Alternative Investments carries a 5-8% weight at CFA Level 1, making it one of the lighter sections. But here’s what experienced CFA candidates know: Alternative Investments is arguably the highest return-on-study-time section in the entire exam. The concepts are relatively straightforward, the question types are predictable, and the content is genuinely interesting — you’ll learn about hedge funds, private equity, real estate, and commodities.
I consistently tell my mentees to treat Alternatives as a “bank” — a section where smart study can lock in reliable marks that offset weaker performance elsewhere.
What Alternative Investments Covers
What Makes an Investment “Alternative”?
Alternative investments are defined by what they’re not — they’re everything outside traditional stocks, bonds, and cash. They share several common characteristics:
- Lower liquidity than public markets
- Less transparency and regulation
- Higher fees (typically)
- Different risk-return profiles
- Low correlation with traditional assets (a diversification benefit)
- Complex legal structures
Understanding these shared characteristics is important because the exam frequently tests general features of alternatives before diving into specific asset classes.
Hedge Funds
Hedge funds are privately pooled investment vehicles that employ a wide range of strategies. For a deeper look at how these funds operate in practice, see our article on hedge funds explained.
Common strategies you need to know:
- Long/short equity: Buying undervalued stocks and shorting overvalued ones. The most common hedge fund strategy.
- Market neutral: Long/short equity with hedged market exposure (beta near zero)
- Event-driven: Profiting from corporate events (mergers, bankruptcies, restructurings)
- Global macro: Taking positions based on macroeconomic views across countries and asset classes
- Relative value: Exploiting pricing discrepancies between related securities
Fee structure: The classic “2 and 20” — 2% management fee on assets under management plus 20% performance fee on profits. You should understand high-water marks and hurdle rates:
- High-water mark: The performance fee is only charged on gains above the previous peak NAV. This prevents managers from earning performance fees on recouped losses.
- Hurdle rate: The minimum return the fund must earn before the performance fee kicks in.
Key exam focus: Fee calculation problems. Given a fund’s return, AUM, management fee, performance fee, high-water mark, and hurdle rate, calculate the total fee. These are mechanical but require careful reading.
Private Equity
Private equity involves investing in companies that are not publicly traded, or taking public companies private.
Types of PE investments:
- Venture capital: Early-stage investing in startups and growth companies
- Leveraged buyouts (LBOs): Acquiring mature companies using significant debt financing
- Growth equity: Investing in established companies that need capital to expand
- Distressed investing: Buying the debt or equity of financially troubled companies
The PE fund lifecycle: Commitment period (first 3-5 years where capital is called), investment period, and harvesting period (selling investments, typically years 5-10). Understanding this lifecycle explains the J-curve effect — PE funds typically show negative returns in early years before gains materialize.
Valuation challenges: Private companies don’t have market prices, making valuation inherently uncertain. Common approaches include comparable company analysis, precedent transactions, and discounted cash flow models.
Real Estate
Real estate investing can be direct (owning properties) or indirect (through REITs, real estate funds, or real estate limited partnerships).
Key concepts:
Valuation approaches:
- Income approach (cap rate = NOI / Property Value)
- Cost approach (replacement cost minus depreciation)
- Sales comparison approach (comparable property transactions)
REITs (Real Estate Investment Trusts):
- Publicly traded vehicles that provide real estate exposure with stock-like liquidity
- Required to distribute most of their income as dividends
- Valued using Funds from Operations (FFO), not traditional earnings
Net Operating Income (NOI): NOI = Rental income - Operating expenses (excluding financing costs and depreciation)
The capitalization rate (cap rate) is the most frequently tested real estate concept. Know how to calculate it and interpret it — a higher cap rate implies higher risk or lower growth expectations.
Commodities
Commodities include physical goods like oil, gold, agricultural products, and industrial metals.
Ways to invest:
- Physical ownership (impractical for most investors except precious metals)
- Futures contracts (most common institutional approach)
- Commodity ETFs and ETNs
- Shares in commodity-producing companies
Key pricing concepts:
- Spot price vs. futures price
- Contango: Futures price > spot price (normal for commodities with storage costs)
- Backwardation: Futures price < spot price (can occur when immediate supply is tight)
- Roll yield: The return from rolling expiring futures contracts into new ones. Positive in backwardation, negative in contango.
Diversification benefit: Commodities historically have low correlation with stocks and bonds, making them useful for portfolio diversification — a concept rooted in Modern Portfolio Theory. They also provide a potential hedge against inflation.
Other Alternatives
The curriculum also touches on:
- Infrastructure: Toll roads, airports, utilities, telecommunications
- Collectibles and art: High-value tangible assets
- Farmland and timberland: Natural resource investments
These are covered more lightly but can appear in exam questions.
Why Alternative Investments Is a Smart Study Priority
High ROI: The content is conceptually simpler than FRA, Fixed Income, or Derivatives. Most concepts are definitional or require basic calculations (fee computations, cap rate calculations). You can score well with relatively modest study time.
Predictable questions: Alternative Investment questions tend to fall into recognizable patterns — identifying hedge fund strategies from descriptions, calculating fees, computing cap rates, or identifying characteristics of PE fund structures. Practice a few of each type and you’ll be well prepared.
Interesting content: Let’s be honest — learning about how hedge funds make money, how PE firms structure buyouts, and how real estate is valued is inherently more engaging than memorizing accounting standards. Use this to your advantage. Engaged studying is effective studying.
Study Strategy for Alternative Investments
Read the material once, thoroughly
Unlike FRA or Fixed Income, where you need multiple passes, Alternative Investments is a section where one careful reading of the curriculum combined with practice problems is often sufficient. The concepts are largely self-contained and intuitive.
Focus on fee calculations for hedge funds
These are the most calculation-intensive questions in Alternatives and the most commonly tested. Practice scenarios with:
- Management fees calculated on beginning vs. ending AUM
- Performance fees with and without high-water marks
- Performance fees with hurdle rates
- Net-of-fee return calculations
Work through 10-15 fee calculation problems and you’ll be prepared for anything the exam throws at you.
Master the cap rate for real estate
Cap rate = NOI / Property Value. You should be able to:
- Calculate cap rate given NOI and property value
- Calculate property value given NOI and cap rate
- Interpret what a change in cap rate means
- Compare two properties using cap rates
Know the vocabulary cold
Many Alternative Investment questions are definitional — “which of the following best describes a global macro hedge fund strategy?” The question is really testing whether you know the definitions. Create flashcards for key terms and review them a few times in the weeks before the exam.
Understand contango vs. backwardation
This topic combines conceptual understanding with practical implications for commodity investors. Know the definitions, the conditions that cause each, and the impact on roll yield. This is tested frequently and is straightforward once you understand it.
Common Mistakes in Alternative Investments
Mistake 1: Confusing management fees and performance fees. Management fees are based on AUM and are charged regardless of performance. Performance fees are based on returns and are charged only when the fund makes money (subject to high-water marks and hurdle rates).
Mistake 2: Forgetting the high-water mark in fee calculations. If a fund lost money last year, the performance fee this year is only charged on gains above the previous peak, not on the total current-year return. Missing this in a calculation changes the answer significantly.
Mistake 3: Confusing NOI with net income in real estate. NOI excludes financing costs and depreciation. Using net income instead of NOI in a cap rate calculation gives the wrong answer.
Mistake 4: Mixing up contango and backwardation effects on roll yield. In contango, you sell the expiring (cheaper) contract and buy the new (more expensive) one — negative roll yield. In backwardation, the opposite — positive roll yield.
Mistake 5: Overlooking the J-curve in PE. Early PE fund returns are typically negative due to management fees and initial investments that haven’t appreciated yet. This is expected behavior, not a sign of poor performance.
Practical Exam Tips
Tip 1: For hedge fund strategy identification questions, focus on the key differentiator for each strategy. Long/short = directional stock bets. Market neutral = hedged beta. Event-driven = corporate events. Global macro = macroeconomic views.
Tip 2: For fee calculation questions, read every word carefully. The difference between “2% management fee on beginning-of-year AUM” and “2% management fee on end-of-year AUM” changes the answer.
Tip 3: Real estate questions often combine cap rate calculations with qualitative interpretation. After calculating, be ready to explain what the number means in context.
Tip 4: For questions about the benefits of alternatives in a portfolio, the answer almost always involves low correlation with traditional assets and diversification benefits.
Time Allocation
Budget 15-25 hours for Alternative Investments:
- Alternative investment characteristics: 2-3 hours
- Hedge funds and fee calculations: 4-6 hours
- Private equity: 3-4 hours
- Real estate: 3-4 hours
- Commodities: 2-3 hours
- Practice problems: 3-5 hours
This is one of the lowest time investments in the curriculum, yet it can yield a disproportionately high score contribution.
Final Thoughts
Alternative Investments is the section that smart candidates use to build a scoring cushion. The content is accessible, the questions are predictable, and the time investment is modest. Don’t make the mistake of leaving it until the last minute and skimming it — a small, focused investment of study time here pays off handsomely on exam day.
If you want guidance on integrating Alternatives into your overall study plan, or if you’re interested in a career in alternative investments and want to understand how the CFA charter supports that path, reach out for a free mentorship session. Alternatives is a growing area of finance, and getting a strong foundation at Level 1 opens doors you might not expect — our asset management guide explores many of those career paths.