Private equity, hedge funds, real estate, commodities, and infrastructure — alternative investment strategies and performance metrics for CFA Level I.
Definition first
This guide is designed for first-pass understanding. Start with core terms, then apply the framework in your own account workflow.
Alternative investments — private equity, hedge funds, real estate, commodities, infrastructure, and natural resources — represent a massive and growing share of institutional portfolios. Yale's endowment pioneered the model of allocating heavily to alternatives, and today most pension funds, sovereign wealth funds, and family offices follow suit. The CFA Level I curriculum introduces the major alternative asset classes, their risk-return characteristics, and their role in portfolio diversification. This guide covers everything you need to know.
What Makes an Investment "Alternative"?
An alternative investment is anything outside the traditional trio of stocks, bonds, and cash. But beyond that simple definition, alternative investments share several common characteristics that distinguish them from traditional assets:
Illiquidity: Most alternatives cannot be quickly bought or sold on a public exchange. Private equity funds lock up capital for 7-12 years. Real estate transactions take months. This illiquidity is both a risk (you can't exit when you want) and a source of return (the illiquidity premium).
Limited transparency: Alternative investments often have less regulatory disclosure than public securities. Hedge fund strategies may be proprietary. Private equity valuations are based on appraisals rather than market prices.
High minimum investments: Many alternatives require $1 million or more to participate. This limits access to institutional investors and high-net-worth individuals.
Complex fee structures: The "2 and 20" model (2% management fee plus 20% of profits) is far more expensive than a 0.03% index fund fee.
Low correlation with traditional assets: This is the primary reason alternatives are attractive for portfolio construction. If alternatives don't move in lockstep with stocks and bonds, adding them can improve risk-adjusted returns.
Specialized expertise required: Evaluating a leveraged buyout or a timber investment requires knowledge that most equity analysts don't have.
Private Equity: Buying and Building Companies
Private equity (PE) involves investing in companies that are not publicly traded — or taking public companies private. PE is the largest alternative asset class by assets under management and one of the most important topics in the CFA alternative investments curriculum. For a deeper dive, see our complete guide to private equity.
Venture Capital
Venture capital (VC) is PE investing in early-stage companies — startups that have high growth potential but no proven business model, limited revenue, and often no profits. VC firms provide capital in exchange for equity stakes and actively work with portfolio companies on strategy, hiring, and fundraising.
VC investing follows a staged approach: seed funding (earliest stage, often pre-revenue), Series A/B/C (progressively larger rounds as the company proves its model), and late-stage/growth equity (pre-IPO companies with proven revenue). Each stage has different risk-return characteristics. Seed investments fail most of the time, but the rare winner can return 100x or more.
The VC return distribution is highly skewed: a small number of investments generate the vast majority of returns. A VC fund might invest in 30 companies, see 20 fail completely, have 8 return 1-3x, and rely on 2 massive winners to drive the entire fund's performance. This is fundamentally different from public equity investing, where the return distribution is more symmetric.
Leveraged Buyouts (LBOs)
Leveraged buyouts are the signature PE transaction. A PE firm acquires a mature company using a combination of equity (typically 30-40% of the purchase price) and debt (60-70%). The debt is loaded onto the acquired company's balance sheet, and the company's own cash flows are used to service it.
LBO value creation comes from three sources: operational improvements(cutting costs, growing revenue, improving margins), debt paydown (using the company's cash flows to reduce debt, which increases the equity value), and multiple expansion (selling the company at a higher valuation multiple than the purchase multiple). The leverage amplifies equity returns when things go well — and amplifies losses when they don't.
GP/LP Structure and Fee Economics
PE funds are structured as limited partnerships. The General Partner (GP) is the PE firm that makes investment decisions and manages portfolio companies. The Limited Partners (LPs) are the investors — pension funds, endowments, sovereign wealth funds, and wealthy individuals — who provide capital but have no role in investment decisions.
The fee structure typically includes a management fee (1.5-2% of committed capital annually) and carried interest (typically 20% of profits above a hurdle rate, usually 8%). Carried interest is the GP's primary incentive to generate strong returns. Some funds have a clawback provision requiring the GP to return excess carried interest if later investments perform poorly.
PE Performance Metrics: DPI, RVPI, and TVPI
Because PE funds are illiquid and have long holding periods, traditional performance measures like annual returns are incomplete. The CFA curriculum emphasizes three multiples:
DPI (Distributions to Paid-In): Cumulative distributions divided by cumulative invested capital. This measures how much cash the fund has actually returned to LPs. A DPI of 1.0 means LPs have gotten their money back; above 1.0, they're in profit. DPI is the most reliable metric because it's based on actual cash flows.
RVPI (Residual Value to Paid-In): The current value of remaining investments divided by cumulative invested capital. This is the unrealized portion — based on estimates and appraisals, not actual sales. RVPI is inherently less reliable than DPI.
TVPI (Total Value to Paid-In): DPI + RVPI. The total value multiple. A TVPI of 2.0x means the fund's investments are worth twice what LPs invested. Early in a fund's life, TVPI is mostly RVPI (unrealized). Late in a fund's life, TVPI is mostly DPI (realized cash).
The J-curve effect is a well-known pattern in PE: funds typically show negative returns in their early years (as management fees are charged and investments haven't yet appreciated) before turning positive as portfolio companies are sold. This makes point-in-time return comparisons misleading for young funds.
Hedge Funds: Active Strategies at Scale
Hedge funds are pooled investment vehicles that employ a wide range of strategies, often using leverage, short selling, and derivatives to generate returns. Unlike mutual funds, hedge funds face fewer regulatory constraints and can invest in almost anything. They're available only to accredited or qualified investors.
Major Hedge Fund Strategies
The CFA curriculum categorizes hedge fund strategies into four broad groups:
Long/short equity: The most common strategy. The fund buys stocks expected to rise (long positions) and sells short stocks expected to fall (short positions). The net exposure can be adjusted — a fund might be 130% long and 30% short (100% net long) or 50% long and 50% short (market neutral). The goal is to generate alpha from stock selection while reducing market exposure.
Event-driven: These strategies focus on corporate events — mergers, acquisitions, restructurings, bankruptcies, spin-offs. Merger arbitrage buys the target company and shorts the acquirer, profiting from the spread between the current market price and the deal price. Distressed debt buys the bonds of companies in or near bankruptcy at deep discounts.
Global macro: These funds take large directional bets on macroeconomic trends — interest rates, currencies, commodities, equity indexes. George Soros's famous bet against the British pound in 1992 is the classic example. Global macro funds use futures, options, and currency forwards extensively.
Relative value: These strategies exploit price discrepancies between related securities. Fixed income arbitrage might buy an underpriced bond and short an overpriced one with similar characteristics. Convertible arbitrage buys convertible bonds and shorts the underlying stock. The focus is on the spread between related instruments, not the direction of the overall market.
Hedge Fund Fee Structure: 2 and 20
The traditional hedge fund fee structure is "2 and 20": a 2% annual management fee on assets under management plus a 20% incentive fee on profits. Many funds also have a high-water mark — the incentive fee is only charged on new profits above the previous peak NAV. This prevents the manager from earning incentive fees on recovering losses.
These fees significantly erode returns. If a hedge fund earns a gross return of 12%, the net return after 2-and-20 is roughly 8% (2% management fee, then 20% of the remaining 10% profit = 2%, leaving 8% net). Over long periods, fee drag is one of the main reasons many hedge funds underperform simple index strategies on a net-of-fee basis.
Fee structures have been under pressure in recent years, and many funds now charge lower fees — "1 and 15" or "1.5 and 17.5" structures are increasingly common, especially for large institutional allocations.
Real Estate: The Original Alternative
Real estate is the largest alternative asset class by total value and one of the most accessible. Investors can access real estate through direct ownership (buying properties) or indirect vehicles (REITs, real estate funds, real estate limited partnerships).
Direct vs Indirect Real Estate Investment
Direct investment means buying physical properties — residential rental properties, commercial buildings, industrial warehouses, land. Direct investment offers control over the asset, potential tax advantages (depreciation, 1031 exchanges), and the ability to add value through renovations or improved management. The downsides are illiquidity, large capital requirements, management burden, and concentration risk. See our guide on home equity for the residential side.
Indirect investment includes REITs (Real Estate Investment Trusts), real estate mutual funds, and private real estate funds. REITs are publicly traded companies that own and operate income-producing real estate. They must distribute at least 90% of taxable income as dividends, making them attractive for income-seeking investors. REITs offer liquidity (they trade on stock exchanges), diversification across properties and geographies, and professional management. The tradeoff is that they correlate more highly with the stock market than direct real estate does.
Real Estate Valuation
The CFA curriculum covers three main real estate valuation approaches:
Income approach: Value equals the present value of expected future net operating income (NOI). The simplest form divides NOI by a capitalization rate (cap rate): Value = NOI / Cap Rate. A property generating $500,000 in NOI with a 5% cap rate is worth $10 million.
Sales comparison approach: Value is estimated by comparing the property to recent sales of similar properties, with adjustments for differences in size, location, condition, and features.
Cost approach: Value equals the cost of the land plus the cost to construct an equivalent building, minus depreciation. This approach is most useful for unique or special-purpose properties where comparables are limited.
Commodities: Physical Assets as Investments
Commodities include energy (crude oil, natural gas), metals (gold, silver, copper), agriculture (corn, wheat, soybeans), and livestock. Investors can gain commodity exposure through direct ownership (gold bars in a vault), futures contracts, commodity ETFs, or stocks of commodity-producing companies.
Contango and Backwardation
Two crucial concepts for commodity futures investing are contango and backwardation, which describe the shape of the futures term structure:
Contango: When futures prices are higher than the current spot price (and longer-dated futures are priced higher than shorter-dated ones). This is the normal state for most commodities because futures prices include storage costs, insurance, and financing (the cost of carry). In contango, rolling futures contracts forward creates a negative roll yield — you sell the expiring contract at a lower price and buy the next one at a higher price.
Backwardation: When futures prices are lower than the spot price. This occurs when there's strong near-term demand or supply shortages. In backwardation, rolling forward generates a positive roll yield. Backwardation is generally favorable for long commodity futures investors.
Commodity Indexes
Most institutional commodity exposure comes through commodity index investing. Major indexes include the Bloomberg Commodity Index (BCOM), the S&P GSCI, and the DBIQ Optimum Yield Diversified Commodity Index. These indexes differ in their commodity weightings (energy-heavy vs diversified), roll methodology (which futures contracts to hold), and rebalancing rules.
The total return from a commodity futures investment has three components: spot return (change in the underlying commodity price), roll yield (gain or loss from rolling futures contracts), and collateral yield (interest earned on the margin deposit, typically invested in Treasury bills).
Infrastructure and Natural Resources
Infrastructure investments include essential physical assets: toll roads, airports, ports, pipelines, power plants, water systems, telecommunications networks, and social infrastructure (hospitals, schools). Infrastructure investments typically feature long-duration assets with stable, inflation-linked cash flows and high barriers to entry. Many operate as regulated monopolies or near-monopolies.
Infrastructure can be accessed through direct investment (brownfield or greenfield projects), listed infrastructure companies, or private infrastructure funds. Brownfield investments (existing assets) offer more predictable cash flows; greenfield investments (new construction) offer higher potential returns with greater risk.
Natural resources encompass farmland, timberland, water rights, and mineral rights. Timberland is particularly interesting because trees are a "biological factory" — they grow whether markets are up or down, and the owner can choose when to harvest. Farmland provides both income (crop production) and capital appreciation (land values).
Risk-Return Profile vs Traditional Investments
The appeal of alternatives lies in their diversification potential and their risk-return characteristics relative to traditional stocks and bonds:
Private equity: Historically the highest-returning alternative, with top quartile PE funds returning 15-25% net annually. But average PE returns are much more modest, and bottom quartile funds often lose money. Manager selection is critical.
Hedge funds: Returns vary enormously by strategy. The hedge fund industry as a whole has struggled to outperform simple 60/40 portfolios after fees in recent years. The best funds deliver consistent risk-adjusted returns with low correlation to markets.
Real estate: Historically returns 8-12% annually (income plus appreciation), with lower volatility than equities. The income component provides a floor. Direct real estate has low correlation with stocks; REITs are more correlated.
Commodities: Low long-term real returns on average, but valuable for inflation protection and diversification. Gold in particular serves as a crisis hedge.
Infrastructure: Typically 6-10% annual returns with low volatility and high income yield. Strong inflation linkage (many infrastructure assets have inflation-adjusted revenue contracts).
Due Diligence for Alternative Investments
Because alternatives are complex, illiquid, and often opaque, thorough due diligence is essential. The CFA curriculum — particularly the ethics and professional standards framework — emphasizes several areas:
Strategy evaluation: Understanding the investment strategy, its sources of return, and the conditions under which it might underperform.
Manager assessment: Evaluating the GP's track record, team stability, operational capabilities, and alignment of interests with LPs.
Operational due diligence: Reviewing the fund's service providers (administrator, auditor, prime broker), valuation procedures, compliance framework, and risk management systems. Operational failures have caused some of the largest hedge fund blowups in history.
Legal and structural review: Understanding fund terms (lock-up periods, gate provisions, side pockets), fee structures, reporting obligations, and investor rights.
Performance attribution: Determining whether past returns came from skill (alpha) or simply from market exposure (beta). Many hedge fund returns can be replicated with simple factor-based strategies.
The Role of Alternatives in Portfolio Diversification
The fundamental argument for alternatives in a portfolio is diversification. If alternative assets have low correlation with stocks and bonds, adding them to a traditional portfolio can improve the efficient frontier — achieving either higher returns for the same risk, or the same returns with lower risk. This is a direct application of Modern Portfolio Theory.
However, the diversification benefits of alternatives are complicated by several factors:
Stale pricing: Private assets are appraised infrequently, which artificially smooths returns and understates correlation with public markets. When you mark PE investments to market more frequently, their correlation with stocks increases significantly.
Tail risk: Some alternatives (especially hedge funds using leverage) can experience extreme losses during market crises — exactly when diversification is most valuable. Correlations tend to increase during stress periods.
Illiquidity cost: The inability to rebalance alternative allocations quickly can cause portfolio drift and reduce the practical diversification benefit.
Access and implementation: The best alternative managers are often closed to new investors, and there's significant performance dispersion between top and bottom quartile managers.
Despite these caveats, most large institutional investors maintain significant alternative allocations — typically 20-40% of total assets. The trend toward alternatives continues to accelerate as institutions seek returns in a lower-yield environment.
Alternative Investments on the CFA Level I Exam
Alternative investments carry a 5-8% weight on the Level I exam. The exam focuses on conceptual understanding rather than deep quantitative analysis (that comes at Level II). Key areas include:
Characteristics common to all alternative investments
PE fund structure, fee economics, and performance metrics (DPI, RVPI, TVPI)
Hedge fund strategy categories and their risk-return profiles
Real estate valuation approaches and direct vs indirect investment
Commodity futures concepts (contango, backwardation, roll yield)
Infrastructure and natural resource investment characteristics
Due diligence processes for alternative investments
The role of alternatives in portfolio construction
The biggest mistake candidates make is treating alternatives as a pure memorization topic. While there are terms and categories to know, the exam increasingly tests your ability to apply concepts. Why would an investor choose a long/short equity strategy over a global macro strategy? How does contango affect the returns of a commodity futures investor? What are the limitations of using TVPI to evaluate a young PE fund? These are the types of questions you should be prepared to answer.
Alternatives connect directly to the derivatives curriculum (hedge funds and commodities use derivatives extensively) and to portfolio management (the role of alternatives in asset allocation). Building these connections across topics will strengthen your exam performance.