Overview
Alternative Investments is 5-10% of the CFA Level 2 exam and deepens Level 1's overview into valuation and analysis of alternatives, tested in vignettes. It has three areas. Private equity and real estate valuation cover valuing private equity investments (and understanding fund structures, the J-curve, and exit strategies) and real estate (the income, cost and sales-comparison approaches, and valuing real estate investment trusts). Commodities, infrastructure and hedge funds cover commodity pricing and the components of commodity returns (spot, roll and collateral yield), infrastructure investment, and hedge-fund strategies and their characteristics. Performance and due diligence cover measuring the performance of alternative investments (accounting for their illiquidity and fee structures) and the due-diligence process for selecting and monitoring them.
The exam rewards valuing private equity and real estate, understanding commodity returns and hedge-fund strategies, and analyzing alternative performance and fees. The content is more analytical than at Level 1, with some valuation calculations.
How it's tested
CFA Level 2 Alternative Investments questions present a valuation or analysis situation in a vignette and ask you to value an alternative, analyze its returns, or assess performance and fees. CFA Level 2 questions sit in vignettes: a case gives facts, numbers and exhibits, and each question requires pulling the right input and applying the right model, so read the case, identify the model, and compute carefully.
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Value the alternative
A private equity or real estate situation is described, and you apply the valuation approach.
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Returns and strategies
A commodity or hedge-fund situation is described, and you analyze the return components or strategy.
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Performance and due diligence
A performance or selection situation is described, and you apply the measurement or due-diligence concept.
The exam asks about the total return on a commodity futures position, split into the spot price change, the roll from rolling contracts, and the collateral yield. A commodity futures return has three components: spot, roll (positive in backwardation, negative in contango) and collateral. Recognizing that commodity returns combine spot, roll and collateral yield is the analysis the exam expects.
Topic areas 3
Official topic areas from the CFA Institute outline, in outline order.
9.1 Private equity and real estate valuationValuing private equity and real estate.
- What it means
- This covers private equity valuation, the methods for valuing portfolio companies, fund structures and economics (committed capital, the J-curve of returns, carried interest), and exit strategies, and real estate valuation, the income approach (direct capitalization and discounted cash flow), the cost approach and the sales-comparison approach, and valuing real estate investment trusts (REITs).
- What to understand
- Private equity funds draw committed capital over time, show early negative returns before gains (the J-curve), and exit through sales or IPOs, with managers earning carried interest. Real estate is valued by capitalizing income, discounting cash flows, comparing sales, or estimating cost, and REITs by their net asset value or cash flow. Knowing these valuation methods and structures is tested.
- How it shows up
- A private equity or real estate situation is described, and you must apply the valuation approach.
- Common confusion
- Confusing the real estate valuation approaches, or misunderstanding the J-curve or carried interest.
9.2 Commodities, infrastructure, and hedge fundsCommodity returns, infrastructure, and hedge-fund strategies.
- What it means
- This covers commodities, the components of commodity futures returns (spot, roll and collateral yield), and the concepts of contango and backwardation, infrastructure investment and its characteristics, and hedge funds, the main strategies (equity, event-driven, relative value, macro) and their risk and return characteristics.
- What to understand
- Commodity futures returns combine the spot price change, the roll return (positive in backwardation, negative in contango) and the collateral yield. Infrastructure offers stable, long-term income. Hedge-fund strategies differ in their sources of return and risk. Knowing the commodity return components and the hedge-fund strategies is tested.
- How it shows up
- A commodity or hedge-fund situation is described, and you must analyze the returns or identify the strategy.
- Common confusion
- Confusing contango with backwardation (and the roll return's sign), or confusing the hedge-fund strategies.
9.3 Alternative investment performance and due diligenceMeasuring performance and conducting due diligence.
- What it means
- This covers measuring the performance of alternative investments, accounting for illiquidity, valuation challenges and fee structures (management and performance fees, hurdle rates, high-water marks), performance metrics suited to alternatives, and the due-diligence process for selecting and monitoring alternative investments and managers.
- What to understand
- Alternative performance must account for illiquidity, infrequent and sometimes subjective valuations, and complex fees that reduce net returns. Due diligence assesses the strategy, the manager, operations and risks before investing and on an ongoing basis. Knowing how to measure alternative performance net of fees and the due-diligence process is tested.
- How it shows up
- A performance or due-diligence situation is described, and you must apply the measurement or process.
- Common confusion
- Ignoring the effect of fees on net performance, or underestimating the role of due diligence.
High-yield concepts
The terms, rules and formulas this domain turns into questions most often.
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Private equity J-curve
Early losses then gains.
- Remember
- Returns negative before positive.
- Tested as
- PE questions.
- Trap
- Expecting early gains.
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Carried interest
The manager's share of profits.
- Remember
- Aligns incentives.
- Tested as
- PE questions.
- Trap
- Ignoring it.
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Real estate approaches
Income, cost, sales comparison.
- Remember
- Different valuation methods.
- Tested as
- Real estate questions.
- Trap
- Confusing the approaches.
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Income approach
Capitalize or discount income.
- Remember
- For income-producing property.
- Tested as
- Real estate questions.
- Trap
- Misapplying it.
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REIT valuation
Net asset value or cash flow.
- Remember
- For listed real estate.
- Tested as
- Real estate questions.
- Trap
- Overlooking it.
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Commodity return components
Spot, roll, collateral yield.
- Remember
- Three sources of return.
- Tested as
- Commodity questions.
- Trap
- Treating it as just spot.
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Contango vs. backwardation
Futures above versus below spot.
- Remember
- Roll return sign differs.
- Tested as
- Commodity questions.
- Trap
- Confusing the two.
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Infrastructure
Long-lived physical assets.
- Remember
- Stable, long-term income.
- Tested as
- Infrastructure questions.
- Trap
- Overlooking illiquidity.
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Hedge-fund strategies
Equity, event, relative value, macro.
- Remember
- Different return sources.
- Tested as
- Hedge-fund questions.
- Trap
- Confusing the strategies.
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Alternative fees
Management plus performance.
- Remember
- Hurdle and high-water mark.
- Tested as
- Performance questions.
- Trap
- Ignoring the fee drag.
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Due diligence
Assess strategy, manager, operations.
- Remember
- Before and during investment.
- Tested as
- Selection questions.
- Trap
- Skipping it.
Side by side
Concepts candidates mix up, compared on the point that decides the answer.
Contango vs. backwardation
| Concept | Meaning | Key difference | Common trap |
|---|---|---|---|
| Contango | Futures above spot | Negative roll return | Confusing with backwardation |
| Backwardation | Futures below spot | Positive roll return | Confusing with contango |
Real estate valuation approaches
| Concept | Meaning | Key difference | Common trap |
|---|---|---|---|
| Income | Capitalize or discount income | For income property | Confusing with cost |
| Cost | Replacement cost less depreciation | For special-use property | Confusing with income |
| Sales comparison | Comparable sales | For active markets | Confusing with income |
Commodity return components
| Concept | Meaning | Key difference | Common trap |
|---|---|---|---|
| Spot return | Change in the spot price | Direct price move | Treating as the only component |
| Roll return | From rolling futures | Sign depends on the curve | Ignoring it |
| Collateral return | Interest on collateral | Yield on posted margin | Ignoring it |
Exam traps
Each trap is an answer that looks right. Learn the clue that should change your mind.
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Commodity return is just spot
- What candidates pick
- Treat a commodity futures return as only the change in the spot price.
- Why it looks right
- Spot is the obvious driver.
- Why it's wrong
- Commodity futures returns combine the spot return, the roll return (positive in backwardation, negative in contango) and the collateral yield.
Clue to watch for The position is in commodity futures, not the physical.
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Backwardation is negative roll
- What candidates pick
- Say backwardation produces a negative roll return.
- Why it looks right
- The terms are confusing.
- Why it's wrong
- Backwardation (futures below spot) produces a positive roll return as contracts roll up to spot; contango produces a negative roll return.
Clue to watch for The futures curve is downward-sloping (backwardation).
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Early PE gains
- What candidates pick
- Expect a private equity fund to show gains in its early years.
- Why it looks right
- Investment should pay off.
- Why it's wrong
- The J-curve means PE funds typically show negative returns early (from fees and immature investments) before gains materialize later.
Clue to watch for The fund is in its early years.
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Ignore fees in performance
- What candidates pick
- Report an alternative fund's gross return as the investor's performance.
- Why it looks right
- Gross is the headline.
- Why it's wrong
- Management and performance fees, plus hurdles and high-water marks, reduce the net return investors actually earn.
Clue to watch for The question asks for the investor's net performance.
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Cost approach for income property
- What candidates pick
- Value an income-producing office building using the cost approach.
- Why it looks right
- Cost is a method.
- Why it's wrong
- Income-producing property is best valued by the income approach (capitalizing or discounting its income); the cost approach suits special-use or new property.
Clue to watch for The property generates rental income.
Answer framework
For any Alternative Investments item set, use these steps to find the answer the exam expects.
- For private equity, apply the valuation methods and understand fund structures (committed capital, the J-curve, carried interest) and exits.
- For real estate, choose the income (for income property), cost or sales-comparison approach, and value REITs appropriately.
- For commodities, break the futures return into spot, roll (positive in backwardation, negative in contango) and collateral components.
- For hedge funds and infrastructure, identify the strategy or characteristics and their return and risk sources.
- Measure alternative performance net of fees (management, performance, hurdle, high-water mark) and apply the due-diligence process. Where two approaches seem to fit, choose the one that matches the asset type and the data the vignette provides.
Practice question
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Study strategy
Approach Level 2 Alternative Investments as a deeper, more analytical treatment than Level 1, with valuation calculations. Start with private equity and real estate valuation: the PE fund structures (the J-curve, carried interest) and valuation, and the real estate approaches (income for income property, cost, sales comparison) and REIT valuation.
Then learn the commodity return components (spot, roll, collateral) and the crucial contango-versus-backwardation distinction that sets the roll return's sign, plus infrastructure and the hedge-fund strategies. Finally, master alternative performance measurement net of fees (management, performance, hurdle, high-water mark) and the due-diligence process.
Because the material is applied in vignettes with some calculations, drill item sets on commodity returns, real estate valuation and performance net of fees. Because Level 2 is tested through vignettes, practice full item sets under timed conditions (about 12 minutes per set), pulling the right figure from the right exhibit, and review misses by checking both input selection and calculation. Afterwards, move to Portfolio Management.
FAQ
How much of CFA Level 2 is Alternative Investments?
Alternative Investments is 5-10% of the exam, a smaller weight, deepening Level 1's overview into the valuation and analysis of private equity, real estate, commodities, infrastructure and hedge funds, tested in vignettes.
What are the three components of a commodity futures return?
The spot return (the change in the commodity's spot price), the roll return (the gain or loss from rolling expiring futures into new contracts, positive in backwardation and negative in contango), and the collateral return (the interest earned on the cash posted as collateral).
What is the difference between contango and backwardation?
Contango is when futures prices are above the spot price, producing a negative roll return as contracts roll down toward spot. Backwardation is when futures are below spot, producing a positive roll return as contracts roll up toward spot. The distinction drives the roll component of commodity returns.
What is the J-curve in private equity?
The J-curve describes the typical return pattern of a private equity fund: negative returns in the early years (from fees and immature investments) followed by rising, positive returns later as investments mature and are exited. The cumulative return path resembles the letter J.
How is income-producing real estate valued?
Primarily by the income approach, which either capitalizes the property's net operating income (direct capitalization) or discounts its projected cash flows. The cost approach (replacement cost less depreciation) and the sales-comparison approach (comparable sales) are used in other situations.
Why must alternative performance be measured net of fees?
Alternative investments typically charge both a management fee and a performance fee, often with a hurdle rate and a high-water mark, which significantly reduce the return investors actually keep. Gross returns overstate investor performance, so net-of-fee measurement is essential.
How does Alternative Investments connect to the rest of the Level 2 exam?
Alternatives are part of a diversified portfolio in portfolio management, their valuation draws on the discounted-cash-flow and multiple methods from equity and real estate, and their fee and performance analysis relates to the performance evaluation covered in portfolio management.
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