Free CAIA Level II Practice Questions

A is correct. Active return is defined as the portfolio's return minus the benchmark return. It captures the total value added or subtracted by the manager relative to the chosen benchmark, encompassing both security selection and allocation effects.
Choice B is incorrect because total return is not measured relative to any benchmark and does not isolate manager skill.
Choice C is incorrect because return above the risk-free rate is the definition of excess return (or the Sharpe ratio numerator), not active return.
Choice D is incorrect because active return includes all sources of relative performance versus the benchmark, not just security selection.

D is correct. In TPA, a strategic overlay uses instruments such as derivatives or liquid proxies at the total-portfolio level to adjust factor exposures — adding or reducing equity beta, duration, or inflation sensitivity — without requiring changes to individual manager mandates. This preserves manager autonomy while giving the CIO control over aggregate risk.
Choice A is incorrect because a strategic overlay is not a fund-of-funds structure; it operates above individual manager portfolios as a risk-expression tool.
Choice B is incorrect because compliance with benchmark constraints is a governance function distinct from the strategic overlay's risk-management role.
Choice C is incorrect because a strategic overlay is broader than a fixed-income duration target; it can address any factor across the entire portfolio.

D is correct. Volatility of volatility refers to the variability of volatility itself — that is, how much realized volatility fluctuates over time. This is directly relevant to funds that have short volatility or short variance exposures (selling variance swaps, VIX futures, or variance options). A fund that sells variance at a fixed strike profits when realized variance is low and stable, but suffers convex losses when realized variance spikes unexpectedly. High vol-of-vol means there is a significant probability of a volatility regime shift that moves far beyond the level implied by historical averages. In due diligence, assessing a short-vol manager's exposure to vol-of-vol — and whether their risk models account for regime changes — is essential to understanding the true tail risk of the strategy.
Choice A is incorrect because comparing reported VaR to position-level data is a portfolio risk review or valuation consistency check, not specifically a vol-of-vol consideration.
Choice C is incorrect because duration risk and interest rate sensitivity in fixed income portfolios are not primarily a vol-of-vol issue. Duration estimation is affected by yield curve shape and convexity, not by the variability of rates' own volatility.
Choice B is incorrect because tracking error and active share analysis in long-only equity management involves return dispersion relative to a benchmark, not the second-order dynamics of volatility. This is a benchmarking and portfolio construction question, not a vol-of-vol question.