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CAIA Level I · Topic guide

Introduction to Alternative Investments

Alternative investments differ by the economic exposure, the vehicle holding it, and the terms available to the investor. Start with those three layers, then assess cash flows, fees, leverage, liquidity and the reliability of reported returns.

The key decisions, at a glance

  • 1. Asset versus vehicle

    A property and a listed property fund can expose investors to real estate through different liquidity terms.

    Watch for: The asset label alone does not tell you when you can exit.

  • 2. Return measurement

    Use time-weighted returns to isolate investment performance and money-weighted returns to reflect cash-flow timing.

    Watch for: An IRR and an annual arithmetic average are not interchangeable.

  • 3. Leverage

    Borrowing changes the payoff to the equity capital supporting the investment.

    Watch for: Low historical volatility does not prove low leverage risk.

  • 4. Data quality

    Check valuation frequency, failed funds and backfilled histories.

    Watch for: A smooth or selected return series can overstate the apparent benefit.

Original worked case

The same investment, two different return measures

Given: Invest $100 at time 0 and another $100 after year 1. Value is $110 just before the second investment and $189 at the end of year 2. No distributions or fees.

  1. 01 Year 1

    110 / 100 - 1 = 10%.

  2. 02 Year 2

    189 / 210 - 1 = -10%.

  3. 03 Link periods

    (1.10 × 0.90) - 1 = -1% cumulative time-weighted return.

Answer and interpretation

The investor contributed $200 and ends with $189. The money-weighted return solves -100 - 100/(1+r) + 189/(1+r)² = 0, approximately -3.71% annually.

Change one assumption

A larger second contribution increases the influence of the losing second year on the investor’s money-weighted result.

Independent teaching example with the stated assumptions. Not an official exam question, marking key or observed market trend.

Understand the method

Part 1

Separate the underlying asset from the investment vehicle

An asset describes the economic claim: ownership of a business, a loan, property income, commodity exposure or another payoff. A vehicle describes how an investor holds that claim, such as a partnership, listed company, pooled fund or derivative contract. These are separate dimensions. A listed property company and a directly owned building can share property fundamentals while differing in financing, governance, trading and valuation.

This distinction prevents a common classification error: calling every investment inside an alternative fund an independent source of diversification. Two vehicles can hold the same borrowers or respond to the same equity shock. Start with the cash-flow driver, identify leverage and contractual priority, and only then assess the wrapper’s fees and liquidity. An alternative label alone establishes neither higher returns nor lower portfolio risk.

Part 2

Draw the cash-flow timeline before calculating a return

A commitment is a promise to provide capital under specified terms. A capital call is an actual payment. A distribution returns cash to the investor, while residual net asset value is a valuation of what remains. These amounts occur at different dates. Adding distributions to residual value can describe total value, but it cannot by itself describe how rapidly the investment generated that value.

For a single payment and a single later receipt, an annualized compound return is (ending value / beginning value) raised to 1 / years, minus one. Doubling in five years gives about 14.87% annually; doubling in ten gives about 7.18%. For multiple irregular cash flows, an internal rate of return uses the actual dates. Timing matters, and an early distribution financed by borrowing can change the reported IRR without creating operating value.

Part 3

Choose a measure that answers the question being asked

Time-weighted returns isolate successive investment-period returns from external cash-flow timing. Money-weighted returns reflect the investor’s actual pattern of contributions and receipts. Neither is universally superior. Use the former to compare comparable portfolio management periods and the latter to understand the experience of committed capital, while being explicit about the treatment of fees and unrealized assets.

Volatility measures dispersion, not every economically important risk. A strategy can show a narrow range of ordinary outcomes and still suffer a rare large loss. Downside scenarios, maximum drawdown, leverage, margin needs and inability to sell address different questions. Compare measures over consistent horizons and currencies; an annual return divided by monthly volatility is not a correctly scaled Sharpe ratio.

Part 4

Interrogate smooth returns and selective databases

Private valuations may respond slowly to changes in public markets because transactions are infrequent and appraisal inputs are updated periodically. The resulting return series can look less volatile and less correlated than the underlying economics. An unchanged mark means the reported estimate has not moved; it does not prove that an executable sale price is unchanged.

Database selection creates another problem. Surviving funds may be more visible than closed funds, and a manager entering a database may contribute favourable historical returns. Test whether the sample excludes failures, backfills history or uses different valuation dates. Before treating an apparent diversification benefit as reliable, consider whether common risk factors are being hidden by measurement and reporting conventions.

A map of exposure and access

Business ownership

Example access
Private fund or listed equity
First analytical question
Where does enterprise value and financing risk sit?

Lending

Example access
Direct loan or credit fund
First analytical question
What repays principal and protects recovery?

Property income

Example access
Building, fund or listed property company
First analytical question
How do occupancy, costs and capital values change?

Commodity price

Example access
Physical inventory or futures
First analytical question
Are storage, collateral and contract rolling included?

More worked practice

Original teaching cases. Use the stated assumptions; these are not official exam questions or marking keys.

Same multiple, different investment experience

Given: Investment A pays $150 after three years for a $100 outlay. Investment B pays $150 after six years. There are no intermediate flows, fees or taxes.

  1. 1Both value multiples are 150 / 100 = 1.50x.
  2. 2A’s compound annual return is 1.5^(1/3) - 1 = 14.47%.
  3. 3B’s compound annual return is 1.5^(1/6) - 1 = 6.99%.

Interpretation: The multiple measures value relative to invested capital. Annualization adds the time dimension. Neither calculation tells you the risk taken or whether interim valuations were credible.

Check your understanding

Answer first, then open the explanation. These checks are original practice and do not generate an exam score.

1. Does a daily-traded wrapper make the underlying buildings liquid?

No. The shares may trade daily while the buildings remain slow and costly to sell. Share prices can diverge from reported property NAV.

2. Can a low measured correlation be a valuation artifact?

Yes. Stale or smoothed marks can shift the timing of recorded returns. Investigate shared economic exposures and stress scenarios.

3. Which cash flows belong in an investor-level IRR?

Use dated investor contributions and receipts plus a clearly identified terminal residual valuation. Keep gross asset cash flows separate from net investor cash flows.

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Common questions

Does alternative mean uncorrelated?

No. It is an asset or strategy classification, not a promise about correlation. Economic exposures can overlap traditional assets.

Why can appraisal values look less volatile?

Infrequent, lagged valuations can spread a price change across periods. Reported smoothness is not the same as the ability to sell at a stable price.

Sources and scope

The sources below establish their stated framework or subject context. Calculations and cases are our own teaching material; these sources do not endorse them or establish complete exam coverage.

By MiloPrep editorial team. Updated 10 October 2026. Independent study notes, not affiliated with or endorsed by CAIA Association. How we prepare our content.

Notes

  • * Study scope: Selected study concepts, not complete curriculum coverage. Match your sitting to the official exam-year materials; CAIA’s current resource page now links to 2027. ↩ Return to content