Alternative Investment Features, Methods, and Structures (2024 CFA® Level I Exam – AI – LM 1)

Summary

The video script is an introductory module on alternative investments for the CFA program. It defines alternative investments as any investment vehicle that doesn't fit into fixed income or equity securities. The speaker, Jim, explains that these investments are appealing due to their potential to increase expected returns and improve portfolio risk-return profiles, especially in low-interest-rate environments. The script delves into the characteristics of alternative investments, including specialized knowledge requirements, low liquidity, and longer investment horizons. It also discusses various types of alternative investments, such as private capital, real assets, and hedge funds, and touches on the complexities of valuing and managing these assets. The module outlines the structure of investment funds, including management fees, performance fees, and the concept of co-investment. It concludes with a brief overview of the limited partnership agreement and the role of accredited investors, emphasizing the importance of diversification and the modern portfolio theory in alternative investments.

Takeaways

• 📚 **Alternative Investments Overview**: The script introduces alternative investments as a category of investment vehicles that do not fit into traditional fixed income or equity securities.
• 🤔 **Diversification and Risk Reduction**: Alternative investments are used to diversify portfolios and potentially lower the standard deviation of a portfolio, aiming to improve the risk-return profile.
• 💡 **Direct and Co-investment**: The concept of direct investment in alternative assets versus investing in a fund that pools capital for such investments is discussed, highlighting the focus areas for further learning.
• 🏦 **Private Capital and Real Assets**: Examples of alternative investments include private capital, real assets like commercial real estate, and hedge funds, with further details provided in subsequent modules.
• 📈 **Potential for Higher Returns**: The script touches on the potential for alternative investments to offer higher returns, especially in a low-interest-rate environment.
• 💰 **Specialized Knowledge and Valuation**: Investing in alternative assets requires specialized knowledge due to the unique nature of these investments and the complexities associated with valuing them.
• 🔗 **Correlation with Traditional Assets**: The low correlation between alternative investments and traditional equity or fixed income securities is a key reason for their inclusion in a diversified portfolio.
• 🚨 **Liquidity and Investment Horizons**: Alternative investments typically have less liquidity and longer investment horizons compared to traditional investments.
• 💼 **Management and Performance Fees**: The script explains the complex fee structures associated with alternative investments, including management fees and performance or carried interest fees.
• 📜 **Legal Agreements and Structures**: The importance of legal agreements like limited partnership agreements and the role of side letters in defining the relationship and terms between investors and fund managers are discussed.
• 🔍 **Due Diligence and Trust**: Emphasizes the need for investors to conduct thorough research and place trust in the expertise and integrity of the fund manager when investing in alternative investments.

Q & A

What is the definition of alternative investments in the context of the CFA program?

Alternative investments are any kind of investment vehicle that doesn't fit into fixed income and equity securities. They are considered for their potential to diversify a portfolio and potentially improve its risk-return profile.

Why are alternative investments considered for inclusion in a portfolio?

Alternative investments are considered to add securities to the portfolio that can lower the standard deviation of the portfolio, thereby reducing risk, and at the same time, increase expected return, thus potentially improving the portfolio's risk-return profile.

What are the three main categories of alternative investments mentioned in the script?

The three main categories of alternative investments mentioned are private capital, real assets, and hedge funds.

What is the concept of direct and co-investment in alternative investments?

Direct and co-investment refers to the opportunity for investors to invest not only in a fund that holds a diversified portfolio of alternative assets but also to invest directly into specific alternative assets alongside the fund, offering a chance for more active involvement and potentially reduced management fees.

What are some of the challenges associated with alternative investments?

Challenges include the need for specialized knowledge to value cash flows and risks, lower liquidity, longer investment horizons, large capital outlay, complex compensation structures, and the difficulty in evaluating the performance of the investments.

How does the compensation structure for a hedge fund manager typically work?

The compensation structure often involves a management fee based on assets under management or committed capital, a performance fee based on returns above a certain hurdle rate, and a carried interest, which is a share of the profits above the hurdle rate, often split between the fund manager and the investors.

What is a hurdle rate in the context of alternative investments?

A hurdle rate is a minimum return threshold that must be met before the fund manager can receive a performance fee. It's used to ensure that the investors receive an adequate return before the manager is compensated for outperformance.

What is a high-water mark in the context of performance fees for alternative investments?

A high-water mark is a reference point that indicates the highest value that a fund has reached historically. Performance fees are typically only paid if the fund's value exceeds this high-water mark, ensuring that managers do not receive fees following a period of decline.

What is a limited partnership agreement and how does it relate to alternative investments?

A limited partnership agreement is a legal contract that outlines the terms of the relationship between a general partner, who runs the business, and the limited partners, who are passive investors. It is a common structure in alternative investments, particularly in private equity and real estate.

What are side letters in the context of limited partnerships?

Side letters are private agreements between a limited partner or a group of limited partners and the general partner. They may stipulate special terms or conditions that are not included in the main limited partnership agreement, such as different compensation arrangements or distribution timings.

What are the advantages and disadvantages of investing in a fund versus direct investment in alternative assets?

Advantages of fund investment include access to the manager's expertise, lower minimum capital requirements, and reduced responsibility for the investor. Disadvantages include higher management fees, the need to research and trust the fund manager, and potentially less control over individual investments.