cash, there is also room for alternative assets in a diversified portfolio. These alternative investments encompass hedge funds, private equity, real estate, natural resources, and infrastructure – the five main categories. It's important to note that for the Level 1 exam, candidates aren't required to possess an extensive understanding of these concepts. However, in Levels 2 and 3, the readings delve deeper into these subcategories.
- Strategy Differentiation: Distinguishing between various hedge fund strategy categories is vital for effective decision-making.
- Quantitative Aspects: While CFA Level 1's Alternative Investments mainly focus on qualitative aspects, it's essential to grasp key investment return calculations and performance metrics.
- Limited Calculator Use: Expect minimal calculator usage during this predominantly qualitative study session.
- Complex Learning Curve: Given their relative unfamiliarity, alternative investments present a wealth of new terminology, valuation models, and market structures to master across all three CFA levels.
Frequently Asked Questions
How do I study for Level 1 Alternative Investments for the CFA exam?
The learning modules and practice questions predominantly emphasize conceptual understanding, particularly focusing on definitions and contextual comprehension, making them relatively easy to score well on. While a limited number of calculations are involved, primarily about cost analysis and the impact of fee structures on returns, these too can be mastered with practice.
For registered candidates, the CFA Institute offers official study materials and an array of online resources accessible through its website. However, engaging with a comprehensive QBank that spans all chapters and readings is the most effective approach to preparing for the exam. The UWorld CFA QBank, in particular, provides a substantial collection of over 100 questions, each accompanied by detailed explanations, extensively covering the domain of artificial intelligence.
How do I practice CFA Level 1 Alternative Investments questions?
How do I practice CFA L1 Alternative Investments formulas?
Is CFA level 2 Alternative Investments hard?
How to prepare for the CFA Level 3 Alternative Investments section?
Mastery in Alternative Investments demands rigorous practice, and there’s no better tool than QBank sessions. UWorld’s CFA Level 3 prep is not just cost-effective with three tailored plans but also boasts an abundance of QBank resources. Elevate your preparation with progress-tracking through Mock Exams, engaging lecture series, and a suite of flexible, student-centric features. It’s the unparalleled companion to ensure your triumph in acing the exam.