STRATHMORE INSTITUTE OF MATHEMATICAL SCIENCES

BACHELOR OF BUSINESS SCIENCE IN FINANCIAL ENGINEERING, FINANCIAL

ECONOMICS AND ACTUARIAL SCIENCE
SPECIAL EXAM
BSF 4230 ADVANCED PORTFOLIO MANAGEMENT

DATE: 28th April 2022 Time: 2 Hours

Instructions
1. This examination consists of FIVE questions.
2. Answer Question ONE (COMPULSORY) and any other TWO questions.
Question one

Roberto and Mariana Kibet live in a large city in Kenya with their two children, ages four and
two. Roberto is 30 years old and Mariana will be 30 years old later this month. Roberto is a
manager in a manufacturing facility and Mariana is a musician in the local symphony orchestra.

Roberto and Mariana’s annual salaries total Kshs120,000 after tax. Their salaries just cover their
living expenses. The average annual inflation rate is four percent and their salaries and expenses
are expected to increase at this rate. They are healthy and believe their jobs and earning potential
are secure. The Kibet’s salaries, dividends, and interest are taxed at 20 percent, and capital gains
at 15 percent.

Mariana’s parents have significant wealth and funded an irrevocable personal trust for her.
Kenya has a wealth transfer tax that applies to transfers into trusts and to inheritances. Kenya has
adopted the Prudent Investor Rule for the administration of trusts. The current value of the trust
is Kshs 1,500,000. The terms of the trust state that when Mariana reaches the age of 30, she will
receive a tax-free distribution of half the value of the trust. The balance of the trust will remain
invested and will distribute in total to her when she reaches age 40. Since she does not have
access to the remaining balance for ten years, this balance is not considered a part of the

Kibet’s investable assets, but is part of their total net worth. In addition, Mariana expects to
inherit a substantial sum of money upon the death of both parents.

The Kibets have Kshs 500,000 in investable assets, currently all in short-term bank deposits. It is
their intention to maintain at least this amount in investable assets, on an inflation-adjusted basis,
in the future.

The Kibets currently live with Mariana’s parents, but are now purchasing a home. The purchase
price of the home is Kshs 850,000. The down payment is 30 percent of the cost of the home and
will be funded from the trust distribution. The Kibets will take out a fixed rate mortgage for the
balance of the purchase price. The after-tax mortgage cost will be fixed at Kshs 55,000 (principal
and interest) annually for 30 years, with the first annual payment due one year from now.

The Kibet’s immediate investment goal is to have their investment portfolio cover the cost of the
mortgage, while maintaining the portfolio’s inflation-adjusted value. They plan to retire at the
age of 60 and their long-term goal is to have an investment portfolio that will provide an annual
income comparable to their current salaries adjusted by inflation. Their family health insurance is
provided by Roberto’s employer, both now and in retirement. They are hopeful their two
children will attend the local university at no cost. The university does not charge tuition fees for
qualified students who pass its entrance exam. Those who do not pass the exam are required to
pay full tuition, which is high relative to the Kibet’s living expenses.

In order to meet their investment goals, the Kibets realize they need to consider investments
other than short-term bank deposits. The Kibets hire Luiz Oliveira, CFA, to manage an
investment portfolio that they will fund with their Kshs 500,000 in bank deposits and the net
proceeds of Mariana’s trust distribution at age 30.

Required:

a)
 i) Prepare the return objectives portion of the Kibet’s investment policy statement
(IPS). (2 marks)
ii) Calculate the after-tax nominal rate of return that is required for the next year.
(9 marks)
b)
i) Identify two factors in the Kibet’s situation that increase their ability to take risk.
(2 marks)
ii) Identify two factors in the Kibet’s situation that decrease their ability to take risk.
(2 marks)
iii) Determine whether the Kibets have below-average, average, or above average
ability to take risk. (1 mark)
c) Prepare the following constraints of the Kibet’s IPS:
i) Liquidity. (2 marks)
ii) Time horizon. (3 marks)

Twenty-five years have passed. The Kibets are now 55 years old and their two children are
grown and financially independent. Mariana’s parents passed away earlier this year and left her
an inheritance of Kshs 8,000,000 after-tax. The Kibets have five years remaining on their
mortgage and the Kshs 55,000 annual mortgage payment will continue to be funded from their
investment portfolio. They intend to work another five years and then retire at age 60. Their
salaries are expected to continue to cover their living expenses until retirement. Their investment
portfolio, including the inheritance, now totals Kshs 10,200,000.

The Kibets explain to Oliveira that in retirement, they would like to maintain their current
standard of living and start a regular program of donating money to their favorite charities. They
also hope to leave an inheritance of Kshs 5,000,000 to each of their two children at their death.

Oliveira calculates they will need a portfolio value of Kshs 15,000,000 when they retire in order
to support these goals.

d)
i) Prepare the current return objectives portion of the Kibet’s IPS.
(3 marks; each point is 1 mark)
 ii) Calculate the after-tax nominal rate of return that is required for the portfolio.
(6 marks)

Question Two

a)

Ralph Employees Defined Benefit Plan has the following features:

Kes ‘000’
Projected benefit obligation (PBO) 12,477
Pension assets 8,734
Average duration of pension liabilities 14 years
The plans risk management committee has set a goal to maintain the market value of pension
assets at or above 65 percent of PBO.

The nominal discount rate for calculating PBO in 2022 will be reduced to 6.5 percent from 7.0
percent in 2021.

Roger represents the management of a defined benefit pension plan’s board of trustees and Tate
represents employee plan participants. They make the following statements during a meeting
between the plan participants and the employer:

Roger: “To increase the probability that pension plan assets will be sufficient to fund
pension plan benefits, the plan should invest most of its assets with equity
managers having the best track records as measured against market index
benchmarks.”

Tate: “To avoid the risk of market losses making the funding shortfall worse over the
next year, we should limit TEPP’s investments to short-term, risk-free securities.”

Required:

i) Give reasons why each statement is incorrect, based on the pension plan liabilities. (7
marks).
ii) Evaluate the most likely effect of the change in the discount rate for 2008 on PBO,
holding all else constant. (3 marks)
 b) Discuss the psychological traps that an analyst need to consider when carrying out capital
market expectations forecast. (10 marks)

Question Three

KCB Bank is a US-based commercial bank that began operations in 1896. In order to attract
skilled labor, KCB Bank offers employees attractive benefits which include a defined benefit
pension plan and annual wage increases above the rate of inflation. An asset only (AO) approach
to strategic asset allocation is currently used for the investment management of the pension plan.
Omondi is a consultant to the board of trustees of KCB Bank’s pension plan. The board asks
Omondi to recommend a strategic asset allocation for the pension plan given the following
investment policy objectives:
Return requirement: Earn an average annual return of 8.7 percent plus management and
administration fees of 0.7 percent.
Risk objective: A maximum standard deviation of portfolio returns of 10.0
percent.
For the strategic asset allocation analysis, Omondi has generated the corner portfolios shown in
Exhibit 1. The KCB Bank pension plan investment policy statement (IPS) prohibits short
positions and the use of leverage. The IPS allows investment in any single portfolio or
combination of portfolios described in Exhibit 1.

a) Using traditional mean-variance analysis:

 i) Select the most appropriate portfolio or combination of portfolios for the strategic asset
allocation of the KCB Bank pension plan. Justify your response with two reason other
than meeting KCB Bank’s return requirement. (3 marks)
ii) Determine the weight of total equities (U.S. and non-U.S. combined) in the most
appropriate strategic asset allocation. (5 marks)
b) Omondi proposes that the IPS be changed to allow borrowing or lending at the risk-free rate,
currently 4.5 percent. He suggests that this change would enable KCB Bank’s pension plan to
minimize its expected standard deviation of return while achieving the plan’s required return.
i) Determine the most appropriate strategic asset allocation for the KCB Bank pension
plan based on Omondi’s proposal and the optimal asset allocation for the overall
portfolio. (6.5 marks)
ii) Explain how this allocation improves the plan’s risk-adjusted return. (4 marks)
iii) Determine the weight of total equities (U.S. and non-U.S. combined) in the most
appropriate strategic asset allocation. (1.5 marks)
Question Four

a) An investment adviser is counselling Kerubo, a client who recently inherited Kes 1,200,000
and has above-average risk tolerance (RA = 2). Because Kerubo is young and one of her
purposes is to fund a comfortable retirement, she wants to earn returns that will outpace
inflation in the long term. Goddard expects to liquidate Kes 60,000 of the portfolio in 12
months, however, to make the down payment on a house. If that need arises, she states that it
is important for her to be able to take out the Kes 60,000 without invading the initial capital
of Kes1,200,000. Below are the three alternative strategic asset allocations.

Investor’s Forecasts
Asset Allocation Expected Return Standard Deviation of Return
A 10.00% 20%
B 7.00% 10%
C 5.25% 5%
Required:
 i) Based only on Kerubo’s risk-adjusted expected returns for the asset allocations, which
asset allocation would she prefer? (3 marks)
ii) Given Kerubo’s desire not to invade the Kes 1,200,000 principal, what is the shortfall
level, RL? (2 mark)
iii) According to Roy’s safety-first criterion, which of the three allocations is the best? (3
marks)
iv) Recommend a strategic asset allocation for Goddard. (2 marks)
b) Discuss 4 more challenges in forecasting of assets yields. (6 Marks)
c) Differentiate between the following styles of investment
i) Social Responsible investing
ii) Contrarian Investing. (4 marks)

Question Five
a) Discuss 3 approaches to equity investment portfolio management. (6 marks)
b) When carrying out monitoring of the portfolio, the portfolio manager must review a
number of areas in relation to client’s portfolio. Discuss five areas covered under such
reviews. (10 marks)
c)

Jose Moreno is an analyst for a fund sponsor in Latin America. The fund sponsor uses two equity
managers (Manager A and Manager B) and each invests in developed and emerging markets.

Costa prepares a performance attribution analysis for the total fund. He identifies the fund’s sources
of return and develops the macro attribution table in Exhibit 1.

Exhibit 1
Total Fund Level
Macro Attribution for 1 January – 31 March
Decision-Making Fund Incremental Return Incremental Value
Level Value Contribution (%) Contribution/(Withdrawal)
(Investment (in Kes) (in Kes)
Alternative)
Beginning value 360,000,000 0 0
Risk-free asset 361,800,000 0.5 1,800,000
 Asset category 388,872,000 7.52 27,072,000
Benchmarks 389,376,000 0.14 504,000
Investment 389,664,000 0.08 288,000
managers
Allocation effects 389,304,000 -0.10 (360,000)
Total fund 389,304,000 8.14 29,304,000
Demonstrate whether the total fund outperformed a pure indexing strategy. (4 marks)