Reading 58: Introduction to Alternative Investments
The CFA curriculum is always changing and this last reading of Level 1 has been completely overhauled by the Institute and is considered a new reading. There is only this one reading regarding alternative investments, but you still don’t want to overlook the material in this section. As alternatives become more important in the market, it’s safe to expect this to play a bigger role in higher level curriculums in the future.
Alternative investments include any assets that do not fall into the traditional asset class categories of equity and fixed income. It can include derivatives, real estate, commodities, short-selling of stocks, or many others. Common characteristics of alternative investments include limited liquidity, low correlation of returns with traditional assets, lax regulation, low transparency, and special tax and legal considerations. The primary benefit of investing in alternatives is the diversification effect due to the low correlation of returns compared to traditional investments.
There are no formal categories for alternative investments, but there are several common groups into which they fall. Private Equity investments, either as funds or individual securities, represent ownership in companies that are not listed for the public. Real Estate includes investments in land and buildings, often done through direct ownership, shares in Real Estate Investment Trust (REIT) funds, or mortgages and mortgage-backed securities. Commodities are physical goods such as oil, metals, and agricultural products. Other securities can be things as diverse as fine art and collectible baseball cards.
Hedge Funds are special investment funds that aim to provide the highest possible absolute returns. They are actively managed and typically invest in aggressive strategies across many different asset classes. Many try to maximize returns through the use of leverage, arbitrage, and derivative strategies to outperform conventional funds. Investment withdrawal and lockup periods are common to prevent investors from removing their funds in the middle of an investment strategy. Hedge funds can be difficult to compare due to lack of transparency in holdings and returns compared to other kinds of investment funds.
Private Equity Funds invest in non-publicly traded companies. They often use strategies including leveraged buyouts, distressed investing, and other methods of acquiring a portfolio of private companies. A frequent exit strategy involves taking a portfolio company to IPO or organizing a sale in order to recoup capital investment.
Hedge Funds use a different approach to fees compared to traditional fund managers. The standard general fee is what’s known as the “2 and 20” structure. This includes an annual management fee equal to 2% of the assets under management and 20% of the returns to the fund. Many funds utilize a “high watermark” feature to prevent the manager from charging multiple times for the same performance. Under this feature, performance increases only count towards the 20% the first time they occur. If the fund drops in value, the returns will not start accruing more of the 20% fee until the fund exceeds the previous high point prior to the decline.
Valuations for private equity and hedge funds is trickier than for traditional funds due to the use of leverage and non-traditional strategies in hedge funds and private holdings in private equity funds. Discount cash flow models are commonly used for private securities that do not have any market information to help determine the proper valuation. Fund performance is also more difficult to compare between different managers due to the calculations needed to find proper valuations of fund assets. Private equity returns are often back-weighted because no cash is generated for investors until the security is sold at the end of the investment period.
Real estate valuation typically involves using one or more of three common approaches: comparable sales, income approach, and replacement cost. The Comparable Sales method involves using the sale price of properties that are similar to the owned property to determine an appropriate value. The Income Approach uses the present value of the income the property is expected to generate as the property value. The Replacement Cost method calculates the financial cost to replace the exact property at current market rates. REIT funds are valued by calculating a Net Asset Value of the fund’s holdings.
The due diligence process for alternative investments is also more complicated than traditional assets. This analysis for private equity, real estate, or hedge fund managers can be complicated due to a lack of transparency among different fund managers and differences in the way that firms calculate and publish their returns. Reporting standards are laxer for firms that do not hold public companies or sell shares broadly to the public. Proper analysis of a manager includes looking at their operations, organization, portfolio management practices, accounting controls, and a multitude of other factors. Due diligence on real estate assets typically involves assessment of the property itself and the economic factors to which it is exposed.