CFA Level I Exam · Alternative Investment Features, Methods, and Structures

Risks, Returns, and Due Diligence for Alternative Investments

Updated 7 October 2026 · Fact-checked

Alternative investments are hard to measure because many trade rarely, are valued by appraisal, and use leverage and illiquid structures. Reported returns look smoother and less correlated than true returns, so risk is understated. You solve questions by spotting the bias, adjusting for it, and listing the due diligence checks that address it.

Understand Risks, Returns, and Due Diligence

Alternative investments (hedge funds, private equity, real estate, infrastructure, commodities) do not trade on liquid exchanges the way listed shares do. That one fact drives most of this topic. Without frequent market prices, you cannot measure return and risk in the usual way.

Many alternatives are valued by appraisal or by manager estimates. Appraisers lean on past transactions and often update values slowly. This produces smoothing (also called appraisal bias): reported returns move less than true market returns. The result is a lower reported standard deviation, a lower reported correlation with other assets, and a higher Sharpe ratio than the true economics justify. Beta is also understated.

Other measurement problems matter too. Survivorship bias arises when failed funds drop out of databases, so average returns look better. Backfill bias (instant history bias) arises when a fund enters a database only after good results and its earlier record is added. Selection bias arises when only funds that choose to report are included. Survivorship and backfill bias typically overstate returns. They also typically understate risk, because the missing funds are often the ones that failed. Selection bias can distort results in either direction, depending on why funds choose to report. Returns of alternatives are also often non-normal: negative skew and fat tails (excess kurtosis) are common, so standard deviation alone understates tail risk. Illiquidity, leverage, and option-like payoffs add to this.

Diversification is the usual reason to hold alternatives. But the benefit looks larger on paper than it is, because smoothed data understate correlation. In stress periods, correlations with equities often rise, and illiquid holdings cannot be sold easily. So you should be cautious about large allocations justified by reported statistics.

Due diligence is the investor's check on a manager and a fund before and after investing. It covers the investment strategy and process, the people and their track record, the operations and valuation process, risk management and leverage, the legal terms and fees, the service providers (administrator, auditor, prime broker, custodian), and governance. Because alternatives are opaque and less regulated, due diligence is more intensive than for traditional funds, and it continues after the investment is made.

Key formulas to remember

Unsmoothing (de-smoothing) returns: R*(t) = [R(t) − φ × R(t−1)] ÷ (1 − φ); Here R*(t) is the unsmoothed return, R(t) is the reported return, and φ is the smoothing (first-order autocorrelation) parameter between 0 and 1. You need to know the idea and direction of the effect more than the algebra: unsmoothing raises standard deviation.
Effect of smoothing on risk statistics: Reported σ < true σ; reported correlation < true correlation; reported Sharpe ratio > true Sharpe ratio; These directions hold when appraisal smoothing is present. Use them to eliminate wrong options.
Sharpe ratio: Sharpe = (Rp − Rf) ÷ σp; Understated σp inflates the ratio. Compare it only after considering smoothing and non-normal returns.
Excess kurtosis and skew: Normal distribution: skewness = 0, kurtosis = 3 (excess kurtosis = 0); Negative skew and positive excess kurtosis mean more frequent large losses than a normal model predicts.

How to solve Risks, Returns, and Due Diligence questions

Use the same short routine for any question on measuring or evaluating alternatives.

1Identify the asset type and how it is valued: market prices, appraisal, or manager estimates.
2Ask which bias applies: smoothing, survivorship, backfill, or selection.
3Decide the direction of the distortion on returns, standard deviation, correlation, beta and Sharpe ratio.
4Check for other risks: illiquidity, leverage, non-normal returns, fat tails, and fees.
5For diversification questions, ask whether reported correlation is understated and whether it rises in stress.
6For due diligence questions, match the concern to the area: strategy, people, operations, valuation, risk, legal, service providers.
7Eliminate the two options that state the wrong direction or confuse one bias with another, then choose.

Quickest way: Direction-of-bias shortcut

When to use it: Use for any 90-second question asking how a bias or data issue changes reported statistics.

Smoothing: risk and correlation look lower, Sharpe looks higher.
Survivorship and backfill: returns typically look higher and risk typically looks lower. Selection bias can distort results in either direction.
Due diligence: if the question is about trust in reported numbers, think valuation process and independent administrator.
Pick the option with the consistent direction and drop the others.

Common mistakes in Risks, Returns, and Due Diligence

Saying smoothing raises reported volatility.
Students link appraisals to extra noise.
Fix: Appraisals lag the market, so reported returns are damped. Reported standard deviation is too low.
Confusing survivorship bias with backfill bias.
Both inflate database returns and sound alike.
Fix: Survivorship: failed funds disappear. Backfill: a fund's good early history is added after it joins the database.
Believing low reported correlation means true diversification.
The numbers look convincing.
Fix: Smoothing understates correlation, and correlations tend to rise in crises. Treat the benefit as overstated.
Relying on standard deviation alone for hedge fund risk.
It is the default risk measure in the course.
Fix: Also consider skewness, kurtosis, drawdown, leverage and liquidity, since returns are often non-normal.
Treating due diligence as a one-time check before investing.
Students think of it as screening only.
Fix: It is ongoing. Monitor performance, style drift, valuation, and operations after investing.

Worked examples

Example 1

A real estate fund reports annual returns using appraised values. Compared with true market-based returns, the fund's reported Sharpe ratio is most likely:

A) lower

B) the same

C) higher

Show the solution

Appraised values lag the market, so returns are smoothed.
Smoothing lowers the reported standard deviation.
The Sharpe ratio divides excess return by standard deviation, so a smaller denominator raises the ratio.
The average return is roughly unchanged, so the ratio rises.

Answer: C) higher

Example 2

A database of hedge funds includes only funds that existed at the end of the sample period. Which statement is most accurate?

A) Average returns are understated.

B) Average returns are overstated.

C) Average returns are unaffected.

Show the solution

Funds that closed, usually after poor results, are missing.
This is survivorship bias.
Excluding poor performers raises the measured average return.
Therefore the database overstates returns and typically understates risk.

Answer: B) Average returns are overstated

Exam tips

Memorise the direction of each bias; most questions test direction, not calculation.
Three-option MCQs often include one option with the opposite direction: eliminate it first.
Link smoothing to the trio: lower σ, lower correlation, higher Sharpe.
For due diligence, match the scenario (for example, no independent valuation) to the right area of review.
Expect conceptual questions on why diversification benefits are overstated.

Practice questions from Alternative Investment Features, Methods, and Structures

Risks, Returns, and Due Diligence in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Risks, Returns, and Due Diligence: frequently asked questions

Why are alternative investment returns smoothed?

Many alternatives are valued by appraisal or manager estimates rather than frequent market prices. Appraisers rely on past data and update slowly, so reported returns lag true returns and look less volatile.

What is the difference between survivorship bias and backfill bias?

Survivorship bias occurs when funds that failed or closed are removed from a database. Backfill bias occurs when a fund joins a database and its earlier, usually good, history is added. Both overstate average returns.

What does due diligence for alternatives cover?

It covers strategy, people, operations, valuation, risk management, leverage, legal terms, fees, service providers and governance. It continues after investment through monitoring.

Do alternatives still diversify a portfolio?

They can, but reported correlations are often understated by smoothing and tend to rise in market stress. The benefit is usually smaller than the raw data suggest.