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IFT Notes for Level I CFA® Program
IFT Notes for Level I CFA® Program

R47 Introduction to Alternative Investments

Part 4


6.3 Risk/Return of Natural Resources

Risk/Return: Commodities

Commodities offer potential for returns, portfolio diversification, and inflation protection.

Commodity spot prices are a function of supply and demand, the costs of production and storage, value to users, and global economic conditions.

  • Supplies of commodities depend on production and inventory levels.
  • Demand of commodities depends on the consumption needs of end users.
  • Demand may be high while supply may be low during economic growth; conversely, demand may be low and supply high during times of economic slowdown.
  • If demand changes very quickly during any period, resulting in supply-demand mismatch, it may lead to price volatility.

Risk/Return: Timberland and farmland

Timberland and farmland investments have similar risks as other real estate investments in raw land. However, weather is major risk factor for these investments. Bad weather conditions can drastically reduce harvest yields.

Another important risk factor is the international competitive landscape. Unlike other real estate that is mainly impacted by local factors, timberland and farmland produce commodities that are globally traded; therefore, they are impacted by global factors.

6.4 Diversification Benefits of Natural Resources

Diversification Benefits: Commodities

Commodities are attractive to investors not only for the potential profits but also because:

  • They provide a good inflation hedge. Some commodity prices are a component of inflation calculations e.g., food and energy.
  • They provide effective portfolio diversification. Historically, the correlation between commodities and traditional investments has been low.

Diversification benefits: Timberland and farmland

ESG investors looking for responsible and sustainable investing can include timberland and farmland in their portfolios. These investments can help mitigate climate change.

Timberland and farmland have also exhibited low correlation with traditional investments. Thus, they can provide effective diversification benefits.

6.5 Instruments

Instruments: Commodities

Commodity investments are typically made through derivatives as the storage and transportation costs for holding physical commodities are significant. Commodity derivative contracts may trade on exchanges or over the counter. The popular derivatives include futures

, forwards, options,  and swaps.

Commodity exposure can also be achieved through:

  • Exchange traded products (either funds or notes).
  • Managed futures (also known as CTAs)
  • Funds that specialize in specific commodity sectors e.g., private energy partnerships are similar to PE funds and can be used to gain exposure to the energy sector.

Instruments: Timberland and Farmland

The primary investment vehicles for timberland and farmland are investment funds. These funds could be offered publicly via REITs or privately via limited partnerships.

Large investors can also consider direct investments in these assets.

7. Real Estate

7.1 Overview of the Real Estate Market

Real estate has two major sectors:

  • Residential: Includes individual single-family detached homes and multi-family attached units owned by the residents. Residential real estate is the largest sector, making up some 75% of the market globally.
  • Commercial: Commercial real estate primarily includes office buildings, shopping centers, and warehouses. When residential real estate properties (described above) are owned with the intent to rent, they are classified as commercial real estate.

The key reasons for investing in real estate are:

  • Potential for competitive long-term returns (income and capital appreciation).
  • Rent for long-term leases will lessen the impact of economic shocks.
  • Diversification because of low correlation with other asset classes such as stocks, bonds.
  • Inflation hedge.

Investment characteristics of real estate are as follows:

  • Indivisibility – requires large capital investments
  • Illiquidity
  • Unique characteristics (no two properties are identical).
  • Fixed location.
  • Requires professional operational management.
  • Local markets can be very different from national or global markets.

7.2 Characteristics: Forms of Real Estate Ownership

Real estate investing can be categorized along two dimensions: public/private markets and debt/equity based.  Exhibit 27 presents the four quadrants for the basic forms of real estate investments with examples:

Basic forms of real estate investments and examples

Debt Equity
Private • Mortgages

• Construction lending

• Mezzanine debt

• Direct ownership of real estate: ownership through sole ownership, joint ventures, separate accounts, or real estate limited partnerships

• Indirect ownership via real estate funds

• Private REITs

Public • MBS (residential and commercial)

• Collateralized mortgage obligations

• Mortgage REITs

• ETFs that own securitized mortgage debt

• Shares in real estate operating and development corporations

• Listed REIT shares

• Mutual funds

• Index funds

• ETFs

Equity-based investments represent ownership of real estate properties.  Ownership can be through sole ownership, joint ventures, real estate limited partnerships, etc. A variation of equity-based investments is leveraged ownership: Assume a building costs $10 million, and you put $3 million of your money and borrow $7 million. This is called leveraged ownership. That is, leveraged ownership is where a property is obtained through equity and mortgage financing.

If you are investing in a debt-based real estate investment, it means you are lending money to a purchaser of real estate. A classic example is a mortgage loan.  This is considered a real estate investment because the value of the mortgage loan is related to the value of the underlying property.

There can be many variations within the basic forms:

  • Direct real estate investing: Involves purchasing a property and originating debt for one’s own account. The major advantages are: control, and tax benefits. The major disadvantages are: extensive time and expertise required to manage the property, the large capital requirements, and highly concentrated portfolios.
  • Indirect real estate investing: Pooled investment vehicles are used to access the underlying real estate assets. The vehicles can be public or private, such as limited partnerships, mutual funds, corporate shares, REITs, and ETFs.
  • Mortgages: Represent passive investments in which the lender can expect to receive a predefined stream of payments over the life of the mortgage.
  • Private fund investing styles: Most real estate private equity funds are structured as infinite-life open-end funds, which allow investors to contribute or redeem capital throughout the life of the fund.
  • REITs: REITs combine the features of mutual funds and real estate. An REIT is a company that owns income-producing real estate assets. In REITs, average investors pool their capital to invest (take ownership) in several large-scale, diversified income-generating real estate properties. The REIT issues shares, where each share represents a percentage ownership in the underlying property. The income generated is paid as a dividend to the shareholders.

The main advantage of the REIT structure is that it avoids double corporate taxation. Normal corporations pay taxes on income, and then the dividend paid from the after-tax earnings are taxed again at the shareholder’s personal tax rate. REITs can avoid corporate income taxes by distributing 90% – 100% of their rental income as dividends.

The value of the REIT shares is based on the dividend. REIT shares often trade publicly on exchanges. It is a way for individual investors to earn a share of the income from commercial properties (office buildings, warehouses, and shopping malls) without buying them. Risk and return of REITs vary based on the types of properties they invest in. Equity REITs invest primarily in residential and commercial properties.

7.3 Characteristics: Real Estate Investment Categories

Residential Property

  • Properties such as residences, apartment buildings, and vacation homes, purchased with the intent to occupy.
  • Most home buyers cannot fund the home entirely with cash. Instead, it is leveraged equity, i.e., they borrow money (loan/mortgage) to make the purchase.
  • Most lenders require an equity contribution of at least 10% – 20% of the property purchase price.

Commercial Property

  • Undertaken by investors (both institutional and HNIs) with limited liquidity needs and long time horizons.
  • Primarily comprises office buildings purchased with the intent to rent.
  • Direct investment: can be equity or debt financed.
  • Debt financing: lender must ensure the borrower is credit worthy. The property must generate enough cash flows through rent to service the debt. How much loan the borrower can get (based on loan-to-value ratio) depends on the value of the property.
  • Equity investing: Requires active and experienced management.


  • Risk and return characteristics depend on the type of investments made.
  • Mortgage REITs are similar to fixed-income investments.
  • Equity REITs are similar to direct equity investments in leveraged real estate.

Mortgage-Backed Securities

  • An MBS issuer forms a special purpose vehicle (SPV) to buy mortgages from lenders and uses them to create a diversified mortgage pool.
  • Tranches of the SPV are sold to investors who receive the incoming steam of mortgage payments associated with their tranche.
  • Different tranches have a different priority distribution ranking of incoming cash flows. Risk averse investors prefer the lowest-risk tranches, which are the first to receive interest and principal payments, but they also offer the lowest returns. Highest-risk tranches are the last to receive interest and principal payments, but they offer the highest return.

7.4 Risk and Return Characteristics

Real Estate Indexes

There are a number of indexes to measure real estate returns that vary based on the underlying constituents and longevity.

  • REIT Index: It is constructed using the prices of publicly traded shares of REITs to construct the indices. The accuracy of the index depends on how frequently the shares of the index trade.
  • Appraisal Based Index: Often actual transaction prices are not used by private real estate indexes because real estate assets do not transact very often and managers do not take the effort to revalue property. The drawbacks are: the appraisals are backward looking, they are subject to the biases of the appraisers, and they smooth-out volatility.
  • Repeat Sales Index: These indexes are transaction based rather than appraisal based. Repeat sales of properties are used to construct the indices; i.e., the change in the price of the same properties is measured in this method. These indexes suffer from sample selection bias because it is highly unlikely that the same properties come up for repeat sales every year.

Real Estate Investment Risks

Like any investment, real estate investing has its risks if the outcome does not turn out to be as per expectations.

  • Property values are subject to variability based on national and global economic conditions, local real estate conditions (more supply than demand or demand more than supply), and interest rate levels.
  • Ability to select, finance, and manage real estate properties. This includes collecting rent, maintenance, undertaking repairs on time, and finally disposing the property. Economic conditions may be different when the property was bought and when it is sold.
  • Expenses may increase unexpectedly.
  • Leverage magnifies risks to equity and debt investors.

7.5 Diversification Benefits

Many investors prefer real estate for its ability to provide high, steady current income. Real estate also has moderate correlation with other asset classes and thus provides some diversification benefits. However, there are periods when equity REIT correlations with other securities are high, and their correlations are highest during steep market downturns.

8. Infrastructure

8.1 Introduction and Overview

The assets underlying infrastructure investments are real, capital intensive, and long-lived. These assets are intended for public use, and they provide essential services e.g., airports, health care facilities, and power plants.

Infrastructure assets were primarily owned, financed, and operated by the government. Of late, they are financed privately with the intent of selling the newly built assets to the government. The provider of the assets and services has a competitive advantage as the barriers to entry are high due to high costs and regulation.

Investors invest in infrastructure assets


  • The assets
  • can generate stable long-term cash flows that adjust for economic growth and
  • High levels of leverage can be used to acquire these assets which has a potential to enhance investor returns.
  • The assets can help incorporate ESG criteria, e.g., investments in renewable energy sources.

8.2 Description

Categories of Infrastructure Investments

Infrastructure investments may be categorized based on: (1) underlying assets, (2) stage of development of the underlying assets, and (3) geographical location of the underlying assets. Let us look at the various sub-categories now.

Infrastructure investments based on underlying assets: They can be classified into economic and social infrastructure assets.

  • Economic infrastructure assets: These include transportation, communication, and social utility assets that are needed to support economic activity. Examples of transportation assets are roads, airports, bridges, tunnels, ports, etc. Examples of utility assets are assets used to transmit and distribute gas, electricity, generate power, etc. Examples of communication assets are assets that are used to broadcast information.
  • Social infrastructure assets: These are assets required for the benefit of the society such as educational and healthcare facilities.

Infrastructure investments based on the stage of development of the underlying assets: They can be classified into brownfield and greenfield investments.

  • Brownfield investments: These are investments in existing investable infrastructure assets. These may be assets, with a financial and operating history, which the government wants to privatize.
  • Greenfield investments: These are investments in yet-to-be-constructed infrastructure assets. The objective may be to construct and sell the assets to the government, or to hold and operate the assets.

Infrastructure assets may also be categorized based on their geographical location.

Forms of Infrastructure Investments

Investors may invest either directly or indirectly in infrastructure investments. The investment form affects the liquidity and the income and cash flows to the investor.

The advantages of investing directly in infrastructure are that investors have a control over the asset and can capture the full value of the asset. But the downside of a large investment is that it results in concentration and liquidity risks.

Most investors invest indirectly. Some forms of indirect investments include:

  • investment in an infrastructure fund
  • infrastructure ETFs
  • shares of companies

Investing in publicly traded infrastructure companies offer the benefit of liquidity. Publicly traded infrastructure securities also have a reasonable fee structure, transparent governance, and provide the benefit of diversification. Master limited partnerships (MLPs) are pass-through entities similar to REITs and are listed on exchanges.

8.3 Risk and Return Characteristics

Infrastructure investments with the lowest risk have stable cash flows and higher dividend payout ratios, but they also have lower expected returns and lesser growth opportunities. An example of a low-risk infrastructure investment is toll roads, or a brownfield investment in an asset leased to a government school. An example of a high-risk infrastructure investment is a fund with a greenfield investment.

Some of the risks associated with infrastructure investments include:

  • Revenues being different than expected.
  • Leverage creates financial, operational, and construction risk.
  • Regulatory risk

8.4 Diversification Benefits

Some of the advantages to investors from investing in infrastructure are as follows:

  • a steady income stream
  • potential for capital appreciation
  • diversification because of low correlation of infrastructure assets to traditional investments
  • protection against inflation
  • match the long-term liability structure of some investors such as pension funds

9. Issues in Performance Appraisal

9.1 Overview of Performance Appraisal for Alternative Investments

It can be difficult to conducting performance appraisal on alternative investments because these investments have the following characteristics:

  • asymmetric risk–return profiles
  • limited portfolio transparency
  • illiquidity
  • product complexity
  • complex fee structures

9.2 Common Approaches to Performance Appraisal and Application Challenges

Traditional risk and return measures (such as the Sharpe ratio – measure of return per unit of risk) are not always appropriate for alternative investments because:

  • Many alternative investments exhibit asymmetric risk and return profile, which means they might have high kurtosis (leptokurtic) and negative skewness. Downside risk measures such as VaR and Sortino ratio will underestimate the loss for a negatively skewed distribution.
  • Alternative investments such as hedge funds and private equity have limited transparency. This is because the alternative investment industry is not as regulated as traditional investments.
  • Most alternative investments are relatively illiquid.

Apart from the Sharpe ratio other metrics used to review the performance of alternative investments, include:

  • Sortino ratio: measure of return relative to downside volatility
  • Treynor ratio: measure of the excess average return of an investment relative to its beta to a relevant benchmark.
  • Calmar ratio: average return relative to the worst drawdown loss (distance between a peak and a trough of a portfolio). It is typically calculated using the prior three years of data.
  • MAR ratio: a variation of the Calmar ratio. Instead of just three years, it uses the full investment history and the average drawdown.
  • Batting average: refers to the percentage of profitable trades.
  • Slugging percentage: the magnitude of the gains from winning trades divided by the losses from losing trades

9.3 Private Equity and Real Estate Performance Evaluation

Private equity and real estate investments often display a J-curve effect – initial decline followed by strong growth over the long term.

The IRR calculation is frequently used to evaluate private equity investments. However, the determination of an IRR involves certain assumptions about a financing rate to use for outgoing cash flows (typically a weighted average cost of capital) and a reinvestment rate assumption to make on incoming cash flows (which must be assumed and may or may not actually be earned).

To overcome this complexity, the multiple of invested capital (MOIC), or money multiple is frequently used. It simply measures the total value of all distributions and residual asset values relative to an initial total investment.

The cap rate is often used to evaluate real estate investments. It is calculated as the annual rent actually being earned divided by the price originally paid for the property.

9.4 Hedge Funds: Leverage, Illiquidity, and Redemption Terms


Hedge funds often use leverage to enhance returns. To lever their portfolio hedge funds use derivatives or borrow capital from prime brokers. Hedge funds have to deposit cash or other collateral into a margin account with the prime broker and the prime broker lends securities to the hedge fund. If the margin account falls below a certain level, a margin call is initiated and the hedge fund has to put up more collateral. This can magnify the losses of a hedge fund because it may have to liquidate the losing position to meet the margin call.

Illiquidity and Potential Redemption Pressures

Hedge funds are valued on a daily, weekly, monthly, and/or quarterly basis. The value of a hedge fund depends on the value of underlying positions.

The price used for valuation depends on whether market prices are available and if the underlying position is liquid. When market prices are available, the fund decides what price to use. Common practice is to quote at . A conservative approach is to use bid prices for long and ask prices for short.

GAAP accounting rules categorize hedge fund investments into three buckets:

  • Level 1: An exchange-traded, publicly traded price is available and is used for valuation purposes.
  • Level 2: When such price is not available, outside broker quotes are used.
  • Level 3: When broker quotes are not available or are unreliable, as a final recourse, assets are valued using internal models.

Level 3 assets values require additional scrutiny from investors. The models used should be appropriate and consistent. The values obtained may not reflect true liquidation values. Also, the returns may be smoothed and the volatility understated.

Another factor that can magnify losses for hedge funds is redemption pressure. Redemptions usually occur when the hedge fund is performing poorly. Redemptions can force hedge fund managers to liquidate positions at disadvantageous prices.

To discourage redemptions:

  • Hedge funds sometimes charge redemption fees to offset the transaction costs for the remaining investors.
  • Hedge funds use notice periods which provide the hedge fund manager an opportunity to liquidate positions in an orderly manner.
  • Hedge funds use lockup period (time periods when investors cannot withdraw their capital) which provide the hedge fund manager sufficient time to implement his investment strategy.

10. Calculating Fees and Returns

10.1 Alternative Asset Fee Structures and Terms

Example: Incentive Fees Relative to Waterfall Types

A PE fund invests $10 million in Portfolio company A and $12 million in portfolio company B. Company A generates a $6 million profit, but Company B generates a $7 million loss. The time period for the gain and loss are the same. The manager’s carried interest incentive fee is 20% of profits. Calculate the incentive fee under:

  1. A European-style waterfall whole-of funds approach
  2. An American-style waterfall deal-by-deal basis (assuming no clawback)

Solution to 1:

Overall, the fund lost money (+$6 million – $7 million = -$1 million) so under a European-style whole-of-fund waterfall, the manger will not receive any incentive fee

Solution to 2:

Under an American-style waterfall, the GP could still earn 20% x $6 million = $1.2 million as incentive fees on the profitable Company A deal.

10.2 Custom Fee Arrangements

Hedge funds commonly use a “2 and 20” fee structure and fund of funds commonly use the “1 and 10” fee structure. However, many variations of the fee structure exist.

Analysts should be aware of any custom fee arrangements in place that will affect the calculation of fees and performance. These can include such arrangements such as:

  • Fees based on liquidity terms and asset size: Hedge funds may provide a fee discount to investors who are willing to accept lower liquidity e.g., longer lockups. Similarly, hedge funds may provide a fee discount to larger investors. These terms are negotiated with individual investors via side letters, which are special amendments to the fund’s LPA.
  • Founder’s share: To entice early participation in new hedge funds, managers often offer incentives known as founder’s class shares. These shares have a lower fee structure e.g., “1.5 and 10” instead of “2 and 20” and are typically applicable to a certain cutoff threshold e.g., the first $100 million in assets.
  • Either/or fees: A few large institutional investors have recently worked out a new fee model with some hedge fund managers. These managers agree either to charge a 1% management fee or to receive a 30% incentive fee above a mutually agreed-on hurdle rate, whichever is greater. The 1% management fee allows a fund to cover its expenses during down years and the 30% incentive fee incentivizes and rewards managers during up years.

Example: Fee and return calculations

Consider a hedge fund with an initial investment of 200 million; the fee structure is 2 and 20 and is based on year-end valuation. In year 1, the return is 30%.

  1. What is the total fee if management fee and incentive fee are calculated independently? What is the investor’s effective return?
  2. What is the total fee if the incentive fee is calculated after deducting the management fee? Investor’s net return?
  3. If there is a hurdle rate of 5% and fees are based on returns of in excess of 5%, what is the total fee? What is the investor’s net return?
  4. In the second year, the fund declines to 220 million. Assume that management fee and incentive fee are calculated independently as indicated in Part 1, but now a high water mark is also used in fee calculations. What is the total fee? What is the investor’s net return?
  5. In the third year, the fund value increases to 256 million. What is the total fee and investor’s net return?


  1. Initial investment grows to: 200 x 1.3 = $260 million.

Profit = $60 million.

Management fee: 0.02 x 260 = $5.2 million.

Incentive fee which is 20% of profit = 20% x 60 = $12 million.

Total fee = $5.2 million + $12 million = $17.2 million.

Investor’s return = [(260-17.2)/200] -1 = 21.4%

  1. Incentive fee after deducting management fee = 20% x (260 – 200 – 5.2) = 10.96.

Total fee = 5.2 + 10.96 = $16.16 million.

Investor’s return = [(260-16.16)/200] – 1 = 21.92%.

As you can see the return is better than Part 1 because incentive fee paid is relatively less here.

  1. There is a hurdle rate of 5%. So, 200 x 0.05 = $10 million must be subtracted before incentive fees are paid.

Incentive fee = 0.2 x (260 – 200 – 5.2 – 10) = 8.96.

Total fee = 5.20 + 8.96 = $14.16 million.

Incentive fee is further reduced and the investor’s return is enhanced.

Investor’s return = [(260-14.16)/200] – 1 = 22.92%.

  1. Management fee = 0.02 x 220 = 4.4. To calculate the incentive fee, we need to determine whether the fund value has exceeded the high water mark. The high water mark was achieved at the end of Year 1. This value was 260 million – 17.2 million = 242.8 million. The incentive fee is 0 because the fund value is below the high water mark. Hence the total fee = $4.4 million.

Investor’s return = [(220-4.4)/242.8] – 1 = -11.2%

  1. Management fee = 256 x .02 = 5.12. Since $256 has exceeded high water mark of 242.8 million, an incentive fee would be paid. Incentive fee = (256 – 242.8) x 0.2 = 2.64. Total fee = 5.12 + 2.64 = 7.76 million.

Investor’s net return = [(256- 7.76)/215.6] – 1 = 15.14%.


Example: Hedge fund versus fund of funds

An investor is contemplating investing £200 million in either the Hedge Fund (HF) or the Fund of Funds (FOF). FOF has a “1 and 10” fee structure and invests 10% of its assets under management in HF. HF has a standard “2 and 20” fee structure with no hurdle rate. Management fees are calculated on an annual basis on assets under management at the beginning of the year. Management fees and incentive fees are calculated independently. HF has a 25% return for the year before management and incentive fees.

  1. Calculate the return to the investor of investing directly in HF.
  2. Calculate the return to the investor of investing in FOF. Assume that the other investments in the FOF portfolio generate the same return before management fees as HF and have the same fee structure as HF.

Solution to 1:                                                                                                                                              

HF has a profit before fees on a £200 million investment of £50 million (= 200 million × 25%). The management fee is £4 million (= 200 million × 2%) and the incentive fee is £10 million (= 50 million × 20%). The return to investor is 18% (= (50 – 4 – 10) / 200).

Solution to 2:                                                                                                                                              

FOF earns an 18% return or £36 million profit after fees on £200 million invested with hedge funds. FOF charges the investor a management fee of £2 million (= 200 million × 1%) and an incentive fee of £3.6 million (= 36 million × 10%). The return to the investor is 15.2% (= (36 – 2 -3.6) / 200).

10.3 Alignment of Interests and Survivorship Bias

Hedge fund index returns can be overstated due to survivorship, and backfill biases.

  • Survivorship bias occurs when an index is composed of only surviving funds over a period of time, which tends to overstate the index returns.
  • Backfill bias occurs when a new fund enters a database and historical returns of that fund are added (i.e., “backfilled”). Usually, funds that performed well are added which tends to overstate the index returns.


A PE fund makes two investments for $5 million each in Company A and Company B. One year later Company A returns a $8 million profit. But two years later Company B turns out to be a complete bust and is worth zero.

The GP’s carried interest is 20% of aggregate profits and there is a clawback provision. How much carried interest will the GP receive in year 1 and year 2.


In year 1, the GP will receive a carried interest of 20% of $8 million = $1.6 million. This amount would typically be held in an escrow account for the benefit of the GP but not actually paid.

In year 2, the GP loses $5 million of the initial $8 million gain, so the aggregate profit is only $3 million. The carried interest payable is 20% x $3 million = $0.6 million. The GP has to return $1 million of the previously accrued incentive fee to the LPs because of the clawback provision.



The hedge fund had an initial investment of $60 million. At the end of the first year, the value was 70 million after fees. At the end of the second year, the value was 80 million before fees. The fund has a 2 and 20 fee structure and incentive fees are calculated using a high water mark and a soft hurdle rate of 5%. Calculate the total fee paid for year 2.


Management fee = 80 x .02 = 1.6 million

Incentive fee = (80 – 70) x .2 = 2 million

Total fee = 1.6 + 2 = 3.6 million

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