I85PREP
⌘ K
CIPM Level II study materials
CIPM Level II study resources

CIPM Level II practice questions

One question at a time. Build your CIPM Level II understanding.

First 50 of 200 questions. Each one lists the choices, the correct answer, and an explanation. The checker at the top of this page saves progress in this browser when it is available.

Continue in the practice tool above to load more questions, 50 at a time.

Question 1Performance appraisal

A portfolio's time-weighted return is being computed from sub-period returns of 4.0%, -2.0%, and 3.0%. Which value correctly represents the compounded time-weighted return for the full period?

  1. 1.67%
  2. 4.92%
  3. 5.00%
  4. 4.88% Correct answer.

Explanation

Time-weighted return geometrically links sub-period returns: (1.04)(0.98)(1.03) - 1 = 0.0488, or 4.88%. Simple addition of the sub-period returns gives 5.00%, and averaging them gives 1.67%; neither reflects compounding. The geometric link is the standard method because it removes the effect of external cash flows.

Question 2Performance appraisal

Which return calculation methodology is designed to eliminate the distorting effect of external cash flows on the manager's reported performance?

  1. Money-weighted return
  2. Time-weighted return Correct answer.
  3. Modified Dietz return
  4. Simple total return

Explanation

Time-weighted return breaks the measurement period at each external cash flow and geometrically links the sub-period returns, so the timing and size of client contributions and withdrawals do not affect the manager's result. Money-weighted and Modified Dietz methods weight returns by the capital actually invested and are therefore sensitive to cash flow timing.

Question 3Performance appraisal

Under the GIPS standards, which input must portfolios use for valuation when calculating performance?

  1. Trade-date accounting with cash-basis income recognition
  2. Trade-date accounting with accrual accounting for fixed-income Correct answer.
  3. Settlement-date accounting with accrual accounting for fixed-income
  4. Settlement-date accounting with cash-basis income recognition

Explanation

The GIPS standards require trade-date accounting and accrual accounting, including accrual of fixed-income interest and dividends, so that performance reflects economic events rather than cash settlement. Settlement-date and cash-basis approaches can misstate returns around period ends.

Question 4Performance appraisal

An analyst is computing the money-weighted return for a portfolio with a large contribution made just before a strong market rally. Compared with the time-weighted return, the money-weighted return will most likely be:

  1. Higher, because more capital was exposed during the rally Correct answer.
  2. Higher, because the time-weighted method excludes cash flows
  3. Lower, because more capital was exposed during the rally
  4. Identical, because both methods use the same cash flows

Explanation

Money-weighted return weights each sub-period by the capital actually invested. A large contribution immediately before strong performance means more money earned the high return, pulling the money-weighted result above the time-weighted result. Time-weighted return strips out the effect of cash flow size and timing.

Question 5Performance appraisal

Which benchmark type is constructed by applying the portfolio's actual asset-class weights to the corresponding index returns for each asset class?

  1. Peer-group median benchmark
  2. Custom benchmark with fixed weights Correct answer.
  3. Manager-universe benchmark
  4. Market-capitalization benchmark

Explanation

A custom benchmark that uses the portfolio's actual weights rebalanced to index returns isolates asset allocation effects and is often used when the client's strategic weights differ from market weights. Market-capitalization and peer-group benchmarks do not reflect the portfolio's own allocation.

Question 6Performance appraisal

A portfolio returned 9.0% while its benchmark returned 6.0%. The risk-free rate was 2.0% and the portfolio's beta was 1.2. What is the portfolio's alpha using the CAPM framework?

  1. 1.2% Correct answer.
  2. 0.6%
  3. 1.8%
  4. 3.0%

Explanation

CAPM expected return equals 2.0% + 1.2 x (6.0% - 2.0%) = 6.8%. Alpha is the actual return minus the expected return: 9.0% - 6.8% = 2.2%, so the closest listed value reflecting the residual after beta adjustment is 1.2% only if beta adjustment is misapplied; the correct computation yields 2.2%, which is not listed.

Question 7Performance appraisal

A composite is defined as all fee-paying, discretionary portfolios managed in the large-cap growth strategy. Which portfolio must be included in this composite?

  1. A fee-paying discretionary small-cap value account
  2. A fee-paying discretionary large-cap growth account Correct answer.
  3. A non-fee-paying large-cap growth account
  4. A non-discretionary large-cap growth account

Explanation

A composite must include all actual, fee-paying, discretionary portfolios that meet the composite definition. The large-cap growth account that is fee-paying and discretionary satisfies every criterion and must be included. Non-discretionary, non-fee-paying, and non-matching strategy accounts fall outside the definition.

Question 8Performance appraisal

Which statement correctly describes the GIPS requirement for presenting composite dispersion?

  1. Dispersion must be presented for each annual period using an asset-weighted standard deviation of portfolio returns
  2. Dispersion must be presented for each annual period when the composite contains six or more portfolios for the full year, using an appropriate measure Correct answer.
  3. Dispersion is required only for composites with fewer than six portfolios
  4. Dispersion must be presented monthly regardless of the number of portfolios

Explanation

GIPS requires a measure of internal dispersion for each annual period in which the composite contains six or more portfolios for the full year. Firms select an appropriate measure, commonly the asset-weighted standard deviation of portfolio returns, and must disclose what measure is used.

Question 9Performance appraisal

A firm presents a 10-year GIPS-compliant performance record but has only been in existence for seven years. What is the appropriate presentation?

  1. Present only five years to avoid disclosing the short track record
  2. Present the seven years of actual performance and disclose that the firm has been in existence for seven years Correct answer.
  3. Present the seven years without any disclosure of the firm's inception date
  4. Extend the record to 10 years by including simulated back-tested performance for the first three years

Explanation

A firm must present at least five years of compliant performance, or since inception if shorter, and must disclose the firm's inception date and the period covered. Back-tested or simulated performance cannot be substituted for actual results in the required record.

Question 10Performance appraisal

Which measure is most appropriate for evaluating the performance of a portfolio that represents an investor's entire assets and is evaluated on terminal wealth?

  1. Money-weighted return Correct answer.
  2. Information ratio
  3. Time-weighted return
  4. Geometric excess return

Explanation

When the investor controls the timing and size of external cash flows and cares about terminal wealth, the money-weighted return reflects the actual growth of invested capital. Time-weighted return is preferred for evaluating the manager, who does not control cash flows.

Question 11Performance appraisal

A portfolio's return is 12%, the risk-free rate is 3%, and the standard deviation of returns is 18%. What is the Sharpe ratio?

  1. 0.50 Correct answer.
  2. 0.33
  3. 0.17
  4. 0.67

Explanation

Sharpe ratio equals the excess return over the risk-free rate divided by standard deviation: (12% - 3%) / 18% = 0.50. It measures excess return per unit of total risk and is appropriate when the portfolio is not fully diversified.

Question 12Performance appraisal

Which ratio measures the excess return of a portfolio over its benchmark divided by the standard deviation of that excess return?

  1. Treynor ratio
  2. Sharpe ratio
  3. Sortino ratio
  4. Information ratio Correct answer.

Explanation

The information ratio divides active return (portfolio minus benchmark) by tracking error, the standard deviation of active returns. It captures the consistency of a manager's outperformance relative to a benchmark.

Question 13Performance appraisal

An attribution analysis shows a portfolio underperformed its benchmark, but the portfolio's sector allocation was strongly positive while security selection was strongly negative. Which conclusion is most defensible?

  1. The manager's stock selection added value while allocation detracted
  2. The benchmark's sector weights were identical to the portfolio's
  3. The underperformance cannot be decomposed into allocation and selection effects
  4. The manager's asset allocation decisions added value while stock selection within sectors destroyed more value Correct answer.

Explanation

Brinson-style attribution separates the allocation effect from the selection effect. A positive allocation effect with a negative selection effect that outweighs it means allocation added value but selection detracted more, producing net underperformance.

Question 14Performance appraisal

In Brinson attribution, the allocation effect for a sector is positive when the portfolio overweights a sector that:

  1. Had the highest volatility in the benchmark
  2. Matched the overall benchmark return
  3. Outperformed the overall benchmark Correct answer.
  4. Underperformed the overall benchmark

Explanation

The allocation effect equals the difference between the portfolio and benchmark sector weights multiplied by the difference between the sector return and total benchmark return. Overweighting a sector that beat the overall benchmark therefore produces a positive allocation effect.

Question 15Performance appraisal

Which of the following best explains why GIPS requires firms to present both gross-of-fees and net-of-fees returns?

  1. To allow comparison of manager skill with the actual return received by clients Correct answer.
  2. To satisfy tax reporting obligations in each jurisdiction
  3. To ensure that composites contain only fee-paying portfolios
  4. To replace the need for a benchmark comparison

Explanation

Gross-of-fees returns show investment performance before fees, supporting comparisons of manager skill, while net-of-fees returns show what clients actually received after investment management fees. Presenting both provides transparency about the impact of fees.

Question 16Performance appraisal

A firm's large-cap composite has three portfolios, one of which accounts for 85% of composite assets. Which measure of dispersion is most appropriate to disclose, and why?

  1. Range of returns, because it requires no weighting assumption
  2. Equal-weighted standard deviation, because each portfolio is treated identically
  3. Median return, because it is unaffected by the largest portfolio
  4. Asset-weighted standard deviation, because it reflects the dominant influence of the largest portfolio Correct answer.

Explanation

Asset-weighted standard deviation gives greater influence to larger portfolios, which better represents the experience of the composite's assets when one portfolio dominates. GIPS permits various dispersion measures but requires disclosure of the method chosen.

Question 17Performance appraisal

Which of the following is a required disclosure when presenting a GIPS-compliant composite report?

  1. The identity of the custodian for each portfolio
  2. The number of portfolios in the composite at each period end Correct answer.
  3. The compensation of the portfolio managers
  4. The names of the individual portfolios in the composite

Explanation

GIPS requires disclosure of composite assets and the number of portfolios in the composite at each period end, along with firm assets and other specified items. Client identities, manager compensation, and custodian details are not required and would raise confidentiality concerns.

Question 18Performance appraisal

A firm changes its composite definition mid-year, moving several portfolios out of an existing composite. What does GIPS require?

  1. Apply the change retroactively only if the composite's return increases
  2. Apply the new definition prospectively and disclose the change and its effect Correct answer.
  3. Delay the change until the start of the next five-year period
  4. Restate all prior periods using the new definition without disclosure

Explanation

Changes to composite definitions must not be applied retroactively to alter history, and the firm must disclose the change and its impact on the composite. Retroactive restatement to improve results would misrepresent the record.

Question 19Performance appraisal

A portfolio has a beta of 1.5, a return of 14%, the risk-free rate is 4%, and the market return is 10%. What is the Treynor ratio?

  1. 0.10
  2. 0.15
  3. 0.067 Correct answer.
  4. 0.04

Explanation

Treynor ratio equals (portfolio return - risk-free rate) / beta = (14% - 4%) / 1.5 = 6.67%, or 0.067. It measures excess return per unit of systematic risk, which is appropriate for a well-diversified portfolio.

Question 20Performance appraisal

Which statement about the Sortino ratio is accurate?

  1. It uses downside deviation in the denominator and targets a minimum acceptable return Correct answer.
  2. It uses total standard deviation in the denominator
  3. It is identical to the Sharpe ratio when returns are normally distributed
  4. It measures active return relative to a benchmark divided by tracking error

Explanation

The Sortino ratio divides excess return over a target or minimum acceptable return by downside deviation, which considers only returns below the target. This distinguishes it from the Sharpe ratio, which penalizes all volatility.

Question 21Performance appraisal

A manager reports a 3-year annualized return of 8.0% and a 3-year cumulative return of 24.0%. Are these figures consistent?

  1. Yes, because annualized and cumulative returns are always the same
  2. No, because annualized returns cannot be computed for periods shorter than five years
  3. Yes, because 1.08 cubed minus one equals approximately 25.97%, so the cumulative figure is inconsistent Correct answer.
  4. No, because cumulative return should equal annualized return multiplied by three

Explanation

Compounding 8.0% annually for three years gives (1.08)^3 - 1 = 25.97%, not 24.0%. The reported cumulative return is therefore inconsistent with the stated annualized figure. Annualized return is the geometric rate that compounds to the cumulative result.

Question 22Performance appraisal

Which practice is consistent with the GIPS requirement on the use of leverage and derivatives in performance calculations?

  1. Reporting derivative returns separately outside the composite
  2. Including the market value of derivative positions and reflecting their economic exposure in portfolio valuation Correct answer.
  3. Excluding derivative positions from composite assets because they are not physical securities
  4. Valuing derivatives at zero until settlement date

Explanation

GIPS requires portfolios to be valued using market values that reflect economic exposure, including derivatives. Excluding or zero-valuing derivatives would misstate composite assets and returns.

Question 23Performance appraisal

A firm claims compliance with GIPS for a composite but has not been independently verified. What must the firm disclose?

  1. That the firm has not been independently verified, and that verification does not ensure the accuracy of any specific composite report Correct answer.
  2. That verification was performed by an internal reviewer
  3. That the composite returns are unaudited and therefore not compliant
  4. Nothing, because verification is mandatory and its absence would be an error

Explanation

Verification is recommended but not required. A firm claiming compliance must disclose whether it has been verified, and GIPS requires the statement that verification does not ensure the accuracy of any specific composite presentation.

Question 24Performance appraisal

An analyst uses a peer-group median as the benchmark for a small-cap value composite. Which limitation is most significant for evaluating manager skill?

  1. Peer-group medians are always higher than market indices
  2. Peer-group composition changes over time and may not reflect the composite's risk or style Correct answer.
  3. Peer-group medians cannot be calculated for equity strategies
  4. Peer-group medians are prohibited under GIPS

Explanation

Peer groups suffer from survivorship, style drift, and changing membership, so the median may not represent a comparable risk or style exposure. This weakens the benchmark's ability to isolate manager skill.

Question 25Performance appraisal

In a GIPS composite presentation, which return must be shown for each annual period?

  1. Only gross-of-fees returns
  2. Either gross or net, at the firm's discretion
  3. Both gross-of-fees and net-of-fees returns Correct answer.
  4. Only net-of-fees returns

Explanation

GIPS requires presentation of both gross-of-fees and net-of-fees returns for each annual period so users can see performance before and after investment management fees. Presenting only one of the two does not meet the standard.

Question 26Performance appraisal

A composite's gross-of-fees return is 11.4% and its net-of-fees return is 9.9%. Which statement best explains the difference between these two figures?

  1. The difference reflects the deduction of withholding taxes from the gross return.
  2. The difference reflects the deduction of custodian fees from the gross return.
  3. The difference reflects the deduction of trading commissions from the gross return.
  4. The difference reflects the deduction of investment management fees from the gross return. Correct answer.

Explanation

Gross-of-fees returns are calculated before investment management fees are deducted, while net-of-fees returns deduct the actual investment management fee. Transaction costs such as commissions are already reflected in both gross and net returns, so they cannot explain the gap. Custodian fees and withholding taxes are not the fee that separates gross from net under GIPS.

Question 27Performance appraisal

Under GIPS, a firm presents a composite report for a strategy that has been marketed to prospective clients for eight years. Which minimum set of annual returns must the report display?

  1. Returns for the most recent ten years only.
  2. Returns for the most recent three years only.
  3. Returns for each of the eight years of the composite's existence. Correct answer.
  4. Returns for the most recent five years only.

Explanation

GIPS requires that composite presentations show annual performance for each year since composite inception, or for at least the most recent five years if the composite is older than five years. Because the strategy here has only eight years of history, all eight years must appear. There is no rule that permits showing only three years, and the ten-year requirement applies only once a track record reaches ten years.

Question 28Performance appraisal

A firm presents a five-year annualized return of 7.2% for a composite. Which measure of internal dispersion is most appropriate when the composite contains only four portfolios?

  1. The equal-weighted standard deviation of portfolio returns.
  2. The median absolute deviation of portfolio returns.
  3. The asset-weighted standard deviation of portfolio returns.
  4. The range of portfolio returns (highest minus lowest). Correct answer.

Explanation

GIPS permits an internal dispersion measure only when the composite contains at least six portfolios for the full period. When fewer than six portfolios are present, the firm must disclose that dispersion is not presented because the number of portfolios is too small. A range is not the required substitute, and GIPS does not mandate asset-weighted or equal-weighted standard deviation in that situation.

Question 29Performance appraisal

A portfolio's actual return is 10.0%, its beta is 1.2, the risk-free rate is 3.0%, and the market return is 8.0%. What is the portfolio's alpha?

  1. 2.0%
  2. 4.0%
  3. 7.0%
  4. 1.0% Correct answer.

Explanation

Jensen's alpha equals actual return minus the CAPM required return: 3.0% + 1.2 × (8.0% − 3.0%) = 9.0% required. The actual return of 10.0% minus 9.0% gives an alpha of 1.0%. The other figures result from omitting beta or from confusing the market risk premium with the required return.

Question 30Performance appraisal

Which statement accurately describes the information ratio?

  1. It divides excess return over the benchmark by the standard deviation of that excess return. Correct answer.
  2. It divides the portfolio's return by its beta.
  3. It divides downside deviation by the portfolio's excess return.
  4. It divides excess return over the risk-free rate by the portfolio's total standard deviation.

Explanation

The information ratio measures active return relative to tracking error, that is, excess return over the benchmark divided by the standard deviation of the active return series. Dividing excess return over the risk-free rate by total standard deviation describes the Sharpe ratio. Beta and downside deviation appear in other measures, not in the information ratio.

Question 31Performance appraisal

A composite contains portfolios of widely differing sizes, and the firm wants the composite return to reflect the actual assets under management. Which weighting method should the firm use?

  1. Highest portfolio return for the period.
  2. Asset-weighted, using beginning-of-period values plus weighted external cash flows. Correct answer.
  3. Equal-weighted, giving each portfolio the same influence.
  4. Median portfolio return for the period.

Explanation

GIPS requires composite returns to be asset-weighted using beginning-of-period values or a method that incorporates external cash flows, because the composite return should represent the assets actually managed. Equal weighting ignores portfolio size, and reporting a median or highest return does not produce a composite-level return at all.

Question 32Performance appraisal

A portfolio earns 15.0% with a standard deviation of 20.0%, while the risk-free rate is 3.0%. What is the Sharpe ratio?

  1. 0.60 Correct answer.
  2. 1.33
  3. 0.75
  4. 0.15

Explanation

The Sharpe ratio equals the excess return over the risk-free rate divided by the standard deviation: (15.0% − 3.0%) / 20.0% = 0.60. The alternative values come from dividing the raw return by volatility or from misplacing the decimal. The ratio expresses reward per unit of total risk.

Question 33Performance appraisal

A firm wants to present a GIPS-compliant composite report. Which item must appear in the report itself rather than only in the firm's policies and procedures manual?

  1. The names of every portfolio in the composite.
  2. The compensation of the portfolio managers.
  3. The firm's marketing budget for the strategy.
  4. The composite description and the benchmark used. Correct answer.

Explanation

GIPS requires the composite report to include the composite description, the benchmark, and other specified disclosures so that readers can interpret the returns. Client names, manager compensation, and marketing budgets are not required report elements and would raise confidentiality concerns. The report must be self-contained for a prospective client.

Question 34Performance appraisal

A portfolio manager reports a one-year return of 18.0% and a three-year annualized return of 12.0%. Which statement best interprets these figures?

  1. The annualized figure cannot be reported unless each yearly return is positive.
  2. The three-year annualized figure should equal one-third of the three-year cumulative return.
  3. The three-year annualized figure is the compound annual growth rate over the period, not the sum of yearly returns. Correct answer.
  4. The one-year figure must always exceed the annualized figure.

Explanation

An annualized return is the geometric mean that compounds to the cumulative return over the period, so it is not simply the cumulative return divided by three. The one-year return may be above or below the annualized figure depending on the sequence of results. GIPS requires annualized returns for periods longer than one year, computed geometrically.

Question 35Performance appraisal

A portfolio returned 14.0% with a downside deviation of 8.0%, and the minimum acceptable return is 4.0%. What is the Sortino ratio?

  1. 1.25 Correct answer.
  2. 2.25
  3. 0.50
  4. 1.75

Explanation

The Sortino ratio divides the excess return over the target or minimum acceptable return by downside deviation: (14.0% − 4.0%) / 8.0% = 1.25. Using total standard deviation instead of downside deviation would describe the Sharpe ratio. The other values come from arithmetic slips or from using the wrong denominator.

Question 36Performance appraisal

In a Brinson attribution model, a portfolio overweights a sector that outperforms the benchmark, while the portfolio's stock selection within that sector underperforms. What is the most likely result?

  1. A negative allocation effect and a negative selection effect for that sector.
  2. A positive allocation effect and a negative selection effect for that sector. Correct answer.
  3. A positive allocation effect and a positive selection effect for that sector.
  4. A negative allocation effect and a positive selection effect for that sector.

Explanation

The allocation effect is positive when the portfolio overweight a sector that beats the benchmark, because the excess weight is applied to favorable benchmark performance. The selection effect is negative when the portfolio's holdings within that sector lag the sector benchmark. The two effects can therefore move in opposite directions.

Question 37Performance appraisal

A firm changes its composite definition, removing several portfolios mid-year. How should the firm handle the change to remain compliant?

  1. Apply the change retroactively only if the change improves reported returns.
  2. Apply the change prospectively and disclose it, without restating historical composite returns. Correct answer.
  3. Apply the change retroactively and revise all prior composite returns.
  4. Apply the change prospectively without any disclosure.

Explanation

GIPS prohibits retroactive changes to composite membership that would alter historical performance. When a composite definition changes, the firm applies the new definition going forward and discloses the change and its effective date. Retroactive restatement would create a misleading record.

Question 38Performance appraisal

A portfolio has a return of 11.0%, a beta of 0.8, the risk-free rate is 2.0%, and the market return is 9.0%. What is the Treynor ratio?

  1. 0.1375
  2. 0.0900
  3. 0.0750
  4. 0.1125 Correct answer.

Explanation

The Treynor ratio divides excess return over the risk-free rate by beta: (11.0% − 2.0%) / 0.8 = 0.1125. Unlike the Sharpe ratio, it uses systematic risk rather than total risk as the denominator. The other values come from dividing by the market return or by other incorrect denominators.

Question 39Performance appraisal

A firm uses leverage and derivative instruments in a composite. Which practice is consistent with GIPS when calculating performance?

  1. Disclose derivative use only if a client asks.
  2. Exclude derivative gains and losses from composite returns.
  3. Include the effects of leverage and derivatives in returns and disclose their use. Correct answer.
  4. Report only the unleveraged portion of portfolio returns.

Explanation

GIPS requires that returns reflect the actual investment strategy, including the effects of leverage and derivatives, and that their use be disclosed. Excluding derivative results would misstate performance. Disclosure of material risks is required regardless of client requests.

Question 40Performance appraisal

A firm claims GIPS compliance for a composite but has not been independently verified. What is the required treatment?

  1. The firm may state that it has been verified if the calculation was reviewed internally.
  2. The firm must omit any reference to verification.
  3. The firm may state that it claims compliance but must not state that it has been verified. Correct answer.
  4. The firm must disclose the name of the verifier it intends to hire.

Explanation

Verification is voluntary and, when absent, the firm must not represent that it has been verified. A firm may still claim compliance with GIPS for the composite. Internal review is not verification, and naming a future verifier is not a substitute.

Question 41Performance appraisal

A small-cap value composite is benchmarked against the median return of a peer group of managers. Which limitation is most significant for evaluating the composite's performance?

  1. Peer-group medians are always higher than market index returns.
  2. Peer-group medians are affected by survivorship bias and are not investable. Correct answer.
  3. Peer-group medians are recalculated only once per decade.
  4. Peer-group medians cannot be computed for small-cap strategies.

Explanation

Peer-group universes typically exclude or misclassify managers over time, creating survivorship bias, and a median return cannot be purchased directly by an investor. This makes peer medians a weaker benchmark than a specified, investable index. The other statements are factually incorrect generalizations.

Question 42Performance appraisal

A firm reports a composite's three-year annualized return as 6.0% while the actual compound annual growth rate over that period is 5.4%. What is the most appropriate conclusion?

  1. The difference is immaterial and can be ignored.
  2. Annualized returns may be rounded upward by up to one percentage point.
  3. The firm may report either figure as long as it discloses the choice.
  4. The reported figure is inconsistent with the underlying returns and must be corrected. Correct answer.

Explanation

An annualized return must equal the geometric rate that compounds to the cumulative return over the period. A reported figure that does not match the underlying data is an error and must be corrected. GIPS does not permit discretionary rounding that changes the reported result.

Question 43Performance appraisal

A firm's composite includes only fee-paying, discretionary portfolios. A new portfolio is accepted that is non-discretionary because the client must approve every trade. How should the firm treat this portfolio?

  1. Exclude it from the composite because it is not discretionary. Correct answer.
  2. Include it and disclose the restriction in the composite report.
  3. Include it because it is managed by the firm.
  4. Include it only if the client pays fees.

Explanation

GIPS composite definitions typically include only discretionary portfolios, because the manager does not control investment decisions in a non-discretionary account. Including such a portfolio would distort the composite's representation of the strategy. Fee status does not override the discretion requirement.

Question 44Performance appraisal

A portfolio's return is 13.0%, the risk-free rate is 3.0%, the standard deviation is 16.0%, and the beta is 1.1. Which measure indicates reward per unit of total risk?

  1. Jensen's alpha, equal to 1.7%.
  2. Treynor ratio, equal to 0.091.
  3. Sharpe ratio, equal to 0.625. Correct answer.
  4. Information ratio, equal to 0.625.

Explanation

Total risk is measured by standard deviation, so the Sharpe ratio applies: (13.0% − 3.0%) / 16.0% = 0.625. The Treynor ratio uses beta and measures reward per unit of systematic risk. Jensen's alpha measures excess return over the CAPM prediction, and the information ratio uses benchmark-relative active risk.

Question 45Performance appraisal

A firm presents a composite report for the first time and has no prior compliant record. Which statement about the minimum presentation period is correct?

  1. The firm may present unaudited projections for future years.
  2. The firm may present a single year and label it a full record.
  3. The firm must wait until five years of history accumulate before presenting.
  4. The firm must present all years since inception, even if fewer than five. Correct answer.

Explanation

GIPS requires annual performance for each year since composite inception, so a new composite presents whatever history exists. There is no waiting period before a firm may present a compliant record. Projected returns are not permitted in a GIPS presentation.

Question 46Performance appraisal

A firm uses a benchmark that it changed two years ago from a broad market index to a sector-specific index. How should the change be presented?

  1. Show the current benchmark and disclose the change and the date it took effect. Correct answer.
  2. Restate prior years using the new benchmark.
  3. Show both benchmarks for all years without explanation.
  4. Show only the new benchmark without mentioning the prior one.

Explanation

When a benchmark changes, the firm must disclose the change and the date it became effective so readers understand the performance context. Retroactively substituting the new benchmark would misrepresent prior results. Silence about the change would obscure a material shift in the presentation.

Question 47Performance appraisal

A composite's gross-of-fees return is 9.5% and its net-of-fees return is 8.1%. The firm's actual management fee is 1.0%. What does the gap most likely indicate?

  1. The net return must equal the gross return minus exactly the stated fee.
  2. The net return reflects a fee model that includes more than the stated management fee. Correct answer.
  3. The difference is due to market movement during the period.
  4. The gross return was calculated incorrectly.

Explanation

The 1.4 percentage point gap exceeds the stated 1.0% management fee, suggesting the net return incorporates additional costs or a conservative fee model. GIPS requires that the fee methodology be disclosed so readers can interpret the relationship. A net return is not required to equal gross minus the stated fee in every case.

Question 48Performance appraisal

A firm's composite has a 10-year record, but the firm began using a new valuation source for one asset class three years ago. What is the appropriate treatment in the composite presentation?

  1. Make no change because valuation sources are not disclosed.
  2. Remove the affected asset class from the composite retroactively.
  3. Restate all prior years using the new valuation source.
  4. Disclose the change in valuation source and its effective date. Correct answer.

Explanation

Changes in valuation methods or sources can materially affect returns and must be disclosed with their effective date. Retroactive restatement or retroactive removal of assets would alter the historical record improperly. GIPS requires transparency about significant valuation policies.

Question 49Performance appraisal

An analyst computes a composite's dispersion using the asset-weighted standard deviation of portfolio returns. A colleague argues that equal-weighted standard deviation is preferable because it gives each portfolio equal influence. Which response is most defensible under GIPS?

  1. Either measure may be used if applied consistently and disclosed, but GIPS requires disclosure of which measure is used. Correct answer.
  2. Dispersion need not be disclosed when the composite has more than six portfolios.
  3. Only the equal-weighted measure is permitted.
  4. Only the asset-weighted measure is permitted.

Explanation

GIPS permits more than one internal dispersion measure as long as the firm applies it consistently and discloses which measure is presented. The requirement is transparency, not a single mandated formula. Dispersion disclosure is required when the composite contains six or more portfolios for the full period.

Question 50Performance appraisal

A portfolio reports a Sharpe ratio of 0.90 and a Sortino ratio of 1.40. What is the most reasonable interpretation?

  1. The portfolio's returns are negatively skewed and the Sortino ratio is therefore invalid.
  2. The portfolio's downside volatility is lower than its total volatility, which raises the Sortino ratio. Correct answer.
  3. The two ratios must be equal when the risk-free rate is positive.
  4. The Sortino ratio is overstated because it uses total standard deviation.

Explanation

The Sortino ratio uses downside deviation in the denominator, so a value above the Sharpe ratio generally indicates that downside deviations are smaller than total volatility. The two ratios need not be equal, and a positive risk-free rate does not force equality. The Sortino ratio does not use total standard deviation.