Level I · Topic 2 · 20-25% Weight · 35 hours to Master

Introduction to Alternative Investments

The quantitative and theoretical foundation for evaluating non-traditional assets, covering risk, return, and financial economics.

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Why this matters

Before analyzing a buyout deal or a timberland asset, you must understand the math used to measure its performance. This topic provides the quantitative vocabulary used throughout the CAIA program. It is heavy on formulas, distribution shapes, and performance metrics (Sharpe, Sortino, Treynor).

Learning Objectives

  • Distinguish between normal and non-normal distributions (skewness, kurtosis).
  • Calculate and interpret performance measures (Sharpe, Sortino, Treynor, Information Ratio).
  • Understand the basics of financial economics, including the CAPM and arbitrage pricing theory.

Core Concepts

Distribution Shapes and Moments

While traditional finance often relies on the assumption of normally distributed returns, alternative investments frequently exhibit significant skewness and excess kurtosis (“fat tails”).

The Four Moments of a Distribution

Mean (1st), Variance (2nd), Skewness (3rd), and Kurtosis (4th).

Many alternative strategies, like selling options or distressed debt, resemble “picking up pennies in front of a steamroller.” They generate steady small positive returns (negative skew) punctuated by infrequent, massive drawdowns (high kurtosis).

Performance Metrics

$$ Sharpe Ratio = \\frac{E[R_p] - R_f}{\\sigma_p} $$
VARIABLES
  • E[R_p]: Expected return of the portfolio
  • R_f: Risk-free rate
  • \sigma_p: Standard deviation of portfolio returns
Typical Range: 0.5 to 2.0+ for top-quartile funds

The Sharpe ratio penalizes both upside and downside volatility equally. For alternative strategies with asymmetric returns, the Sortino ratio (which only penalizes downside deviation) is often a better fit.

$$ Sortino Ratio = \\frac{E[R_p] - MAR}{TDD} $$
VARIABLES
  • MAR: Minimum Acceptable Return (often the risk-free rate)
  • TDD: Target Downside Deviation
Typical Range: Often higher than Sharpe for trend-following strategies

Practice Questions

PRACTICE QUESTION Easy

A hedge fund exhibits a return distribution with a skewness of -1.5 and a kurtosis of 6.0. Compared to a normal distribution, this fund’s returns have:

  • A. A longer right tail and thinner tails overall.
  • A. A longer right tail and fatter tails overall.
  • C. A longer left tail and fatter tails overall.
90-Second Cheat Sheet

Key Ratios

  • Sharpe: Excess return / Total Risk ($\sigma$)
  • Sortino: Excess return over MAR / Downside Deviation
  • Treynor: Excess return / Systematic Risk ($\beta$)
  • Info Ratio: Active Return / Tracking Error

Recommended Free Resources

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