CFA Level 2 Alternative Investments: notes and free practice
CFA Level 2 Alternative Investments applies valuation and performance analysis to private capital, real assets and other alternative strategies. Distinguish asset values from investor cash flows and gross performance from net performance.
The key ideas, at a glance
Separate the return components
Read the visual, then follow the worked example below. Use the stated case assumptions.
Illustrative worked case
percentage points
- Price
- 5
- Roll
- -3
- Collateral
- 2
- Total return
- 4
The case uses an additive convention: 5% - 3% + 2% = 4%. A price-only view misses the other components.
| Concept | Rule or decision | Common mistake |
|---|---|---|
| Separate the return components | Illustrative collateralized futures return ≈ price + roll + collateral | Contango alone does not guarantee a negative total realized return; the curve and spot price can change. |
| Capitalize the right income | Stabilized property value = next-year NOI / capitalization rate | A capitalization rate is not automatically the total required return or a mortgage rate. |
| Reconcile FFO to AFFO | Start with net income; apply the explicitly stated adjustments | Adding every depreciation item indiscriminately can misstate a specifically defined FFO measure. |
| Read fee and database rules | Incentive base depends on fee order, high-water mark and flows | Fund contracts differ; one fee calculation cannot be generalized to every high-water-mark arrangement. |
01Separate the return components
Illustrative collateralized futures return ≈ price + roll + collateral
Watch for: Contango alone does not guarantee a negative total realized return; the curve and spot price can change.
02Capitalize the right income
Stabilized property value = next-year NOI / capitalization rate
Watch for: A capitalization rate is not automatically the total required return or a mortgage rate.
03Reconcile FFO to AFFO
Start with net income; apply the explicitly stated adjustments
Watch for: Adding every depreciation item indiscriminately can misstate a specifically defined FFO measure.
04Read fee and database rules
Incentive base depends on fee order, high-water mark and flows
Watch for: Fund contracts differ; one fee calculation cannot be generalized to every high-water-mark arrangement.
Selected 2026 study concepts. Match your preparation to your registered exam-year curriculum. These notes are not complete curriculum coverage.
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CFA Level II: 20 practice MCQs
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Put the method to work
One worked example, from facts to answer
Given
Price contribution 5%, roll -3%, collateral 2%; additive convention.
Method
5% - 3% + 2% = 4%.
Answer and interpretation
The illustrative total is 4%, not just the 5% price component.
Original independent teaching example. Assumptions are stated above; this is not an official exam question or scoring key.
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10 free Alternative Investments questions
Five mini-cases, two questions each. Read the case facts, choose an answer and review the method. Short teaching cases, not complete exam item sets or a mock.
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- Question 1 of 10Level II topic sample · Case 1 of 5Alternative InvestmentsMultiple choice
Case facts
A fully collateralized commodity futures strategy reports a 3% price component, -2% roll component and 1.5% collateral return. Use an additive return decomposition for this exercise. Its market is in contango; assume an unchanged upward-sloping futures curve as contracts age for the separate roll interpretation.
Under the stated additive convention, the strategy’s total return is:
Answer and explanations
3% - 2% + 1.5% = 2.5% under the exercise’s additive convention.
Review the method- A: 1.0% adds price and roll but omits collateral income.
- B - correct: 3% - 2% + 1.5% = 2.5% under the exercise’s additive convention.
- C: 6.5% treats the negative roll contribution as positive.
- Question 2 of 10Level II topic sample · Case 1 of 5Alternative InvestmentsMultiple choice
Case facts
A fully collateralized commodity futures strategy reports a 3% price component, -2% roll component and 1.5% collateral return. Use an additive return decomposition for this exercise. Its market is in contango; assume an unchanged upward-sloping futures curve as contracts age for the separate roll interpretation.
With the specified stable contango curve, the long futures position’s roll component is most plausibly:
Answer and explanations
Under the stipulated unchanged upward curve, aging contracts converge toward lower prices, consistent with negative long roll return.
Review the method- A: Higher deferred prices do not by themselves create a positive long roll component.
- B: Roll is only one component; price and collateral also matter.
- C - correct: Under the stipulated unchanged upward curve, aging contracts converge toward lower prices, consistent with negative long roll return.
- Question 3 of 10Level II topic sample · Case 2 of 5Alternative InvestmentsMultiple choice
Case facts
An analyst values a stabilized commercial property with next-year net operating income of $600,000 using direct capitalization at 5%. A sensitivity case raises the capitalization rate to 6% with NOI unchanged. Ignore transaction costs, debt and changes in the income definition.
The analyst’s base-case property value is:
Answer and explanations
$600,000 / 0.05 = $12m using next-year NOI and the stated capitalization rate.
Review the method- A - correct: $600,000 / 0.05 = $12m using next-year NOI and the stated capitalization rate.
- B: 10m is the sensitivity value at 6%, not the 5% base case.
- C: Multiplying NOI by the capitalization rate does not capitalize the income stream.
- Question 4 of 10Level II topic sample · Case 2 of 5Alternative InvestmentsMultiple choice
Case facts
An analyst values a stabilized commercial property with next-year net operating income of $600,000 using direct capitalization at 5%. A sensitivity case raises the capitalization rate to 6% with NOI unchanged. Ignore transaction costs, debt and changes in the income definition.
With NOI unchanged and the capitalization rate at 6%, estimated property value becomes:
Answer and explanations
$600,000 / 0.06 = $10m, below the $12m base-case valuation.
Review the method- A: Raising the capitalization rate reduces rather than increases value at fixed NOI.
- B - correct: $600,000 / 0.06 = $10m, below the $12m base-case valuation.
- C: The original $12m value applies to the 5% rate.
- Question 5 of 10Level II topic sample · Case 3 of 5Alternative InvestmentsMultiple choice
Case facts
A REIT reports net income $24m, real-estate depreciation $12m and property-sale gains $4m. For this exercise, FFO adds back that depreciation and removes those gains. AFFO then subtracts $6m recurring maintenance capital expenditure and $2m straight-line-rent adjustment. No other adjustments apply.
Under the supplied FFO convention, the REIT’s funds from operations are:
Answer and explanations
Net income 24 + real-estate depreciation 12 - property-sale gains 4 = $32m FFO.
Review the method- A: 40 adds the sale gain instead of removing it.
- B: 36 adds depreciation but leaves the sale gain in the measure.
- C - correct: Net income 24 + real-estate depreciation 12 - property-sale gains 4 = $32m FFO.
- Question 6 of 10Level II topic sample · Case 3 of 5Alternative InvestmentsMultiple choice
Case facts
A REIT reports net income $24m, real-estate depreciation $12m and property-sale gains $4m. For this exercise, FFO adds back that depreciation and removes those gains. AFFO then subtracts $6m recurring maintenance capital expenditure and $2m straight-line-rent adjustment. No other adjustments apply.
Under the exercise’s stated AFFO adjustments, adjusted funds from operations are:
Answer and explanations
FFO 32 - recurring maintenance capex 6 - straight-line-rent adjustment 2 = $24m.
Review the method- A - correct: FFO 32 - recurring maintenance capex 6 - straight-line-rent adjustment 2 = $24m.
- B: 26 deducts capex but omits the specified rent adjustment.
- C: 40 adds the cash-oriented deductions instead of subtracting them.
- Question 7 of 10Level II topic sample · Case 4 of 5Alternative InvestmentsMultiple choice
Case facts
A hedge fund begins the year at NAV $100m and ends at $115m before fees, with no flows. Management fee is 2% of beginning NAV. Incentive fee is 20% of the positive ending NAV above a $110m high-water mark after management fees. Fees crystallize at year-end; no other hurdle or catch-up applies.
The hedge fund’s incentive fee under the stated terms is:
Answer and explanations
Management fee is 2; post-management NAV is 113. Incentive fee = 20% × (113 - 110) = $0.6m.
Review the method- A: 3.0 charges 20% of the full gross gain and ignores both management fee order and HWM.
- B - correct: Management fee is 2; post-management NAV is 113. Incentive fee = 20% × (113 - 110) = $0.6m.
- C: 1.0 applies the HWM before deducting the management fee.
- Question 8 of 10Level II topic sample · Case 4 of 5Alternative InvestmentsMultiple choice
Case facts
A hedge fund begins the year at NAV $100m and ends at $115m before fees, with no flows. Management fee is 2% of beginning NAV. Incentive fee is 20% of the positive ending NAV above a $110m high-water mark after management fees. Fees crystallize at year-end; no other hurdle or catch-up applies.
After both fees, the hedge fund’s ending NAV is:
Answer and explanations
Gross NAV 115 - management fee 2 - incentive fee 0.6 = $112.4m net NAV.
Review the method- A: 114.4 deducts the incentive fee but omits the management fee.
- B: 112.0 uses an incentive fee calculated before management fees.
- C - correct: Gross NAV 115 - management fee 2 - incentive fee 0.6 = $112.4m net NAV.
- Question 9 of 10Level II topic sample · Case 5 of 5Alternative InvestmentsMultiple choice
Case facts
An allocator compares an infrequently appraised property index with daily traded listed real estate. The appraisal index has smoother reported returns. A separate hedge-fund database excludes funds that closed after poor performance. The allocator wants to interpret apparent volatility and historical average returns.
What should the allocator infer from the smoother appraisal-index returns?
Answer and explanations
Infrequent appraisals can lag market changes and smooth reported returns, obscuring underlying volatility.
Review the method- A - correct: Infrequent appraisals can lag market changes and smooth reported returns, obscuring underlying volatility.
- B: Smooth reported marks do not prove that economic risk is negligible.
- C: Different valuation frequencies do not establish that market prices are erroneous.
- Question 10 of 10Level II topic sample · Case 5 of 5Alternative InvestmentsMultiple choice
Case facts
An allocator compares an infrequently appraised property index with daily traded listed real estate. The appraisal index has smoother reported returns. A separate hedge-fund database excludes funds that closed after poor performance. The allocator wants to interpret apparent volatility and historical average returns.
Excluding closed poor-performing hedge funds most directly creates:
Answer and explanations
Surviving funds can look better when poor performers that closed disappear from the database.
Review the method- A: Omitting unsuccessful funds is a nonrandom selection, not an unbiased sample.
- B - correct: Surviving funds can look better when poor performers that closed disappear from the database.
- C: The stated exclusion tends to omit weak results rather than mechanically reduce all returns.
Four ideas to put to work
Find the method you need
Start with: NAV, income capitalization, distributions, contract terms and the difference between reported and underlying risk.
METHOD 01
Separate the return components
Illustrative collateralized futures return ≈ price + roll + collateral
- Use a consistent return decomposition and matching measurement horizon.
- Under a stable contango curve, convergence can create a negative roll component for long exposure.
- Collateral income is separate from the futures price movement.
Worked example
- Given
- Price contribution 5%, roll -3%, collateral 2%; additive convention.
- Calculate / decide
- 5% - 3% + 2% = 4%.
- Result
- The illustrative total is 4%, not just the 5% price component.
Watch for: Contango alone does not guarantee a negative total realized return; the curve and spot price can change.
Practise this ideaMETHOD 02
Capitalize the right income
Stabilized property value = next-year NOI / capitalization rate
- Use the income definition and period appropriate to the chosen capitalization rate.
- Test capitalization-rate sensitivity with the same NOI assumptions.
- Consider appraisal lag and smoothing before interpreting index volatility.
Worked example
- Given
- Next-year NOI 450,000, capitalization rate 6%.
- Calculate / decide
- 450,000 / 0.06 = 7,500,000.
- Result
- Estimated unlevered property value is 7.5m under this simplified method.
Watch for: A capitalization rate is not automatically the total required return or a mortgage rate.
Practise this ideaMETHOD 03
Reconcile FFO to AFFO
Start with net income; apply the explicitly stated adjustments
- Add qualifying real-estate depreciation and remove included property-sale gains for the stated FFO convention.
- Apply recurring capital needs and other specified AFFO adjustments.
- Check definitions before comparing issuers; AFFO is not fully standardized.
Worked example
- Given
- Income 15, real-estate depreciation 8, sale gain 2, recurring capex 3.
- Calculate / decide
- FFO = 15 + 8 - 2 = 21; simplified AFFO = 21 - 3 = 18.
- Result
- The cash-oriented adjustment lowers FFO by the recurring capital need.
Watch for: Adding every depreciation item indiscriminately can misstate a specifically defined FFO measure.
Practise this ideaMETHOD 04
Read fee and database rules
Incentive base depends on fee order, high-water mark and flows
- Calculate the management fee using the contractual asset base.
- Apply the incentive fee only to the eligible gain under the supplied terms.
- Check survivorship, backfill and reporting selection before relying on index performance.
Worked example
- Given
- Start NAV 50, gross ending 57, management fee 1; HWM 54; incentive 20% after management.
- Calculate / decide
- After management NAV = 56; incentive = 20% × (56 - 54) = 0.4.
- Result
- Ending net NAV is 55.6 with no flows or other fee clauses.
Watch for: Fund contracts differ; one fee calculation cannot be generalized to every high-water-mark arrangement.
Practise this ideaQuestions about this topic
- Can appraisal smoothing make an asset appear less risky?
- Yes. Infrequent or smoothed valuations can suppress reported volatility and change measured correlations. Interpret the valuation process alongside the reported risk statistics.
- Why is a money multiple insufficient to compare two investments?
- It omits cash-flow timing and can use different value or proceeds definitions. Compare timing, costs, valuation basis and the investor’s net cash flows as well as the multiple.
- What should I check before using a property capitalization rate?
- Match the income definition, valuation date, property risk and market assumptions. A capitalization rate applied to an inappropriate cash-flow measure values a different economic claim.
Sources and curriculum scope
Official outlines establish curriculum scope. The explanations and worked examples are independent teaching material; the sources do not verify or endorse them.
- 2026 CFA Level II outline: Alternative Investments
- CFA Institute: Level II exam and item-set format
- 2026 CFA Level 2 curriculum outline
- 2027 CFA Level 2 curriculum outline
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