Module 10: Alternative Investments in Portfolio
Alternative Investments in CFA Level 3 focus on how non traditional assets are integrated into portfolios to improve diversification and enhance risk adjusted returns.
Unlike earlier levels, the focus here is not just on understanding alternative assets but on:
- their role within a portfolio
- their impact on overall risk and return
- how much allocation should be given
Portfolio managers use alternatives to optimize portfolio performance and manage risks effectively.
Diversification is one of the primary reasons for including alternative investments in a portfolio.
Alternative assets often have low correlation with traditional assets such as equities and bonds.
Why Diversification Matters
Diversification reduces overall portfolio risk by combining assets that do not move in the same direction.
Example
- equities may perform poorly during market downturns
- commodities or hedge funds may perform differently
This helps stabilize portfolio returns.
Types of Alternative Assets
Common alternatives include:
- private equity
- hedge funds
- real estate
- commodities
Each asset class behaves differently under varying market conditions.
Benefits of Including Alternatives
- reduced portfolio volatility
- improved risk adjusted returns
- exposure to different return drivers
Alternative investments have unique risk and return profiles compared to traditional assets.
Return Characteristics
Alternative investments often aim to generate:
- higher returns than traditional assets
- absolute returns independent of market direction
However, returns may be less predictable and vary significantly across strategies.
Risk Characteristics
Alternative investments carry specific risks such as:
Liquidity Risk
Many alternatives cannot be easily sold.
Valuation Risk
Difficulty in accurately determining value.
Leverage Risk
Use of borrowed funds can amplify losses.
Operational Risk
Dependence on management expertise and strategy execution.
Comparison with Traditional Assets
Equities
High return potential but high volatility.
Bonds
Lower risk and stable income.
Alternatives
Moderate to high return with unique risk factors and lower correlation.
Portfolio allocation determines how much of the portfolio should be invested in alternative assets.
Factors Affecting Allocation
Portfolio managers consider several factors:
Risk Tolerance
Higher risk tolerance allows greater allocation to alternatives.
Investment Horizon
Long term investors can invest more in illiquid assets.
Liquidity Needs
Higher liquidity needs reduce allocation to alternatives.
Return Objectives
Higher return goals may require exposure to alternative investments.
Strategic Allocation
Strategic allocation involves setting a long term target percentage for alternative assets.
Example
- 10 to 20 percent allocation to alternatives in a diversified portfolio
Tactical Allocation
Portfolio managers may adjust allocation based on market conditions.
Example
- increasing commodity exposure during inflation
- increasing real estate allocation during economic growth
Role in Portfolio Construction
Alternative investments can:
- enhance diversification
- improve risk return tradeoff
- provide inflation protection
This module is important because it helps candidates:
- integrate alternative assets into portfolios
- evaluate their impact on diversification
- understand risk return tradeoffs
- make allocation decisions
In CFA Level 3, questions often require candidates to recommend allocation to alternative investments based on client needs and market conditions, making this a highly practical and scoring module.