CFA® Alternative Investments
Summary, Syllabus, Topics, and Sample Questions (L1, L2, L3)
Alternative investments are supplemental strategies to traditional long-only positions. The terms “traditional” and “alternative” should not imply that alternatives are necessarily uncommon or that they are relatively recent additions to the investment universe. Alternative investments include such assets as real estate and commodities, which are arguably two of the oldest types of investments.
Alternative investments also include non-traditional approaches to investing in asset classes, such as private equity funds and hedge funds. These funds may give the manager flexibility to use derivatives and leverage, make investments in illiquid assets, and take short positions. The assets in which these vehicles invest can include traditional assets (stocks, bonds, and cash) as well as less traditional assets. Management of Alternative Investments is typically active. This topic explores Alternative Investments, including hedge funds, private equity, real estate, commodities, and infrastructure, covering their common characteristics, and their usefulness for creating diversification and/or higher returns.
What is 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 has a weighting of 5-8% of the total exam content, such that approximately 9-15 questions of the CFA Level I exam questions focus on this topic.
| Topic Weight | No. of Readings | No. of Formulas | No. of Questions |
|---|---|---|---|
| 5-8% | 01 | Nearly 15 | 12 |
Syllabus & Readings Overview
The CFA Level 1 exam includes 60 total readings for 2022 out of which only 1 reading (around 2%) focuses on Alternative Investments (i.e. Reading 47).
| Study Session | No. of Readings | No. of LOS |
|---|---|---|
| 16 | 01 | 10 |
Summary This reading provides a comprehensive introduction to Alternative Investments. Alternative investments are asset classes or investment vehicles that are supplemental to traditional long-only positions in stocks, bonds, and cash. Alternative investments include investments in five main categories: hedge funds, private capital, natural resources, real estate, and infrastructure. | ||
For a more comprehensive enumeration of LOS visit the official CFAI Level 1 syllabus page and select the desired session under “2022 Level 1 Study Sessions”.
Introduction to Alternative Investments
This reading compares Alternative Investments with traditional investments. It describes the fundamental characteristics, categories, and general strategies of Alternative Investments along with their distinguishing characteristics, valuation considerations, risks, returns, costs, and benefits.
For 2022’s curriculum, it is covered in Study Session 16, which includes Reading 47.
Exam weight and Topic Changes in Alternative Investments Level 1
The weighting of the Alternative Investment increased from 2018 to 2020. Since 2021, weighting has fluctuated between 5-8%.
| 2018 | 2019 | 2020 | 2021 | 2022 |
|---|---|---|---|---|
| 4% | 6% | 6% | 5-8% | 5-8% |
Numerous new texts have been added to the curriculum at all three levels, substantially expanding the focus on the topic area of Alternative Investments. 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 Level 1 Changes | |
|---|---|
| Introduction to Alternative Investments | Major Revision |
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
FAQs
Is the CFA Level 1 Alternative Investment topic hard?
It is more qualitative at Level 1 and its difficulty level is about average.
How do I study for Level 1 Alternative Investments for the CFA exam?
Both the reading and practice questions are mostly conceptual, with a focus on definitions. These are easy points to score. There are a few calculations, mostly addressing costs and fee structures and their effects on returns. CFA Institute provides official material as well as online resources for registered candidates on their website.
The best way to study for the exam is to practice with a QBank across all chapters and readings. The UWorld CFA QBank offers over 100 questions and detailed explanations covering AI.
How do I practice CFA Level 1 Alternative Investments questions?
After moving through a QBank the next step, to see how you are doing with the content, is taking Mock Exams. UWorld’s mock exams closely replicate the actual CFA L1 exam experience to help you prepare and boost your confidence on test day. Like the actual CFA exam, our mock exams consist of two 2-hour 15-minute sessions, each with 90 multiple-choice questions spanning multiple subjects and not included in the standard QBank.
What are Alternative Investments in the CFA Institute curriculum?
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 most common categories of Alternative Investments are:
- Hedge funds are pooled investments for which the managers use a wide range of strategies with the aim of generating positive returns
- Private capital includes private equity (leverage buyout, venture capital funds) and private debt (direct lending, mezzanine loans, venture debt, distressed debt).
- Real estate includes two major sectors: residential real estate and commercial real estate
- Natural resources typically include commodities, timberland, and farmland
- Infrastructure such as buildings, bridges, roads etc.
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.
How do I practice CFA L1 Alternative Investments formulas?
Understanding the underlying concept of each formula will help you memorize related concepts and formulas. Think of it as a mathematical depiction of the concept rather than memorizing phrases one by one. As you build this foundation of understanding, reinforce it through repetition and application. Take a look at our CFA L1 Formula Sheet page for further resources and tips.
What is the CFA Level 2 Alternative Investments Topics?
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. At Level 2, 3 of the 47 (6.4%) readings are dedicated to AI. Candidates will dive deeper into the details of the concepts and principles presented in the CFA Level 1 AI curriculum.
Exam weighting
CFA Alternative Investment has a weighting of 5%-10% of the total exam content, such that approximately 6 of the 88 CFA Level 2 exam questions focus on this topic.
| Topic Weight | No. of Readings | No. of Formulas | No. of Questions |
|---|---|---|---|
| 5-10% | 03 | Around 20 | 6 |
Syllabus & Readings Overview
The CFA Level 2 exam includes 47 total readings for 2022 out of which only 3 readings (around 6.4%) focus on Alternative Investments (i.e. Reading 35, 36, and 37).
| Study Session | No. of Readings | No. of LOS |
|---|---|---|
| 14 | 03 | 34 |
Summary It focuses 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. | ||
For a more comprehensive enumeration of LOS visit the official CFAI Level 2 syllabus page and select the desired session under “2022 Level 1 Study Sessions”.
Real Estate Investments
This reading compares various characteristics, classifications, and risks for public and private real estate investments. It further describes 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.
Private Equity Investments
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.
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.
Exam weight and Topic Changes in Alternative Investments Level 2
The weighting of the Alternative Investment has remained constant from 2018 to 2022.
| 2018 | 2019 | 2020 | 2021 | 2022 |
|---|---|---|---|---|
| 5-10% | 5-10% | 5-10% | 5-10% | 5-10% |
| Alternative Investments | #Readings |
|---|---|
| # of unchanged Readings | 0 |
| # of Updated Readings | 0 |
| # of Revised Readings | 2 |
| # of New Extensively Revised or Added Readings | 1 |
The Level II curriculum has been updated with new material examining alternative investments. Private Real Estate Investments and Publicly Traded Real Estate Securities are combined and revised in the “Real Estate Investments” reading. A general overview of real estate investments is given, and the relative advantages of investing in real estate through private entities vs publicly listed securities are then discussed. The reading comprises two actual appraisals and 33 examples. 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” reading describes the risk profile of real estate debt vs equity (as a lender or owner of mortgage-backed securities), with a primary focus on commercial real estate.
| Alternative Investment Level 2 Changes | |
|---|---|
| Real Estate Investments | Major Revision |
| Publicly Traded Real Estate Securities | Dropped |
| Private Equity Investments | Revised |
| Introduction to Commodities and Commodity Derivatives | Revised |
CFA Alternative Investments Level 2 Sample Questions and Answers
The sample questions here are typical of the L2 exam’s complexity and depth: formatted as item sets, with a vignette to deliver a scenario that tests the CFA L2 Curriculum. (On the actual exam, each vignette applies to four questions; we’ve thrown in a couple extra to get a bit more learning in). And be sure to review the illustrated explanations we’ve provided for each question: UWorld’s question bank is designed to expose you to exam-like questions and explain the concepts tested 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 Heng’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
FAQs
Is CFA level 2 Alternative Investments hard?
As with all of the Level 2 curriculum, compared to Level 1, these readings–and the material they explore–have more depth and detail, and therefore are more difficult.
How can I study L2 Alternative Investments for CFA?
The best way to study for the exam is to read the curriculum and practice with a QBank across all chapters and readings. UWorld’s CFA Level 2 test prep helps you review your progress and acts as a catalyst in speeding up your preparation process.
What is CFA Level 3 Alternative Investments?
CFA L3 Alternative Investments present distinctive regulatory and investment characteristics of the major categories of hedge fund strategies. It discusses the role alternative assets play in a multi-asset portfolio and explores how alternatives may serve to mitigate long-only equity risk. Approaches to asset allocation when incorporating alternatives in the opportunity set—whether through the traditional asset allocation approaches or using a risk- or factor-based approach—are examined. There are 2 of the 35 (5.7%) Level 3 readings dedicated to AI.
Candidates will dive deeper into the details of a narrower range of concepts and principles presented in the CFAI Level 2 AI curriculum.
Exam weighting
The CFA Alternative Investment curriculum has a weighting of 5%-10% of the total exam content, so that approximately 6 of the 88 CFA Level 3 exam questions focus on this topic. Each item set on the CFA Level 3 exam 2022 will consist of vignette-supported essay or multiple choice questions.
| Topic Weight | No. of Readings | No. of Formulas | No. of Questions |
|---|---|---|---|
| 5-10% | 02 | Around 5 | 6 |
Syllabus & Readings Overview
The CFA Level 3 exam includes 35 total readings for 2022 out of which only 2 readings (around 5.7%) focus on Alternative Investments (i.e. Readings 19 & 20).
| Study Session | No. of Readings | No. of LOS |
|---|---|---|
| 9 | 02 | 17 |
Summary Presents distinctive regulatory and investment characteristics of the major categories of hedge fund strategies.Discusses the role alternative assets play in a multi-asset portfolio and explores how alternatives may serve to 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. | ||
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 includes 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 discussion of liquidity concerns and time horizon as regarding Alternative Investments’ suitability.
Exam weight and Topic Changes in Alternative Investments Level 3
The weighting of the Alternative Investment has remained constant from 2019 to 2022.
| 2018 | 2019 | 2020 | 2021 | 2022 |
|---|---|---|---|---|
| 5-15% | 5-10% | 5-10% | 5-10% | 5-10% |
| Alternative Investment for Portfolio Management | #Readings |
|---|---|
| # of unchanged Readings | 2 |
| # of Updated Readings | 0 |
| # of Revised Readings | 0 |
| # of New Extensively Revised or Added Readings | 0 |
The two readings in the Alternative Investments for Portfolio Management topic remain unchanged for 2022.
FAQs
Is the CFA Level 3 Alternative Investments topic hard?
The difficulty level is higher than average.
How do I study Level 3 Alternative Investments for the CFA exam?
The best way to study for the exam is to practice with a QBank across all chapters and readings. The UWorld CFA Level 3 QBank is expected to launch in 2023. The CFA Institute provides official material as well as online resources for registered candidates on its website.
How do I practice CFA Level 3 Alternative Investments questions?
After moving through a QBank, check your progress by taking Mock Exams. UWorld is releasing its CFA Level 3 test prep later this year, which will closely replicate the actual CFA L3 exam experience.
Study Tips for CFA Alternative Investments
In addition to the more conventional long-only positions in stocks, bonds, and cash, other assets can be used. Hedge funds, private equity, real estate, natural resources, and infrastructure are the five primary areas of alternative investments. Candidates are not expected to have an extraordinarily in-depth comprehension of this content, at least not for the Level 1 exam, given that this study session is constrained to a single reading with around half a dozen LOS. The readings at Levels 2 and 3 cover the same subcategories but go into more detail.
- It is critical to be able to discern between the many categories of strategies when dealing with hedge funds.
- Although the CFA Level 1 Alternative Investments are addressed from a highly qualitative standpoint, it is realistic to anticipate that you may be asked to estimate hedge fund fees.
- You won't need your calculator much throughout this largely qualitative study session.