Skip to content

CFA Level I Exam · Alternative Investment Performance and Returns

Return Drivers and Performance Measurement Challenges in Alternatives

Updated 7 October 2026 · Fact-checked

Alternative investment returns come from income, price changes, leverage, skill and illiquidity compensation. They are hard to measure because assets trade rarely, values come from appraisals, and fund databases are biased. Appraisals smooth returns, which understates volatility and correlation and overstates Sharpe ratios. Survivorship and backfill bias overstate reported hedge fund returns.

Understand Return Drivers and Performance Measurement Challenges

Alternative investments such as private equity, real estate, infrastructure and hedge funds earn returns from several sources. These include income (rent, interest, dividends), capital appreciation, the use of leverage, manager skill (alpha), and a premium for accepting illiquidity and complexity. Some of these returns are beta, which you could get cheaply from markets. Some are alpha, which only skill can deliver.

The measurement problem starts with illiquidity. Many alternatives trade rarely or never. So there is no observed market price each day. Instead, managers or appraisers estimate value. This is called appraisal-based pricing or smoothed pricing.

Appraisals rely on past transactions, which lag the market. Appraisers also anchor on the previous value and adjust slowly. The result is return smoothing (also called stale pricing). Reported returns rise and fall less than true economic returns. Three effects follow: measured standard deviation is too low, measured correlation with stocks and bonds is too low, and the Sharpe ratio is too high. Diversification benefits look better than they are. Betas and risk-based allocations to the asset are distorted. Reported returns also show positive serial correlation, because this period's appraisal carries information from the last one. Appraisal data may also be affected by the manager's discretion, especially where the manager's fee depends on the value.

Hedge fund databases add their own biases. Reporting is voluntary. Survivorship bias arises when funds that closed or failed drop out of the database, so average returns look better than what investors actually earned. Backfill bias (instant history bias) arises when a fund joins a database and its earlier history is added afterwards. Funds with good results are more likely to choose to list, so the history that gets added tends to be strong. Selection bias arises when only funds that choose to report are included, so funds with poor results that do not report are missing. Survivorship, backfill and selection bias all typically overstate returns. Other issues include small samples, short histories, and returns that are not normal (negative skewness and fat tails), which makes standard deviation an incomplete risk measure.

The fix is not one trick. Analysts can unsmooth returns, use transaction-based indexes, stress test, look at downside measures, and read the data with these biases in mind.

Key formulas to remember

Effect of smoothing on volatility
Reported standard deviation < true standard deviation
Smoothed returns understate risk. Reported correlation with other assets is also too low.
Sharpe ratio
Sharpe = (Rp − Rf) ÷ σp
If σp is understated by smoothing, the Sharpe ratio is overstated.
Unsmoothing (desmoothing) returns
R_true,t = (R_reported,t − (1 − α) × R_reported,t−1) ÷ α, with 0 < α ≤ 1
α is the weight on the current true return. A lower α means heavier smoothing. Know the idea more than the algebra.
Data bias direction
Survivorship, backfill and selection bias → reported returns typically biased upward
Past performance is typically overstated. Smoothing is different: it mainly understates risk and correlation.

How to solve Return Drivers and Performance Measurement Challenges questions

Use this approach for any question on alternative investment return drivers or measurement problems.

  1. 1Identify the asset: private real estate, private equity, or hedge funds. This tells you if the issue is appraisal pricing or database bias.
  2. 2Ask whether the price is observed in a market or estimated by an appraiser or manager.
  3. 3If values are estimated, think smoothing: low standard deviation, low correlation, high Sharpe ratio, positive serial correlation.
  4. 4If the issue is a fund database, decide which bias fits: dropped failures (survivorship), added history (backfill), or voluntary reporting (selection).
  5. 5Decide the direction: smoothing mainly understates risk and correlation, while survivorship, backfill and selection bias typically overstate reported returns.
  6. 6Check each option against that direction and eliminate the two that point the wrong way.
  7. 7For return drivers, separate income, appreciation, leverage, alpha and illiquidity premium.

Quickest way: Direction-and-label shortcut

When to use it: Use this when you have about 90 seconds and the stem describes a data problem or asks for its effect.

  1. Find the clue word: appraisal or stale means smoothing; closed or defunct funds means survivorship; added history means backfill.
  2. Apply the direction rule: smoothing understates risk and correlation (and so overstates the Sharpe ratio); survivorship, backfill and selection bias typically overstate reported returns.
  3. Choose the option that matches that direction and cross out the other two.
  4. If the question asks about diversification, remember smoothed data overstates it.

Common mistakes in Return Drivers and Performance Measurement Challenges

  • Saying smoothing raises volatility or correlation.

    Students think of data being 'adjusted' and assume more noise.

    Fix: Smoothing removes noise. Volatility and correlation are understated, and the Sharpe ratio is overstated.

  • Mixing up survivorship bias and backfill bias.

    Both inflate hedge fund returns and sound alike.

    Fix: Survivorship: failed funds disappear. Backfill: a new fund's earlier good history is added after it joins.

  • Assuming smoothing biases the average return upward, or that appraisal values are always too high.

    Students link every data problem with overstated performance.

    Fix: Appraisals lag the market. They are too high after a fall and too low after a rise. Smoothing mainly understates risk and correlation, not the average return level. Survivorship, backfill and selection bias are the ones that typically overstate reported returns.

  • Treating a low reported correlation with equities as true diversification.

    The statistic looks like real evidence.

    Fix: Stale prices lower measured correlation. True economic correlation is likely higher.

  • Calling the illiquidity premium a risk-free source of return.

    Students see it as extra return for free.

    Fix: It compensates for being unable to sell quickly or at a known price. It is a reward for bearing risk.

Worked examples

Example 1

A private real estate fund reports annual returns with a standard deviation of 4%. The fund is valued by annual appraisals. An analyst concludes the fund has a very high Sharpe ratio and a low correlation with equities. Which is the most likely explanation? A) The fund holds liquid assets that are marked to market daily. B) Appraisal smoothing understated the standard deviation and correlation. C) Survivorship bias removed losing funds from the data.

Show the solution
  1. The fund is valued by appraisals, so prices are estimated, not observed.
  2. Appraisals lag the market and anchor on prior values, which smooths returns.
  3. Smoothing lowers measured standard deviation and correlation, which raises the Sharpe ratio.
  4. Option A contradicts the stem, since appraisal values are not daily market prices.
  5. Option C describes a database issue about a group of funds, not one fund's appraisal valuation.

Answer: B

Example 2

A hedge fund database was started in 2020 and is still maintained. A manager that launched in 2017 and had strong results joined in 2020, and the database added its 2017 to 2019 returns. Funds that had been reporting to the database but closed in 2022 were deleted from it. Which biases are present, and what is the effect on reported average returns? A) Backfill bias and survivorship bias; average returns overstated. B) Backfill bias only; average returns understated. C) Survivorship bias only; average returns understated.

Show the solution
  1. The manager launched in 2017 but joined in 2020. Adding its strong 2017 to 2019 history after it joined is backfill bias.
  2. The funds that closed in 2022 were in the database and were then deleted. Removing failed funds from the record is survivorship bias.
  3. Backfill adds good results and survivorship removes poor ones, so the average reported return is too high.
  4. Options B and C say understated, which is the wrong direction, and each names only one bias.

Answer: A

Exam tips

  • Expect conceptual questions on direction: smoothing lowers risk and correlation, and raises the Sharpe ratio.
  • Match the clue word in the stem to the bias name. Learn the three definitions precisely.
  • When two options both sound plausible, go back to the mechanism: smoothing understates risk and correlation, while survivorship, backfill and selection bias typically overstate returns. Match the option to the cause named in the stem.
  • Do not spend time on unsmoothing algebra. Know what it does, not a long calculation.
  • Link this topic to hedge fund and private equity return questions, where the same biases appear in different words.

Practice questions from Alternative Investment Performance and Returns

Return Drivers and Performance Measurement Challenges: frequently asked questions

What is return smoothing in alternative investments?

It is the tendency of reported returns to be less volatile than true returns, because values come from appraisals that lag the market. This is common in private real estate and private equity. It understates standard deviation and correlation.

What is the difference between survivorship bias and backfill bias?

Survivorship bias happens when failed or closed funds leave the database, so only the winners remain. Backfill bias happens when a fund joins and its earlier good history is added. Both make returns look better than they were.

Why does appraisal pricing make the Sharpe ratio too high?

The Sharpe ratio divides excess return by standard deviation. Appraisal smoothing lowers the measured standard deviation, so the ratio rises while the return stays the same.

Is the illiquidity premium a return driver in alternatives?

Yes. Investors who accept the inability to sell quickly may earn extra return as compensation. It is one of several drivers, along with income, appreciation, leverage and manager skill.