Overview
Alternative investments encompass asset classes outside traditional stocks and bonds: real estate, hedge funds, private equity, commodities, and infrastructure. Level I candidates must understand the characteristics, return drivers, valuation approaches, and risk factors of each. Alternatives are increasingly important in institutional portfolio construction.
Real Estate
Real estate investments range from direct ownership of physical property to publicly traded REITs (real estate investment trusts). Direct real estate is illiquid and requires active management; REITs provide liquidity and diversification but trade at a correlation with equities.
Valuation approaches:
- Income approach: Capitalize net operating income (NOI) using a capitalization rate: Value = NOI / Cap rate
- Sales comparison approach: Benchmarks against comparable recent transactions
- Cost approach: Estimates replacement cost less depreciation
NOI = Rental income − Vacancy losses − Operating expenses (before debt service and taxes).
Hedge Funds
Hedge funds are pooled investment vehicles that pursue diverse strategies — long/short equity, global macro, merger arbitrage, convertible bond arbitrage, managed futures, and more. They typically charge a management fee (1–2%) and a performance fee (15–20% of profits above a hurdle rate), often with a high-water mark ensuring fees are only earned on net new gains.
Hedge funds have low regulatory oversight, limited liquidity (lock-up periods, redemption gates), and tend to report returns with survivorship bias (failed funds leave the database). Due diligence is critical.
Private Equity
Private equity includes venture capital (early-stage companies), leveraged buyouts (acquiring mature businesses with debt), and growth equity (minority stakes in expanding firms). Investments are illiquid, typically over a 7–10 year horizon, with value created through operational improvement, financial engineering, and multiple expansion.
Returns are measured using the internal rate of return (IRR) and the multiple of invested capital (MOIC / TVPI). The J-curve effect describes the pattern of negative early returns (capital calls and fees) followed by positive returns as portfolio companies mature.
Commodities and Infrastructure
Commodity investments provide inflation hedging and portfolio diversification. Returns come from spot price appreciation, roll return (from futures contracts rolling forward), and collateral yield. Commodity futures are normally in contango (futures > spot, negative roll yield) when storage costs are high.
Infrastructure assets (toll roads, airports, utilities) offer long-duration, inflation-linked cash flows. They exhibit low correlation with traditional assets and attract pension funds and sovereign wealth funds seeking liability matching.