The complete guide to alternative investments, from experts working with CFA Institute
Alternative Investments is the definitive guide to understanding non-traditional asset classes. Alternatives are a disparate group of investments that are distinguished from long-only, publicly traded investments in stocks, bonds, and cash (often referred to as traditional investments). Alternative investments include real estate, commodities, infrastructure, and other non-traditional investments such as private equity or debt and hedge funds. They are attractive to investors because of the potential for portfolio diversification resulting in a higher risk-adjusted return for the portfolio.
Alternative Investments and its accompanying workbook (sold separately) lead students and investment professionals through the many characteristics of non-traditional assets, including:
- Narrow specialization of the investment managers
- Relatively low correlation of returns with those of traditional investments
- Less regulation and less transparency than traditional investments
- Limited historical risk and return data
- Unique legal and tax considerations
- Higher fees, often including performance or incentive fees
- Concentrated portfolios
- Restrictions on redemptions (i.e. “lockups” and “gates”)
CFA Institute is the world's premier association for investment professionals, and the governing body for the CFA® Program, CIPM® Program, CFA Institute ESG Investing Certificate, and Investment Foundations® Program. Those seeking a deeper understanding of the markets, mechanisms, and use of alternatives will value the level of expertise CFA Institute brings to the discussion, providing a clear, comprehensive resource for students and professionals alike. Whether used alone or in conjunction with the companion workbook, Alternative Investments offers a complete course in alternative investments and their role in investment management.
Table of Contents
Foreword xv
Preface xvii
Acknowledgments xix
About the CFA Institute Investment Series xxi
Chapter 1 Introduction to Corporate Governance and Other ESG
Considerations 1
Learning Outcomes 1
1. Introduction and Overview of Corporate Governance 2
1.1. Corporate Governance Overview 2
2. Stakeholder Groups 4
2.1. Stakeholder Groups 4
3. Principal- Agent and Other Relationships in Corporate Governance 7
3.1. Shareholder and Manager/Director Relationships 8
3.2. Controlling and Minority Shareholder Relationships 8
3.3. Manager and Board Relationships 9
3.4. Shareholder versus Creditor Interests 9
3.5. Other Stakeholder Conflicts 10
4. Overview and Mechanisms of Stakeholder Management 10
4.1. Overview of Stakeholder Management 10
4.2. Mechanisms of Stakeholder Management 11
5. Mechanisms to Mitigate Associated Stakeholder Risks 15
5.1. Employee Laws and Contracts 16
5.2. Contractual Agreements with Customers and Suppliers 17
5.3. Laws and Regulations 17
6. Company Boards and Committees 18
6.1. Composition of the Board of Directors 18
6.2. Functions and Responsibilities of the Board 19
6.3. Board of Directors Committees 20
7. Relevant Factors in Analyzing Corporate Governance and Stakeholder Management 22
7.1. Market Factors 22
7.2. Non- Market Factors 24
8. Risks and Benefits of Corporate Governance and Stakeholder Management 25
8.1. Risks of Poor Governance and Stakeholder Management 26
8.2. Benefits of Effective Governance and Stakeholder Management 27
9. Factors Relevant to Corporate Governance and Stakeholder Management Analysis 28
9.1. Economic Ownership and Voting Control 29
9.2. Board of Directors Representation 29
9.3. Remuneration and Company Performance 30
9.4. Investors in the Company 31
9.5. Strength of Shareholders’ Rights 31
9.6. Managing Long- Term Risks 32
9.7. Summary of Analyst Considerations 32
10. ESG Considerations for Investors and Analysts 33
10.1. Introduction to Environmental, Social, and Governance issues 33
10.2. ESG Investment Strategies 34
10.3. ESG Investment Approaches 35
10.4. Catalysts for Growth in ESG Investing 38
10.5. ESG Market Overview 39
10.6. ESG Factors in Investment Analysis 39
Summary 42
Chapter 2 Introduction to Alternative Investments 45
Learning Outcomes 45
1. Introduction 45
1.1. Why Investors Consider Alternative Investments 46
1.2. Categories of Alternative Investments 47
2. Investment Methods 49
2.1. Methods of Investing in Alternative Investments 49
2.2. Advantages and Disadvantages of Direct Investing, Co- investing, and Fund Investing 51
2.3. Due Diligence for Fund Investing, Direct Investing, and Co- investing 54
3. Investment and Compensation Structures 56
3.1. Partnership Structures 56
3.2. Compensation Structures 58
3.3. Common Investment Clauses, Provisions, and Contingencies 59
4. Hedge Funds 62
4.1. Characteristics of Hedge Funds 62
4.2. Hedge Fund Strategies 66
4.3. Hedge Funds and Diversification Benefits 71
5. Private Capital 71
5.1. Overview of Private Capital 71
5.2. Description: Private Equity 72
5.3. Description: Private Debt 76
5.4. Risk/Return of Private Equity 79
5.5. Risk/Return of Private Debt 79
5.6. Diversification Benefits of Investing in Private Capital 81
6. Natural Resources 82
6.1. Overview of Natural Resources 82
6.2. Characteristics of Natural Resources 83
6.3. Risk/Return of Natural Resources 87
6.4. Diversification Benefits of Natural Resources 90
6.5. Instruments 95
7. Real Estate 96
7.1. Overview of the Real Estate Market 96
7.2. Characteristics: Forms of Real Estate Ownership 98
7.3. Characteristics: Real Estate Investment Categories 103
7.4. Risk and Return Characteristics 105
7.5. Diversification Benefits 108
8. Infrastructure 110
8.1. Introduction and Overview 110
8.2. Description 112
8.3. Risk and Return Characteristics 114
8.4. Diversification Benefits 117
9. Issues in Performance Appraisal 118
9.1. Overview of Performance Appraisal for Alternative Investments 118
9.2. Common Approaches to Performance Appraisal and Application Challenges 119
9.3. Private Equity and Real Estate Performance Evaluation 122
9.4. Hedge Funds: Leverage, Illiquidity, and Redemption Terms 124
10. Calculating Fees and Returns 128
10.1. Alternative Asset Fee Structures and Terms 129
10.2. Custom Fee Arrangements 129
10.3. Alignment of Interests and Survivorship Bias 134
Summary 136
Chapter 3 Real Estate Investments 145
Learning Outcomes 145
Section A. Overview of Types of Real Estate Investment 146
1. Introduction and Basic Forms of Real Estate Investment 146
1.1. Real Estate Market Size 147
1.2. Real Estate Investment: Basic Forms 147
1.3. Characteristics 150
1.4. Risk Factors 153
2. Economic Value Drivers, Role in Portfolio, and Risk/Return of Real Estate Investments Relative to Stocks and Bonds 157
2.1. Economic Drivers 157
2.2. Role of Real Estate in an Investment Portfolio 160
2.3. Real Estate Risk and Return Relative to Stocks and Bonds 163
2.4. Classifications 166
2.5. Investment Characteristics by Property Type 168
3. Considerations in Analysis and Due Diligence 173
4. Indexes 175
4.1. Appraisal- Based Indexes 175
4.2. Transaction- Based Indexes 176
4.3. Advantages and Disadvantages of Appraisal- Based and Transaction- Based Indexes 177
4.4. Real Estate Security Indexes 179
Section B. Investments in Real Estate through Private Vehicles 179
5. Introduction to Valuation Approaches 179
5.1. Highest and Best Use 181
6. The Income Approach to Valuation: Discount Rates and the Direct Capitalization of NOI and DCF Methods 182
6.1. Similarities in Approaches 183
6.2. The Direct Capitalization Method 183
7. The DCF Method, the Relationship between Discount Rate and Cap Rate, and the Terminal Capitalization Rate 187
7.1. The Relationship between the Discount Rate and the Cap Rate 187
7.2. The Terminal Capitalization Rate 189
8. Private Market Real Estate Debt 194
Section C. Investments in Real Estate Through Publicly Traded Securities 197
9. Types of Publicly Traded Real Estate Securities 197
9.1. REIT Structures 198
9.2. Market Size 199
9.3. Benefits and Disadvantages of Investing in REITs 200
10. Valuation: Net Asset Value Approach 203
10.1. Accounting for Investment Properties 203
10.2. Net Asset Value per Share: Calculation 204
10.3. Net Asset Value per Share: Application 206
11. Valuation: Relative Value (Price Multiple) Approach 208
11.1. Relative Value Approach to Valuing REIT Stocks 208
11.2. Funds from Operations and Adjusted Funds from Operations 209
11.3. P/FFO and P/AFFO Multiples: Advantages and Drawbacks 214
12. REIT Mini Case Study: Example of Disclosures and Valuation Analysis 215
12.1. Selection of Valuation Methods 221
13. Private versus Public: A Comparison 223
Summary 224
General Characteristics of Real Estate 225
Private Equity Real Estate 226
Publicly Traded Real Estate Securities 226
Chapter 4 Private Equity Investments 239
Learning Outcomes 239
1. Introduction 239
2. Introduction to Valuation Techniques in Private Equity Transactions 241
2.1. How Is Value Created in Private Equity? 244
2.2. Using Market Data in Valuation 247
3. Contrasting Venture Capital and Buyout Investments 248
4. LBO model for valuation of Buyout Transactions 249
4.1. The LBO Model 250
5. VC Method for valuation of Venture Capital Transactions 1 253
5.1. Expected Exit Valuation 254
5.2. Required Rate of Return 254
5.3. Option Pools 255
5.4. Stage Financing 256
6. Exit Routes: Return Cash to Investors 258
6.1. Exit Routes: Summary 259
7. Risks and Costs of investing in Private Equity 260
7.1. What Are the Risks and Costs of Investing in Private Equity? 260
8. Private Equity Fund Structures and Terms 261
8.1. Economic Terms 263
8.2. Corporate Governance Terms 264
8.3. Due Diligence Investigations by Potential Investors 266
8.4. Private Equity Fund Valuation 266
9. Evaluating Fund Performance and Concept in Action: Evaluating a Private Equity Fund 267
9.1. Analysis of IRR since Inception 267
9.2. Analysis of Return Multiples 268
Summary 272
Chapter 5 Introduction to Commodities and Commodity Derivatives 279
Learning Outcomes 279
1. Introduction 279
2. Commodity Sectors 280
2.1. Commodity Sectors 282
3. Life Cycle of Commodities 284
3.1. Energy 285
3.2. Industrial/Precious Metals 286
3.3. Livestock 287
3.4. Grains 288
3.5. Softs 289
4. Valuation of Commodities 290
5. Commodities Futures Markets: Participants 292
5.1. Futures Market Participants 292
6. Commodity Spot and Futures Pricing 295
7. Theories of Futures Returns 300
7.1. Theories of Futures Returns 300
8. Components of Futures Returns 306
9. Contango, Backwardation, and the Roll Return 311
10. Commodity Swaps 313
10.1. Total Return Swap 315
10.2. Basis Swap 315
10.3. Variance Swaps and Volatility Swaps 316
11. Commodity Indexes 317
11.1. S&p Gsci 319
11.2. Bloomberg Commodity Index 320
11.3. Deutsche Bank Liquid Commodity Index 320
11.4. Thomson Reuters/CoreCommodity CRB Index 320
11.5. Rogers International Commodity Index 321
11.6. Rebalancing Frequency 321
11.7. Commodity Index Summary 321
Summary 322
Chapter 6 Hedge Fund Strategies 331
Learning Outcomes 331
1. Introduction and Classification of Hedge Fund Strategies 331
1.1. Classification of Hedge Funds and Strategies 333
2. Equity Strategies: Long/Short Equity 336
2.1. Long/Short Equity 337
3. Equity Strategies: Dedicated Short Selling and Short- Biased 340
3.1. Investment Characteristics 340
3.2. Strategy Implementation 342
4. Equity Strategies: Equity Market Neutral 344
4.1. Investment Characteristics 345
4.2. Strategy Implementation 346
5. Event- Driven Strategies: Merger Arbitrage 348
5.1. Merger Arbitrage 348
6. Event- Driven Strategies: Distressed Securities 351
6.1. Investment Characteristics 352
6.2. Strategy Implementation 353
7. Relative Value Strategies: Fixed Income Arbitrage 355
7.1. Fixed- Income Arbitrage 355
8. Relative Value Strategies: Convertible Bond Arbitrage 359
8.1. Investment Characteristics 360
8.2. Strategy Implementation 361
9. Opportunistic Strategies: Global Macro Strategies 363
9.1. Global Macro Strategies 364
10. Opportunistic Strategies: Managed Futures 367
10.1. Investment Characteristics 367
10.2. Strategy Implementation 368
11. Specialist Strategies 371
11.1. Volatility Trading 371
11.2. Reinsurance/Life Settlements 375
12. Multi- Manager Strategies 378
12.1. Fund- of- Funds 378
12.2. Multi- Strategy Hedge Funds 380
13. Analysis of Hedge Fund Strategies using a Conditional Factor Risk Model 384
13.1. Conditional Factor Risk Model 385
14. Evaluating Equity Hedge Fund Strategies: Application 389
15. Evaluating Multi- manager Hedge Fund Strategies: Application 394
16. Portfolio Contribution of Hedge Fund Strategies 397
16.1. Performance Contribution to a 60/40 Portfolio 397
16.2. Risk Metrics 400
Summary 403
Chapter 7 Capital Market Expectations: Forecasting Asset Class Returns 415
Learning Outcomes 415
1. Introduction 415
2. Overview of Tools and Approaches 416
2.1. The Nature of the Problem 416
2.2. Approaches to Forecasting 416
3. Forecasting Fixed Income Returns 418
3.1. Applying DCF to Fixed Income 418
3.2. The Building Block Approach to Fixed- Income Returns 420
4. Risks in Emerging Market Bonds 426
4.1. Economic Risks/Ability to Pay 426
4.2. Political and Legal Risks/Willingness to Pay 427
5. Forecasting Equity Returns 428
5.1. Historical Statistics Approach to Equity Returns 429
5.2. DCF Approach to Equity Returns 430
5.3. Risk Premium Approaches to Equity Returns 432
5.4. Risks in Emerging Market Equities 437
6. Forecasting Real Estate Returns 438
6.1. Historical Real Estate Returns 438
6.2. Real Estate Cycles 439
6.3. Capitalization Rates 440
6.4. The Risk Premium Perspective on Real Estate Expected Return 441
6.5. Real Estate in Equilibrium 442
6.6. Public versus Private Real Estate 442
6.7. Long- Term Housing Returns 443
7. Forecasting Exchange Rates 445
7.1. Focus on Goods and Services, Trade, and the Current Account 446
7.2. Focus on Capital Flows 448
8. Forecasting Volatility 453
8.1. Estimating a Constant VCV Matrix with Sample Statistics 453
8.2. VCV Matrices from Multi- Factor Models 454
8.3. Shrinkage Estimation of VCV Matrices 455
8.4. Estimating Volatility from Smoothed Returns 456
8.5. Time- Varying Volatility: ARCH Models 457
9. Adjusting a Global Portfolio 459
9.1. Macro- Based Recommendations 459
9.2. Quantifying the Views 461
Summary 462
Chapter 8 Asset Allocation to Alternative Investments 475
Learning Outcomes 475
1. Introduction and The Role of Alternative Investments in a Multi- asset Portfolio 475
1.1. The Role of Alternative Investments in a Multi- asset Portfolio 476
2. Diversifying Equity Risk 483
2.1. Volatility Reduction over the Short Time Horizon 483
2.2. Risk of Not Meeting the Investment Goals over the Long Time Horizon 486
3. Traditional Approaches to Asset Classification 488
3.1. Traditional Approaches to Asset Classification 488
4. Risk- Based Approaches to Asset Classification and Comparing Risk- Based and Traditional Approaches 491
4.1. Illustration: Asset Allocation and Risk- Based Approaches 495
4.2. Comparing Risk- Based and Traditional Approaches 497
5. Risk Considerations, Return Expectations and Investment Vehicle 499
5.1. Risk Considerations 499
5.2. Return Expectations 500
5.3. Investment Vehicle 501
6. Liquidity 502
6.1. Liquidity Risks Associated with the Investment Vehicle 503
6.2. Liquidity Risks Associated with the Underlying Investments 505
7. Fees and Expenses, Tax Considerations, and Other Considerations 506
7.1. Tax Considerations 507
7.2. Other Considerations 507
8. Suitability Considerations 510
8.1. Investment Horizon 510
8.2. Expertise 510
8.3. Governance 511
8.4. Transparency 511
9. Asset Allocation Approaches and Statistical Properties and Challenges of Asset Returns 513
9.1. Statistical Properties and Challenges of Asset Returns 514
10. Monte Carlo Simulation 519
10.1. Simulating Skewed and Fat- Tailed Financial Variables 520
10.2. Simulation for Long- Term Horizon Risk Assessment 522
11. Portfolio Optimization 526
11.1. Mean- Variance Optimization without and with Constraints 526
11.2. Mean- CVaR Optimization 528
12. Risk Factor- Based Optimization 532
13. Liquidity Planning and Achieving and Maintaining the Strategic Asset Allocation 535
13.1. Achieving and Maintaining the Strategic Asset Allocation 536
14. Managing the Capital Calls and Preparing for the Unexpected 542
14.1. Preparing for the Unexpected 542
15. Monitoring the Investment Program 547
15.1. Overall Investment Program Monitoring 547
15.2. Performance Evaluation 547
15.3. Monitoring the Firm and the Investment Process 549
Summary 551
Chapter 9 Integrated Cases in Risk Management: Institutional 563
Learning Outcomes 563
1. Introduction 563
2. Financial Risks Faced by Institutional Investors 564
2.1. Long- Term Perspective 564
2.2. Dimensions of Financial Risk Management 564
2.3. Risk Considerations for Long- Term Investors 567
2.4. Risks Associated with Illiquid Asset Classes 569
2.5. Managing Liquidity Risk 573
2.6. Enterprise Risk Management for Institutional Investors 575
3. Environmental and Social Risks Faced by Institutional Investors 577
3.1. Universal Ownership, Externalities, and Responsible Investing 577
3.2. Material Environmental Issues for an Institutional Investor 578
3.3. Material Social Issues for an Institutional Investor 584
Case Study 586
1. Case Study: Introduction 586
2. Case Study: Background 586
3. R- SWF’S Investments: 1.0 586
Investment Committee Meeting 1.0 592
4. R- SWF’S Investments: 2.0 603
Investment Committee Meeting 2.0 608
5. R- SWF’S Investments: 3.0 616
References 617
Glossary 619
About the Editors and Authors 627
Index 631
