Your Cheat Sheet to… CFA Level I: Alternative Investments

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By Marc

The Cheat Sheet articles are a series of articles, each focusing on one specific topic area of the CFA exam for one specific CFA level. In each Cheat Sheet article, we will cover the basics of what you need to know before diving into the material – what it’s about in a nutshell, how significant is it in the CFA exams, real-life applications, and tips for the CFA exams. You should aim to read each relevant Cheat Sheet article before you start studying the topic area to get you to a flying start.

For this article, we will look at Alternative Investments for CFA Level I.

What is the weighting of this topic in the CFA exams?
The Study Session on Alternative Investments has a 4% weighting on the Level 1 CFA exam. So you can reasonably expect encounter 8 to 10 questions from this material on exam day. By contrast, you can expect 24 questions on each of the “core” asset classes, equity and fixed-income.

Even though this is a lighter-than-average topic area, you will have an interest in developing a strong understanding of this material because it has a 5 -10% weighing on the Level II exam and is an important topic on the Level III exam.


What is Alternative Investments about, in a nutshell?
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:
Real estate
Hedge funds
​Owning real estate is a relatively simple concept, but there are several ways to think of this as an asset class. 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).
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. 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)
Commodities
Private equity
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 investing is growing at a rapid rate and this topic will play a larger role in the curriculum at Levels 2 and 3.
This category includes two important sub-categories, buyout funds, which make highly-leveraged purchases of established companies, and 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)…

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

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. In addition, these asset classes can improve a portfolio’s risk-return profile by offering returns that have a low correlation with those of traditional asset classes.


Why should I care about this in real life?
The title “alternative investments” itself suggests that this material is peripheral. It does not help that, as noted above, that this Study Session has a very small exam weighting. Nor does the decision to place this reading (literally) at the back end of the curriculum suggest that it is particularly important.

Not true. Even if you don’t end up working as a commodities trader or hedge fund manager, there is always a need to be familiar with all investment classes. 

Alternative investments constitute a significant share of investable assets classes and should be at least considered for inclusion in any portfolio. At a minimum, it is important for any financial analyst to understand how the types of assets covered in this reading differ from equity and debt, which are covered in far more detail in the curriculum and make up a significantly larger share of questions on the Level I exam.


Any tips for the exam I should know about?

​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).


How does Alternative Investments get tested?

​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 I curriculum covers alternative investments at a high level, it is still necessary to develop a strong understanding of important details.

The Level I curriculum covers Alternative Investments 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: 

Zee Tan
Author: Zee Tan

 

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