CFA LEVEL 1 STUDY SESSION 18 ALTERNATIVE INVESTMENTS

STUDY SESSION 18
ALTERNATIVE INVESTMENTS

Due to diversification benefits and higher expectations of investment returns,
investors are increasingly turning to alternative investments. This study
session describes the common types of alternative investments, methods for their
valuation, unique risks and opportunities associated with them, and the relation
between alternative investments and traditional investments.
Although finding a single definition of an “alternative” investment is difficult,
certain features (e.g., limited liquidity, infrequent valuations, and unique
legal structures) are typically associated with alternative investments. This study
session discusses these features and how to evaluate their impact on expected
returns and investment decisions in more detail. The reading provides an
overview of the major categories of alternative investments, including real estate,
private equity, venture capital, hedge funds, closely held companies, distressed
securities, and commodities.
Each one of these categories has several unique characteristics, and the
readings discuss valuation methods for illiquid assets (such as direct real estate or
closely held companies), performance measures for private equity and venture
capital investments, differences between various hedge fund strategies, and
implementation vehicles for investments in alternative assets.

LEARNING OUTCOMES
Reading 76: Alternative Investments

The candidate should be able to:
a. differentiate between an open-end and a closed-end fund, and explain how net
asset value of a fund is calculated and the nature of fees charged by investment
companies;

b. distinguish among style, sector, index, global, and stable value strategies in
equity investment and among exchange traded funds (ETFs), traditional mutual
funds, and closed end funds;

c. explain the advantages and risks of ETFs;

d. describe the forms of real estate investment and explain their characteristics as
an investable asset class;

e. describe the various approaches to the valuation of real estate;

f. calculate the net operating income (NOI) from a real estate investment, the value
of a property using the sales comparison and income approaches, and the
after-tax cash flows, net present value, and yield of a real estate investment;

g. explain the stages in venture capital investing, venture capital investment
characteristics, and challenges to venture capital valuation and performance
measurement;

h. calculate the net present value (NPV) of a venture capital project, given the
project’s possible payoff and conditional failure probabilities;

i. discuss the descriptive accuracy of the term “hedge fund,” define hedge fund in
terms of objectives, legal structure, and fee structure, and describe the various
classifications of hedge funds;

j. explain the benefits and drawbacks to fund of funds investing;

k. discuss the leverage and unique risks of hedge funds;

l. discuss the performance of hedge funds, the biases present in hedge fund
performance measurement, and explain the effect of survivorship bias on the
reported return and risk measures for a hedge fund database;

m. explain how the legal environment affects the valuation of closely held
companies;

n. describe alternative valuation methods for closely held companies and distinguish
among the bases for the discounts and premiums for these companies;

o. discuss distressed securities investing and compare venture capital investing with
distressed securities investing;

p. discuss the role of commodities as a vehicle for investing in production and
consumption;

q. explain the motivation for investing in commodities, commodities derivatives,
and commodity-linked securities;

r. discuss the sources of return on a collateralized commodity futures position.


Grouped contents

Mutual fund

a. differentiate between an open-end and a closed-end fund, and explain how net
asset value of a fund is calculated and the nature of fees charged by investment
companies;

b. distinguish among style, sector, index, global, and stable value strategies in
equity investment and among exchange traded funds (ETFs), traditional mutual
funds, and closed end funds;

ETFs

c. explain the advantages and risks of ETFs;

Real estae

d. describe the forms of real estate investment and explain their characteristics as
an investable asset class;

e. describe the various approaches to the valuation of real estate;

f. calculate the net operating income (NOI) from a real estate investment, the value
of a property using the sales comparison and income approaches, and the
after-tax cash flows, net present value, and yield of a real estate investment;

venute capital

g. explain the stages in venture capital investing, venture capital investment
characteristics, and challenges to venture capital valuation and performance
measurement;

h. calculate the net present value (NPV) of a venture capital project, given the
project’s possible payoff and conditional failure probabilities;

Hedge fund

i. discuss the descriptive accuracy of the term “hedge fund,” define hedge fund in
terms of objectives, legal structure, and fee structure, and describe the various
classifications of hedge funds;

j. explain the benefits and drawbacks to fund of funds investing;

k. discuss the leverage and unique risks of hedge funds;

l. discuss the performance of hedge funds, the biases present in hedge fund
performance measurement, and explain the effect of survivorship bias on the
reported return and risk measures for a hedge fund database;

closely held companies

m. explain how the legal environment affects the valuation of closely held
companies;

n. describe alternative valuation methods for closely held companies and distinguish
among the bases for the discounts and premiums for these companies;

distressed

o. discuss distressed securities investing and compare venture capital investing with
distressed securities investing;


Commodities

p. discuss the role of commodities as a vehicle for investing in production and
consumption;

q. explain the motivation for investing in commodities, commodities derivatives,
and commodity-linked securities;

r. discuss the sources of return on a collateralized commodity futures position.