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Alternative Investments

Investments outside of traditional asset classes like stocks and bonds.

Alternative investments are financial assets that do not fall into conventional investment categories like stocks, bonds or cash. Examples include private equity, hedge funds, commodities, and real estate.

5 minutes 5 Questions

Concepts covered: Hedge Fund Strategies, Asset Allocation to Alternative Investments

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CFA Level 3 - Alternative Investments Example Questions

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Question 1

Sarah Chen, an accredited investor, has a well-diversified investment portfolio comprising 55% equities, 35% fixed income, and 10% cash. Her financial advisor suggests allocating a portion of her portfolio to alternative investments to potentially enhance returns and further diversify her holdings. The advisor recommends investing in private debt funds and real estate investment trusts (REITs) as suitable alternative investment options. Given Sarah's investment goals, risk tolerance, and the advisor's recommendations, what would be the most appropriate approach for Sarah to incorporate alternative investments into her portfolio?

Invest 20% of her total portfolio in alternative investments, with 15% in private debt funds and 5% in REITs. To accommodate this allocation, proportionately reduce her exposure to equities, fixed income, and cash. Regularly rebalance her portfolio to maintain the target allocations across all asset classes, including alternative investments. Reallocate her entire fixed income exposure (35% of the portfolio) to alternative investments, distributing it equally between private debt funds and REITs. This approach would significantly increase her exposure to alternative investments while maintaining her equity and cash allocations. Gradually allocate 10% of her portfolio to alternative investments, with 5% in private debt funds and 5% in REITs, while maintaining her existing asset allocation for the remaining 90% of the portfolio. Monitor the performance of the alternative investments and make adjustments as necessary based on market conditions and her investment objectives.

Correct Answer: Gradually allocate 10% of her portfolio to alternative investments, with 5% in private debt funds and 5% in REITs, while maintaining her existing asset allocation for the remaining 90% of the portfolio. Monitor the performance of the alternative investments and make adjustments as necessary based on market conditions and her investment objectives.

The most appropriate approach for Sarah is to gradually allocate 10% of her portfolio to alternative investments, with 5% in private debt funds and 5% in REITs, while maintaining her existing asset allocation for the remaining 90% of the portfolio. This approach allows Sarah to cautiously explore the potential benefits of alternative investments without drastically altering her overall investment strategy. Allocating a small portion of her portfolio to alternative investments can provide diversification benefits and potentially enhance returns, while limiting the overall risk exposure. By investing in both private debt funds and REITs, Sarah can further diversify her alternative investment holdings, as these two asset classes have different risk and return characteristics. The other two options are less suitable because they involve significant changes to Sarah's existing portfolio allocation. Reallocating her entire fixed income exposure to alternative investments would dramatically increase her risk profile and potentially disrupt her overall investment strategy. Similarly, investing 20% of her total portfolio in alternative investments might be too aggressive given her current allocation and risk tolerance. By gradually incorporating alternative investments and monitoring their performance, Sarah can make informed decisions about adjusting her allocation based on market conditions and her investment objectives.

Question 2

Elizabeth Thompson, a wealthy investor, is considering adding alternative investments to her portfolio, which currently consists of 65% equities, 25% fixed income, and 10% cash. Her financial advisor suggests investing in private equity and real estate to improve diversification and potentially enhance risk-adjusted returns. The advisor recommends an initial allocation of 10% to private equity and 5% to real estate, funded by reducing her equity exposure. Elizabeth has a long-term investment horizon and a moderate to high risk tolerance. Given her current portfolio composition and investment objectives, what is the most appropriate approach for Elizabeth to incorporate alternative investments?

Reduce the equity allocation by 15 percentage points, allocating 10% to private equity and 5% to real estate, while maintaining the fixed income and cash allocations. Reduce the fixed income allocation by 15 percentage points, allocating 10% to private equity and 5% to real estate, while maintaining the equity and cash allocations at their current levels. Reduce the cash allocation by 5 percentage points and the equity allocation by 10 percentage points, allocating the freed-up capital to private equity and real estate investments in the recommended proportions, resulting in a cash allocation of 5%, equity allocation of 55%, fixed income allocation of 25%, and alternative investments allocation of 15%.

Correct Answer: Reduce the equity allocation by 15 percentage points, allocating 10% to private equity and 5% to real estate, while maintaining the fixed income and cash allocations.

The most appropriate approach for Elizabeth is to reduce her equity allocation by 15 percentage points and allocate 10% to private equity and 5% to real estate, while maintaining the fixed income and cash allocations at their current levels. This approach aligns with the advisor's recommendation and allows Elizabeth to incorporate alternative investments without significantly altering her fixed income and cash positions. Given her long-term investment horizon and moderate to high risk tolerance, a slight reduction in equity exposure to fund the alternative investments is suitable. Reducing the fixed income allocation to fund the alternative investments is not ideal, as it would alter the portfolio's risk and return profile more significantly than intended. Similarly, reducing the cash allocation along with the equity allocation would result in a cash position that may be insufficient for liquidity needs.

Question 3

Jessica Lee, an accredited investor, is meeting with her financial advisor to discuss adding alternative investments to her portfolio. Jessica's current portfolio consists of 60% stocks, 30% bonds, and 10% cash. Her advisor suggests investing in a mix of private equity and hedge funds to enhance diversification and potentially improve risk-adjusted returns. The advisor recommends an initial allocation of 15% to alternative investments. Jessica has a long-term investment horizon and a moderate risk tolerance. Which approach would be most appropriate for Jessica to incorporate alternative investments into her portfolio?

Gradually allocate funds to private equity and hedge funds over time, maintaining the overall 15% target allocation to alternative investments. Regularly rebalance the portfolio to ensure the desired asset allocation is maintained. Allocate 15% of the portfolio to a diversified mix of alternative investments, including private equity, hedge funds, real estate, and commodities, to maximize diversification benefits. Adjust the allocation to traditional assets proportionally to accommodate the alternative investments. Liquidate 15% of the existing stock and bond holdings and immediately invest the proceeds in a single private equity fund to achieve the target alternative investment allocation.

Correct Answer: Gradually allocate funds to private equity and hedge funds over time, maintaining the overall 15% target allocation to alternative investments. Regularly rebalance the portfolio to ensure the desired asset allocation is maintained.

The most appropriate approach for Jessica would be to gradually allocate funds to private equity and hedge funds over time, maintaining the overall 15% target allocation to alternative investments, and regularly rebalance the portfolio to ensure the desired asset allocation is maintained. This approach allows Jessica to ease into alternative investments without making drastic changes to her portfolio all at once. It also helps to maintain her desired asset allocation and risk profile over time. Regular rebalancing ensures that the portfolio remains in line with her investment objectives and risk tolerance. Liquidating a significant portion of her existing holdings to invest in a single private equity fund would concentrate risk and deviate from her moderate risk tolerance. It also fails to provide adequate diversification within the alternative investment allocation. Allocating 15% to a diversified mix of alternative investments beyond private equity and hedge funds, such as real estate and commodities, may introduce additional risks and complexity that may not align with Jessica's investment goals and risk profile. It is important to carefully consider the suitability and understanding of each alternative investment before including them in the portfolio.

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