CFA Level I Book 4: Alternative Investments, Portfolio Management, and Ethics Vocabulary

This set of flashcards covers key vocabulary and technical concepts from the 2025 CFA Level I curriculum regarding Alternative Investments, Portfolio Management, and Ethical Standards.

Alternative Investments

Investment structures that typically do not fall under the head of traditional investments (cash, stocks, and bonds) and generally include hedge funds, private capital, real assets, and commodities.

Private Equity

Equity capital raised from sources other than public markets, typically invested in private companies or in public companies that the fund intends to take private.

Leveraged Buyout (LBO)

A type of private equity investment where a fund uses a large amount of borrowed money to purchase equity in established companies, often in mature or decline stages of their life cycle.

Venture Capital

Private capital provided to young, unproven companies at the start-up or early stages in their life cycles.

Unitranche Debt

A form of private debt that combines different classes of debt (secured and unsecured) into a single loan with an interest rate reflecting the blend of debt classes.

Committed Capital

The total amount of capital that limited partners have promised to provide to a private equity fund, but which may not be drawn down (invested) immediately.

Dry Powder

The portion of a private equity fund's committed capital that has not yet been drawn down or invested by the fund manager.

Hurdle Rate (Preferred Return)

A specified rate of return that must be met or exceeded before the fund manager is entitled to receive any performance or incentive fees.

Soft Hurdle Rate

A performance fee structure where, once the hurdle rate is met, the incentive fee is calculated based on the total increase in the value of the investment, not just the gain above the hurdle.

Hard Hurdle Rate

A performance fee structure where the incentive fee is calculated only on the gains that exceed the specified hurdle rate.

High-Water Mark

A provision ensuring that a fund manager only receives performance fees for gains that exceed the highest net-of-fees value previously recorded for the account.

Clawback Provision

A contractual requirement that allows limited partners to recover previous incentive payments if a general partner receives excess fees on gains that are subsequently reversed by losses on later exits.

J-Curve Effect

The tendency of alternative investment funds to experience negative returns in the early years (capital commitment and deployment phases) followed by increasing returns as investments succeed.

Multiple of Invested Capital (Money Multiple)

A simple performance measure calculated as the ratio of total capital returned plus the value of remaining assets to the total capital paid in.

Greenfield Investment

A type of infrastructure investment in which the assets are yet to be constructed, often involving high uncertainty and capital outflow during the building phase.

Brownfield Investment

An investment to expand or privatize an existing infrastructure asset that is already constructed and operational.

Contango

A market condition where the futures price of a commodity is higher than the spot price, occurring when there is little or no convenience yield to offset storage costs.

Backwardation

A market condition where the futures price of a commodity is lower than the spot price, occurring when the convenience yield is high enough to more than offset storage costs.

Distributed Ledger Technology (DLT)

A database shared among market participants that maintains an identical, secure, and transparent record of all transactions (e.g., blockchain).

Proof of Work (PoW)

A consensus protocol where miners use powerful computers to solve cryptographic problems to verify transactions and add blocks to a blockchain.

Proof of Stake (PoS)

A consensus protocol where network participants, known as validators, pledge collateral (staking) to guarantee the validity of transactions and verify blocks.

Nonfungible Token (NFT)

A digital asset linked to a certificate of authenticity representing a distinct, non-interchangeable object, such as digital artwork.

Smart Contract

A self-executing computer program on a blockchain that automates the execution of terms and conditions based on predetermined criteria.

Systematic Risk (Market Risk)

The component of total risk that cannot be eliminated through diversification, resulting from broad market factors like interest rates and GDP growth.

Unsystematic Risk (Unique Risk)

The firm-specific risk that can be eliminated through diversification by holding a large number of assets in a portfolio.

Beta ($\beta$)

A standardized measure of systematic risk that reflects the sensitivity of an asset's return to the return on the market index, calculated as $\beta_i = \frac{\text{Cov}(R_i, R_m)}{\sigma_m^2}$.

Capital Allocation Line (CAL)

A line representing all possible combinations of a risk-free asset and a specific risky asset (or portfolio).

Capital Market Line (CML)

A specific CAL that uses the market portfolio as the optimal risky portfolio, where expected portfolio return is calculated as $E(R_P) = R_f + \frac{E(R_M) - R_f}{\sigma_M} \times \sigma_P$.

Security Market Line (SML)

The graphical representation of the Capital Asset Pricing Model (CAPM) that plots expected return against systematic risk ($\beta$).

Sharpe Ratio

A measure of excess return per unit of total risk, calculated as $\frac{R_p - R_f}{\sigma_p}$.

Treynor Measure

A measure of excess return per unit of systematic risk, calculated as $\frac{R_p - R_f}{\beta_p}$.

Jensen's Alpha ($\alpha$)

The percentage return of a portfolio in excess of the return predicted by the CAPM, calculated as $\alpha_p = R_p - [R_f + \beta_p(R_m - R_f)]$.

M-Squared ($M^2$)

A performance measure that produces the same rankings as the Sharpe ratio but is expressed in percentage terms as the return of a portfolio leveraged or deleveraged to match the market's standard deviation.

Strategic Asset Allocation

A long-term set of percentage allocations to various asset classes designed to meet an investor's objectives and constraints as specified in the Investment Policy Statement (IPS).

Tactical Asset Allocation

Short-term deviations from the strategic asset allocation weights to take advantage of perceived opportunities in specific asset classes.

Cognitive Errors

Behavioral biases stemming from faulty reasoning, illogical information processing, or memory errors; they are generally easier to correct with education than emotional biases.

Emotional Biases

Behavioral biases stemming from feelings, impulses, or intuition rather than conscious thought; these are generally difficult to overcome and often must be accommodated.

Loss-Aversion Bias

An emotional bias where individuals feel the pain of a loss more intensely than the pleasure of an equal-sized gain, often leading to holding losing positions too long.

Fiduciary Standard

A high legal and ethical standard requiring a professional to act solely in the best interests of the client, placing the client's needs above their own or their firm's.

Mosaic Theory

The idea that an investment professional does not violate laws by trading on a conclusion reached through the analysis of public information combined with non-material nonpublic information.

Composite

A grouping of individual discretionary portfolios managed by an investment firm that represent a similar investment strategy or objective, used for performance reporting under GIPS.