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CFA Level I · CFA Level I Exam

Alternative Investment Performance and Returns for CFA Level I

Alternative investment performance and returns covers how hedge funds, private equity, real estate, infrastructure and natural resources earn and report returns. You solve questions by identifying the structure, applying the right fee or return measure (such as IRR, TVPI, DPI or RVPI), and checking for biases in reported data.

What this chapter covers

This chapter looks at assets outside traditional stocks and bonds. You learn what makes an investment "alternative": illiquidity, limited transparency, unusual fee structures, specialised managers and returns that do not follow public market patterns. You then see how each category earns money and why measuring its performance is harder than for a listed equity fund.

The content splits into two types of work. One is conceptual: categories, return drivers, strategies and measurement problems such as appraisal-based valuations, smoothing and survivorship bias. The other is numerical: hedge fund fee calculations with management fees, incentive fees, hurdle rates and high-water marks, and private equity multiples such as TVPI, DPI and RVPI, plus the idea behind IRR.

The chapter links to other parts of the paper. Fee and return arithmetic draws on Quantitative Methods. Return measurement links to Portfolio Construction, where alternatives are used for diversification. Valuation of real assets connects to Equities and Corporate Finance. Questions on misleading performance reporting can also touch Ethical and Professional Standards.

Alternative Investments carries a 6-9% topic weight for the 2027 curriculum, so it is a smaller topic, but its questions are very learnable. Fee calculations and private equity multiples are formula-driven and fast once practised, which makes them good value in a paper of 180 three-option questions with about 90 seconds each. The conceptual points also help in Portfolio Construction questions. Since there is no minimum score per topic, secure marks here can offset weaker areas elsewhere.

Alternative Investment Performance and Returns: topics in the order to study them

  1. 1Alternative Investment Categories and FeaturesStart with the map: what counts as alternative and how these assets differ from public markets, so later details have a place to sit.
  2. 2Return Drivers and Performance Measurement ChallengesLearn what drives returns and why reported numbers can mislead, which you need before judging any fund's results.
  3. 3Hedge Fund Returns, Fees and StrategiesFee mechanics and strategy types build on the earlier ideas and give you your first set of calculations.
  4. 4Private Equity Performance: IRR, TVPI, DPI and RVPIThis is the most numerical topic, so take it after the concepts are clear and you are comfortable with fund structures.
  5. 5Real Estate, Infrastructure and Natural Resources ReturnsFinish with real assets, where return sources and valuation issues repeat themes from earlier topics.

How to prepare Alternative Investment Performance and Returns

Aim to split your time between understanding structure and practising the few calculations that appear often. Keep sessions short so you can revise on a phone.

  1. Read the categories topic once and build a one-page comparison of liquidity, fees, transparency and typical return sources.
  2. Write down the measurement problems (smoothing, stale pricing, survivorship bias, backfill bias) in your own words with a one-line effect on reported returns.
  3. Practise hedge fund fees by hand: management fee, incentive fee, hurdle rate and high-water mark, in that order. Do at least five varied examples.
  4. For private equity, define each ratio first. Then compute TVPI, DPI and RVPI from a small table of paid-in capital, distributions and remaining value. Check that TVPI = DPI + RVPI.
  5. Use your TI BA II Plus or HP 12C cash flow function for IRR practice, and know how to enter uneven flows.
  6. For real assets, list the income and price sources of return for each type and the main valuation pitfalls.
  7. Finish with timed three-option questions. For each, eliminate the two weakest options and note which trap they set.

Common mistakes in Alternative Investment Performance and Returns

  • Mixing up DPI, RVPI and TVPI

    Fix: Remember DPI is cash already returned, RVPI is value still held, and TVPI is their sum. Check your answer by confirming TVPI is at least as large as DPI.

  • Applying incentive fees before management fees, or ignoring the hurdle and high-water mark

    Fix: Follow the order the question states. Work out the management fee, decide whether the hurdle or high-water mark applies, then compute the incentive fee on the eligible gain.

  • Taking reported alternative returns at face value

    Fix: When a question mentions appraisals, stale prices or index construction, expect volatility to be understated and returns possibly overstated.

  • Treating IRR and multiples as interchangeable

    Fix: Remember IRR accounts for timing of cash flows and multiples do not. A quicker exit can raise IRR without changing the multiple.

  • Entering cash flows with wrong signs in the calculator

    Fix: Enter paid-in capital as negative and distributions as positive, and clear the worksheet before each new problem.

Last-day revision: Alternative Investment Performance and Returns

  • Alternatives are typically less liquid, less transparent and use more specialised managers than traditional assets.
  • Appraisal-based valuations can smooth returns, understating volatility and correlation.
  • Survivorship and backfill bias tend to overstate hedge fund index returns.
  • Hedge fund fees: management fee on assets, incentive fee on profits, often subject to a hurdle and high-water mark.
  • A high-water mark means incentive fees are paid only on gains above the previous peak value.
  • DPI = cumulative distributions ÷ paid-in capital.
  • RVPI = residual value of remaining holdings ÷ paid-in capital.
  • TVPI = DPI + RVPI, the total value relative to paid-in capital.
  • IRR depends on the timing of cash flows, while multiples such as TVPI ignore timing.
  • DPI reflects realised returns only, so it is low early in a fund's life.
  • Real assets earn returns from income and from changes in value; check the stated return source.
  • Read each question for the stated fee basis, such as beginning or ending value, before calculating.

Alternative Investment Performance and Returns practice questions

Alternative Investment Performance and Returns in other exams

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

Alternative Investment Performance and Returns: frequently asked questions

How much of the CFA Level I exam is Alternative Investments?

For exams from February 2027, Alternative Investments has a weight of 6-9%. That is among the smaller topics, but its questions are often direct and formula-based. It is worth learning well.

Do I need to memorise formulas for this chapter?

Yes, but there are few. Know the hedge fund fee steps and the relationships between DPI, RVPI and TVPI. Practise IRR on an approved calculator, either the TI BA II Plus or the HP 12C.

What is the difference between TVPI and DPI?

DPI counts only cash already distributed to investors, relative to paid-in capital. TVPI adds the remaining value of the fund's holdings as well, so it shows total value, realised and unrealised.

Why are hedge fund index returns often considered biased?

Indexes can suffer from survivorship bias, where failed funds drop out, and backfill bias, where funds add past results after they start reporting. Both tend to make average returns look better than what investors actually earned.