CFA Level 3 Alternative Investments

Below, you’ll find my personal CFA level 3 alternative investment notes…

You can find a list of the other categories here: CFA Level 3 Notes, Formulas, and Weights.

Traditional Investments

  • Stocks
  • Bonds

Traditional Alternative Assets

  • Commodities
  • Real Estate
  • Private Equity

Modern Alternative Assets

  • Hedge Funds
  • Managed Futures
  • Distressed Securities

Decision Risk is the maximum loss from changing strategies at the worst time possible.

Core-Satellite Investing is an asset allocation approach. Most often large cap stocks and government bonds are in the core. The satellite ring tends to hold special strategies (add alpha, lower portfolio volatility, etc.). Portfolio managers tend to place alternative investments in the satellite ring.

Commingled Real Estate Funds (CREFs) are similar to REITs.

Property appraisals aren’t as frequent. This smoothed data leads to lower reported volatility and in turn, higher risk adjusted returns. To adjust for this bias, there are ways to unsmooth the appraisal data.

Private, direct investment in Timberland and farmland has worked as a hedge for expected and unexpected inflation. Although, public equity timberland and farmland investments don’t provide a reliable hedge.

Buyout Funds can use Dividend Recapitalization to leverage up to finance a special dividend. Investors can recoup their initial cash outlay in a few years but over leveraging can hurt the company long-term.

Vintage Year is important when comparing private equity fund returns. The funds should be compared to other funds closed in the same year. The economic conditions have a big impact on their returns.

Minority, Non-Marketable Interest (Adjustment Example)
Estimated Total Value if Public = $1,000 Million
Purchase Percentage = 10% = $100 Million (Before Discounts)
Minority Interest Discount = 10% = $90 Million
Marketability Discount = 20% = $72 Million

Commodities generally have positive correlation with inflation and vice versa for stocks/bonds.

Theory of Storage 3 Components

  1. Forgone Interest
  2. Storage Costs
  3. Convenience Yield – embedded consumption option. Moves inversely with inventory levels.

Smauelson Effect is the tendency of future price volatility to drop with time to maturity.

Backwardation provides positive roll return opportunity.

[Contango and Backwardation Chart]

Types of Hedge Funds

  • Equity Market Neutral – Long-Short Positions… can reduce volatility and kurtosis
  • Convertible Arbitrage – Buy convertible securities and hedge part or all of risk
  • Fixed Income Arbitrage
  • Distress Securities
  • Merger Arbitrage
  • Hedged Equity – Similar strategy to market neutral but often net long or short one way
  • Global Macro – Tend to have positive skewness and high kurtosis
  • Emerging Markets
  • Fund of Funds – Fees on Fees but usually don’t have a lock-up period

Hedge Fund General Expense Structure: 1% or 2% AUM fee and 20% of profits (often includes a High-Water Market based on NAV)

Lock-up Periods are Common with Hedge Funds

Absolute Return Funds are hard to compare to benchmarks. Instead, use a minimum return hurdle rate.

Biases in Index Creation

  • Survivorship Bias
  • Stale Price Bias
  • Backfill Bias

Classification and Style Drift are common issues with Fund of Funds. Generally, larger funds earn lower returns and risk-adjusted returns than small funds.

Hedge Fund Rolling Return: RRn,t= (Rt+ Rt-1+ Rt-2…)/n

Maximum Drawdown = High Water Mark – Subsequent Low

Downside Deviation Formula

Sharpe Ratio = (Annualized Rate of Return – Risk Free) / Annualized Standard Deviation

Roy’s Safety-First = (Return – Minimum Required Return) / Standard Deviation

Sharpe Ratio Limitations

  • Time dependent so annual Sharpe is  larger than monthly Sharpe if returns are serially uncorrelated
  • Not as useful when negative or positive skewness
  • Illiquidity bias ratio upward
  • Overestimated when returns are serially correlated
  • Sharpe ratio found not predictive for hedge fund performance
  • Ratio manipulation… Lengthen interval to lower volatility… Writing out-of-the money calls and puts… smoothing returns…

Sortino Ratio = (Annualized Rate of Return – Minimum Acceptable Return) / Downside Deviation

High Kurtosis (leptokurtic) has fatter tails… higher chance of extreme returns

Commodity Trading Advisers (CTAs) manage commodity futures funds

Commodity Pool Operators (CPOs) are general partners who serve as CTAs or hire CTAs

Managed Futures sometimes viewed as a subset of global macro hedge funds

Managed Futures Trading Strategies

  • Systematic Trading follows rule based… trend following… algo trading
  • Discretionary uses portfolio manage judgement

Bankruptcy Reform Act of 1978

Bankruptcy for Distressed Securities

  • Chapter 7 Liquidation
  • Chapter 9 Muni Reorg
  • Chapter 11 Reorganization
  • Chapter 13 Individual (wage earners)

Chapter 7 can switch to Chapter 11… unless it started as Chapter 11. Courts can convert Chapter 11 to Chapter 7.

Orphan Equity is newly issued equity from a company coming out of bankruptcy that looks undervalued.

Distressed Securities Returns have a negative skew and excess kurtosis.

[Negative vs. Positive Skew Chart]

Fallen Angels are debt issuances that are downgraded (IG to High-Yield) and lose investors due to their portfolio mandates… can open up value opportunities

Distressed Debt Arbitrage: Buy distressed debt and short the common equity

Prepackaged Bankruptcy converts distressed debt to private equity. J Factor Risk is the risk from judges’ decisions and legal process. A Cram-Down is a court-ordered arrangement between creditors and the company (similar concept to arbitration).


Please comment below if you have any suggestions or questions. Also, the next category in my CFA level 3 study list is Risk Management.

Invest mindfully,

Brian Kehm

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