CAIA LEVEL II EXAM GUIDE
QUESTIONS WITH CORRECT 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
QUESTIONS WITH CORRECT 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
