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.

C 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.

B 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.