CAIA Level II Exam Questions With Verified Answers

5th percentile vs 25th percentile performance - Answer 5th percentile managers outperform in every comparison BUT 25th percentile managers' performance is more volatile --> even if 25th percentile managers outperform they tend to mean revert --> demonstrates the perils of choosing managers based on historical performance alternative asset performance evaluation - Answer unlike in traditional assets, alpha is difficult to define in alternatives investing; success can be defined as positive absolute return over a market cycle, return greater than an available liquid substitute, or risk-adjusted return greater than published peer group returns due diligence - Answer two types: investment process due diligence and operational due diligence investment due diligence: 1. quantitative screening 2. investment team and organizational attributes 3. investment process review 4. performance analysis operational due diligence - important to protect investors from losses due to operational errors/oversights and fraud 1. Document and legal review 2. Verification of vendor relationships 3. Background checks 4. On-site visits 4 determinants of institutional investors' costs - Answer Cost structure influenced by: 1. Policy portfolio - baseline asset mix that reflects long-term risk and return views 2. Portfolio size - larger portfolios tend to be more complex and thus more expensive 3. Investment vehicles - active vs. passive, separate vs. comingled accounts, limited partnerships, direct investing vs. fund of funds 4. investment model - traditional consultant model, internal CIO model, fund of funds model, outsourced CIO model (OCIO model tends to be less expensive than the traditional consultant model or the ICIO model) The traditional consultant model becomes less efficient as the portfolio grows in size and complexity (consultants meet few times per year, are generally more hands off) BUT internal CIO model is prohibitively expensive for most mid-sized institutions --> mid-sized institutions choose FoF model or OCIO model (which could be a FoF or consultant) 4 categories of costs incurred by institutional investors - Answer 1. Costs related to the construction and management of the portfolio - these are direct and explicit e.g. management fees, performance fees 2. Costs associated with activity and portfolio transactions - these are often embedded (not explicitly charged) and undisclosed e.g. trading and brokerage costs, market impact costs (slippage), prime brokerage costs 3. Fund servicing costs - administrative/operational in nature e.g. custody, audit, legal, administrative fees 4. Investment oversight/monitoring costs - includes overhead and ongoing oversight and monitoring costs e.g. staffing costs, IT, brokerage wrap fees, consultant fees, FoF fees total risk - Answer For institutional investors with liabilities e.g. pension, standalone risk doesn't matter as much as relative risk: portfolio asset risk relative to liabilities Total risk is the volatility of the difference between the present values of portfolio assets and liabilities; the difference between the two is known as the funding status --> total risk is the volatility of the funding status 5 action areas to transition to long-term investing - Answer 1. Investment beliefs - express the long-term investment philosophy of the investor and provides a sustainable foundation for long-term investing; a compass that guides 2. Risk appetite statement - clarifies risk appetite of asset owners 3. Benchmarking process - measures investment success over the long-term; should distinguish between the long-term investment strategy and the asset manager's execution of that strategy 4. Evaluation and incentives - evaluation and incentive framework should support long-term value creation and should align asset owners' and managers' interests 5. Investment mandates - contract between asset owner and manager that formalizes the long-term approach and aligns the interests of asset owners and managers, thereby reducing principal/agent conflicts 7 long-term investment beliefs - Answer Investment beliefs provide investors with a consistent way of thinking about markets, help investors design processes that are consistent with long-term value creation, make it easier for managers to focus on long-term fundamentals, and can be used to devise incentives that are conducive to a long-term mindset 1. Focus on the economic fundamentals not short-term price moves 2. In the short-run prices trend and deviate away from intrinsic values 3. Markets price information in the news, not long-term trends but prices revert to fundamentals 4. Long-term risk of loss (permanent impairment of capital) more important than short-term volatility 5. Diversification in the traditional sense does not necessarily work in a long-term portfolio - differences in the risk-return profiles across asset classes must persist long-term 6. Long-term investors benefit from investment action without short-term pressures 7. Long-term relationships between asset owners and managers foster higher, more sustainable returns benchmarking process - Answer Benchmarks measure investment success and should facilitate long-term, sustainable performance A strategy benchmark is used to measure the success of an investment strategy and should communicate the expected risk-return profile of the chosen strategy, determine whether the strategy achieves long-term success, and communicate relative success to key stakeholders; does not have to be investable e.g. absolute return target like cash + x%, blended index; strategy benchmarks encourage managers to focus on superior, long-term results An execution benchmark represents a low-cost means of executing an intended investment strategy against the mandate and determines how much value an active manager produces and determines his/her incentive compensation e.g. fundamentals based indices, quality indices guiding principle to minimize agency costs - Answer 1. Stakeholders must discuss and agree on a set of investment beliefs that are actionable 2. Stakeholders must clarify issues surrounding risk such as risk tolerance and risk measurement 3. Stakeholders must agree on an investment mandate that formally aligns the interests and behaviors of all relevant parties but especially asset owners and managers 4. Asset owners and managers should discuss and agree on evaluation and performance measures that are consistent with long-term value creation 3 steps and 3 decisions/3 overarching strategies in developing a climate change strategy - Answer Step 1. Measure - quantifying portfolio exposure to high-carbon/high emission investments Step 2. Act - Influencing all key stakeholders to become involved in the process Step 3. Review and monitor - periodically evaluate strategy's effectiveness Decision 1 - Engaging companies (lobbying for corporate strategy that reduces high-carbon and high-emission activities) and policymakers (lobbying for carbon pricing/taxation that encourages substitution, incentives to transition away from fossil fuels, and research funding) Decision 2 - Investing in low-carbon investments e.g. low-carbon indices, ESG funds, green infrastructure Decision 3 - Avoiding high-carbon investments climate change strategy time frame - Answer Asset owners should: In the short-term, integrate low-carbon solutions and avoid high-carbon companies In the medium-term, engage with policy-makers and companies In the long-term, integrate climate change investment in portfolio decisions dynamic asset allocation - Answer The asset allocation strategy chosen will determine a portfolio's rebalancing requirements and thus determine how a portfolio performs under various market conditions e.g. median performance, trending, oscillating 1. Buy and hold is a passive strategy that requires no rebalancing and results in a linear payoff 2. Constant mix allocation requires periodic rebalancing to reestablish the strategic asset allocation as asset values change over time. Upward trending risky assets are sold while downward trending risky assets are purchased to maintain the constant mix, which results in a concave payoff. Concave strategies, which are contrarian in nature, will outperform linear (buy and hold) and convex (CPPI, option-based) strategies in an oscillating market that lacks a defined trend. 3. Constant-proportion portfolio insurance and option-based portfolio insurance strategies aim to invest in risky assets based on a cushion (and a multiplier) between the portfolio value and a pre-determined floor value. As portfolio value increases above the floor value (as the cushion increases) more risky assets are held in the portfolio. Risky assets are sold if that cushion falls. Generally, risky assets are purchased as they increase in value and are sold as they decrease in value. This rebalancing profile results in a convex payoff. Convex strategies are momentum-following in nature and will tend to outperform linear (buy and hold) and concave (constant mix) strategies in a trending market with minimum reversals. Changing the parameters underlying dynamic asset allocation strategies allows the manager to adjust the aggressiveness of the strategy (by decreasing the multiplier) or to lock-in profits after a bull-run (by increasing the floor). As the multiplier approaches 1, the CPPI strategy effectively becomes a buy and hold strategy. benefits of private equity secondaries - Answer On a stand-alone basis: 1. Higher visibility into the composition and performance of the underlying portfolio --> lower blind pool risk 3. Lesser J-curve effect (because uninvested capital isn't a portfolio drag) 4. Lower loss rates and less return volatility 5. Access to funds or GPs that would not have been accessible otherwise Benefits of including in a PE portfolio: 1. Quicker build-up of a diversified private equity portfolio 2. Adds diversification to PE portfolio 3. Smoother cash flow profile because investments have shorter remaining lives Compared to traditional PE funds, PE secondary funds have: 1. higher average IRRs 2. lower TVPI ratios 3. lower loss rates 4. faster return of cash 5. less volatile returns benefits of co-investment - Answer 1. Enhanced return relative to primary strategies 2. J-curve mitigation (no 2/20, less un-invested capital) 3. Higher efficiency in terms of desired risk exposures 4. Tailored portfolios 5. LPs develop investment selection skill longevity risk transfer instruments - Answer buy-in transaction - pension plan pays an up-front premium to an insurer in exchange for periodic benefit payments; sponsor keeps assets and liabilities buy-out transaction - pension plan sends an up-front premium as well as its assets and liabilities to an insurer; insurer assumes responsibility for paying benefits longevity swap transaction - pension plan pays periodic premiums to a counterparty who in turn pays the plan sponsor periodic payments that are based on the difference between expected and actual benefit payments