CFA Alternative Investments Notes: Hedge Funds, Private Equity and Real Estate [Level 1]

These CFA alternative investments notes cover the asset classes that sit outside listed stocks and bonds: hedge funds, private equity, real estate, infrastructure and commodities. Alternative Investments carries a 7 to 10 percent weight in the 2026 CFA Level 1 exam, according to CFA Institute. That range equals roughly 13 to 18 of the 180 exam questions, so this topic is worth a focused revision session. This note explains each asset class, works through hedge fund fees and a property valuation, and flags the traps that cost candidates marks. Build the rest of your plan from our CFA Level 1 notes hub.

CFA alternative investments: what counts as an alternative

An alternative investment is any asset that is not a listed stock, bond or cash deposit. Hedge funds, private equity, private debt, real estate, infrastructure, natural resources and digital assets all qualify. They tend to be less liquid, harder to value and more expensive to hold than listed securities.

Four features explain why examiners group these assets together. First, many alternatives trade rarely, so valuations rely on appraisals or models. Second, access is usually restricted: private funds set minimum investments and lock up money for months or years. Third, fees run higher than a typical index fund, and incentive fees link manager pay to performance. Fourth, returns often move less closely with listed stocks and bonds, which is why portfolios add alternatives for diversification. That benefit is real, but it is not free: the price is illiquidity, complexity and weaker transparency.

One distinction matters most at Level 1: listed alternatives, such as a real estate investment trust traded on an exchange, give daily liquidity and a market price, while unlisted alternatives, such as a private equity fund, give neither.

Hedge fund fees in these CFA alternative investments notes

Hedge funds are pooled funds that can use leverage, short selling and derivatives, and that face far fewer limits than a traditional mutual fund. Strategies include long and short equity, event driven, relative value and global macro. A long and short equity fund buys stocks it expects to rise and sells short stocks it expects to fall. An event driven fund trades around mergers and restructurings. A relative value fund bets that two related prices will return to their normal gap.

Fees are the most tested part of this section. The classic structure is called 2 and 20: a 2 percent management fee on assets plus a 20 percent incentive fee on profits. The management fee is charged whether the fund gains or loses. The incentive fee is charged only on profits above the high-water mark, the highest net asset value the fund has reached. The high-water mark stops a manager from earning an incentive fee twice on the same gain: after a loss, the fund must climb back above its previous peak before any new incentive fee applies. Some funds also add a hurdle rate, so the incentive fee applies only to returns above a set minimum, such as 5 percent.

Worked example: the 2 and 20 fee

Suppose a hedge fund starts the year with a net asset value of $100 million. Before fees, the value rises to $112 million, a gain of $12 million. The management fee is 2 percent of the $100 million starting value, which equals $2 million. The profit after the management fee is $12 million minus $2 million, which equals $10 million. The incentive fee is 20 percent of that $10 million, which equals $2 million. Total fees are $4 million. The investor keeps $12 million minus $4 million, which equals $8 million, a net return of 8 percent on the starting value. Notice how the headline gain of 12 percent becomes a net return of 8 percent once both fees apply.

Two further fee traps deserve attention. A fund of funds charges its own layer of fees on top of the fees of the funds it holds. And a lockup period, often one year, bars withdrawals entirely, while a notice period after that can still delay an exit by months.

Private equity and private debt in CFA alternative investments

Private equity funds raise committed capital from limited partners, and the general partner invests it over several years. The fund has a fixed life, often ten years, and investors cannot redeem on demand. Instead, the manager issues capital calls as deals are found, and returns cash through distributions as portfolio companies are sold or listed. That pattern creates the J-curve: early years show fees and write-downs with little cash back, while later years show distributions as exits arrive.

Buyout funds purchase mature companies, often with borrowed money, then improve operations and sell after several years. Venture capital funds back young companies in stages, accepting that several bets will fail while one success can carry the fund. Growth equity funds established companies that need capital to expand without a full buyout. Private debt funds lend directly to companies, earning interest and fees; they rank ahead of equity if the borrower fails, but they still carry credit risk and illiquidity.

Level 1 questions on private equity usually test structure, not deal math. Know that the general partner manages the fund and earns carried interest, a share of profits above a hurdle, while limited partners supply most of the capital. Know that valuations lag, because portfolio companies are valued by appraisal rather than by a market price. And know that the internal rate of return depends heavily on the timing of capital calls and distributions.

Real estate, infrastructure and commodities in CFA alternative investments

Real estate earns returns from rental income and price growth. Direct ownership gives control but brings management work, large lot sizes and slow sales. A real estate investment trust, or REIT, buys property with pooled investor money and trades on an exchange, which restores daily liquidity and a visible price. Two formulas dominate Level 1 questions here. The capitalization rate, or cap rate, equals net operating income divided by property value. Net asset value per share equals total property value plus cash minus debt, divided by shares outstanding.

Worked example: cap rate and net asset value

Suppose a property produces net operating income of $480,000 per year and the market cap rate is 6 percent. The property value equals $480,000 divided by 0.06, which equals $8,000,000. Now suppose a REIT holds that property plus $200,000 of cash and owes $3,000,000 of debt, with 100,000 shares outstanding. Its net asset value equals $8,000,000 plus $200,000 minus $3,000,000, which equals $5,200,000. Net asset value per share equals $5,200,000 divided by 100,000, which equals $52. Note the inverse link: if the cap rate rose to 8 percent, the same income would support a value of only $6,000,000, since $480,000 divided by 0.08 equals $6,000,000.

Infrastructure covers long lived assets such as toll roads, airports, ports, power grids and water systems. Cash flows are contracted or regulated and many contracts link payments to inflation, which can make them steadier than corporate profits. The risks are different in kind: construction delays, regulatory change and very long holding periods. A futures based commodity fund earns the spot price change plus the roll yield, the gain or loss from selling an expiring futures contract and buying the next one. When futures prices rise with maturity, a pattern called contango, rolling loses money. When futures prices fall with maturity, called backwardation, rolling adds to the return. Digital assets appear in the same Level 1 topic as a newer, volatile category, tested on features and risks rather than any valuation model.

Exam traps that these CFA alternative investments notes warn you about

• The management fee applies to assets, the incentive fee to profits. A 2 percent fee on $100 million is $2 million even in a losing year.
• A high-water mark is not a hurdle rate. The high-water mark is a past peak value. The hurdle rate is a minimum return.
• Higher cap rate, lower value. Value equals income divided by the cap rate, so a rising cap rate cuts the value.
• Contango hurts a long futures position. In contango, each roll sells low and buys high, so the roll yield is negative.
• Appraisal values lag market values. Private equity and direct property valuations move slowly because appraisals update rarely.

One-page revision box: CFA alternative investments notes

• Alternatives = hedge funds, private equity, private debt, real estate, infrastructure, natural resources, digital assets. Listed forms trade daily; unlisted forms do not.
• 2 and 20 = 2 percent management fee on assets plus 20 percent incentive fee on profits above the high-water mark. Worked result: $100 million to $112 million gives $4 million of fees and an 8 percent net return.
• Private equity = closed-end fund, capital calls in, distributions out, J-curve early, general partner manages, limited partners fund, carried interest on profits.
• Cap rate = net operating income divided by value. Net asset value per share = (property value + cash – debt) divided by shares. Worked result: $480,000 at 6 percent gives $8,000,000, and $52 per share.
• Commodities: contango gives a negative roll yield, backwardation gives a positive roll yield. Infrastructure cash flows are often contracted or inflation linked.
• Exam traps: fees on the wrong base, high-water mark versus hurdle rate, cap rate direction, appraisal lag.

Alternative Investments rewards candidates who learn the fee and valuation formulas cold, then practice them with new numbers. After this note, test yourself against our CFA derivatives notes, then return to the CFA notes hub and pick the next topic on your plan.