The Smart Way to Tackle CAIA Level 2 in 2026: Due Diligence and Manager Selection

The Smart Way to Tackle CAIA Level 2 in 2026: Due Diligence and Manager Selection

Topic 7 (“Due Diligence and Selecting Managers”) is where otherwise well-prepared CAIA Level II candidates hemorrhage points—precisely because it’s wordy, list-heavy, and often taught in a way that doesn’t match day-to-day diligence workflows. Candidates on Reddit routinely describe the due diligence section as “non-intuitive” and difficult to “approach” even when they work in manager selection professionally.  The solution is to study it like an allocator: build a repeatable selection system, then learn how CAIA tests the system under time pressure.

Start with the exam reality (so you study the right output)

The Level II exam is split into two timed sections: Section 1 has 100 multiple-choice questions (130 minutes) and Section 2 has three constructed-response (CRQ) sets (130 minutes).  CAIA’s own guidance emphasizes time management tactics like flagging and revisiting questions—use that same discipline in practice.  Also, fewer than 30% of Level II questions are calculation-based, so your edge comes from structured judgment, not math stamina.

For 2026 specifically, CAIA reiterates that the curriculum is updated annually and that using prior editions is not recommended—which matters in Topic 7 because governance norms, risk controls, and “current issues” evolve.

The “pro” framework: a 5-stage manager selection lifecycle

Topic 7 is easiest when you map every reading objective into a single lifecycle.

1) Fund selection is the real decision (and it’s path dependent)

Private fund outcomes are highly dispersed, which is why fund selection dominates results. Your job is to connect this intuition to CAIA’s framing:

• GP–LP dynamics: recognize information asymmetry and adverse selection risk before commitment (who comes to market, and why now?).

• GP–LP relationship lifecycle: diligence changes across entry/establish, build/harvest, then decline/exit phases—expect different transparency, incentives, and behavior at each stage (e.g., fundraising narratives vs harvesting discipline).

• “High vs low quartile through time”: don’t treat quartiles as static labels; ask what process and repeatable edge could plausibly sustain the spread.

2) Treat persistence as a hypothesis, not a promise

CAIA expects you to understand the performance persistence hypothesis, what evidence supports it, and where it breaks. The professional way to express this is with a transition-matrix mindset: “If a manager was top-quartile last fund, what is the probability distribution of quartile outcomes next fund?” That’s what a transition matrix operationalizes.

Then layer the practical caveats CAIA cares about:

• persistence can be distorted by selection effects (who survives, who raises follow-on funds),

• the implementability problem (allocation decisions are made with partial, lagged, and sometimes curated data),

• “gatekeeper risk” (outsourced selection can concentrate everyone into the same trades at the same time).

3) Run manager selection as an agency-problem audit

CAIA explicitly asks you to understand how moral hazard, adverse selection, and the holdup problem shape fund management. Translate that into a diligence checklist:

• Moral hazard: after you commit, how can the GP change risk, valuation, or liquidity posture to protect fees/carry?

• Holdup: what rights do you actually have if terms change or key people leave—before and after the commitment is locked?

• Adverse selection: what is the GP not showing you (pipeline quality, failed deals, mark methodology, concentration, side-letter asymmetry)?

This is where governance frameworks matter. Institutional Limited Partners Association emphasizes alignment, governance, and transparency as core principles; learn the vocabulary because it reappears across Topic 7’s terms, structures, and monitoring.

4) Screen with “fundamental questions,” then validate with evidence

CAIA’s screening objectives are best handled as four buckets—each with “tell me, show me, prove it” rigor:

1. Investment program: What markets, instruments, and edge sources? What capacity constraints? What breaks the edge?

2. Objective: What return target, risk budget, liquidity profile, and benchmark logic?

3. Process: Sourcing → underwriting → portfolio construction → risk controls → exit/harvest. Where are the failure points?

4. Value add: Separate skill from beta and leverage. Ask what the manager does that a replicable strategy cannot.

Then do the performance review the way CAIA intends:

• incorporate AUM history (skill can dilute as assets scale),

• interpret drawdowns by depth and duration (path risk, not just endpoint returns),

• and be ready to name classic statistical traps: survivorship/selection bias, backfill bias, non-stationarity/regime change, autocorrelation/return smoothing, and overfitting from small samples.

CAIA also highlights behavioral distortions—herding, expectation bias, and “gaming” incentives—because they explain why “clean” past data can be misleading.

5) Monitoring is where LPs create (or lose) value

CAIA distinguishes portfolio monitoring vs individual-asset monitoring, and expects you to know monitoring activities, objectives, and limits. The “pro” posture is: monitor to detect drift early, validate controls, and improve outcomes via governance. Active involvement can occur through formal governance (e.g., LPAC engagement, consent rights) and outside governance (e.g., negotiated reporting, periodic deep dives).

Operationally, your monitoring lens should mirror U.S. Securities and Exchange Commission diligence themes: third-party data (aggregators), valuation integrity, and verification discipline.

Use the case studies as pattern recognition, not trivia

The “tail events” and fraud cases (Amaranth Advisors, Long-Term Capital Management, Carlyle Capital Corporation; Bayou Management, Bernie Madoff, Theranos, FTX) are there to teach failure modes: leverage + crowded trades, volatility-of-volatility exposure, operational control gaps, valuation manipulation, and governance failures. Learn the “why it failed” mechanism and turn it into diligence questions and red flags.

How to study Topic 7 efficiently (what successful candidates actually do)

Candidates repeatedly recommend moving through material quickly, then “grinding” practice—because Topic 7 is dominated by qualitative lists that only stick through repetition.  For CRQs, the consistent advice is: don’t write essays; answer in clean bullet points, and if the prompt says “list 3,” don’t dump 10.

Finally, leverage official guidance and resources: CAIA positions due diligence and manager selection as a core Level II topic area and publishes member-oriented diligence resources to move candidates beyond generic risk/return talk.

If you can express Topic 7 as one integrated lifecycle—selection → persistence judgment → agency-risk audit → evidence-based screening → operational/terms diligence → monitoring—you’ll both score higher and sound like a practitioner in the constructed responses.