Introduction to Alternative Investments | CFA Level I Alternative Investments

In this introductory lesson, we’ll explore the differences between alternative and traditional investments, take a brief overview of the various categories of alternative investments, and discuss the role of alternative investments in a portfolio.

Alternative vs. Traditional Investments

Alternative investments differ from traditional investments in the types of assets and securities included, the structure of the investment vehicles, and characteristics. Traditional investments usually focus on stocks and bonds, while alternative investment portfolios can include derivatives, illiquid assets such as real estate, and more. These assets can be bought with leverage and employ short positions.

Investment structures for alternative investments are often more complicated than those of traditional investments, and fee structures are also different, with higher management fees on average and often additional incentive fees based on performance.

Characteristics wise, alternative investments as a group have had low returns correlations with traditional investments. They are generally less liquid, have more specialized investment managers, less regulation and transparency, different legal issues and tax treatments, and more problematic and less available historical return and volatility data.

Categories of Alternative Investments

In this course, we’ll examine six categories of alternative investments:

Hedge Funds: Private investment vehicles that manage portfolios of securities and derivative positions using a variety of strategies. They may employ long and short positions, are often highly leveraged, and aim to deliver investment performance that is independent of broad market performance.

Private Capital: Can be in the form of private equity or private debt. Private equity funds invest in the equity of non-publicly traded companies or in publicly traded firms that the fund intends to take private. Private debt refers to debt provided to private companies and includes direct lending, mezzanine loans, venture debt, and distressed debt.

Real Estate Investments: Direct investments in residential or commercial properties, as well as indirect investments through real estate backed debt, including private commercial real estate equity or debt, real estate investment trusts (REITs), and mortgage-backed securities.

Natural Resources: Mainly commodities. Investments may be in physical products like grains, metals, and crude oil, or through owning physical commodities, commodities derivatives, or shares of commodity-producing firms. Also includes investments in timberland and farmland.

Infrastructure: Long-lived assets that provide public services, such as airports, utility grids, schools, and hospitals. Investors may directly invest in individual projects or gain exposure indirectly through various investment vehicles.

Others: This category includes investments in tangible collectible assets like fine wines, stamps, automobiles, antique furniture, and art, as well as intangible assets like patents.

Why Consider Alternative Investments?

Alternative investment returns have historically had low correlations with traditional investments, potentially reducing overall portfolio risk. However, risk measures like standard deviation may not adequately capture the risk characteristics of alternative investments.

Historical returns for alternative investments have been higher on average than for traditional investments, which could be due to less efficient pricing, illiquidity, or leverage. However, data supporting this notion can be biased due to survivorship and backfill biases.

Survivorship bias

Survivorship bias refers to the upward bias of returns if only the data for surviving firms is included. Since surviving firms tend to be those that had better returns, excluding the returns data for failed firms results in average returns that are biased upward.

Backfill bias

Backfill bias can be introduced when new funds are added to a benchmark index. Since funds that are newly added to an index tend be those that have performed better than average, including their returns for prior years tends to bias the index returns upward.

That’s all for this introductory lesson on alternative investments. Don’t worry if some aspects were skimmed through; they will be covered in detail in the coming lessons. Up next, we’ll learn about methods of investing in alternative investments.