CIFA INTERMEDIATE LEVEL

PORTFOLIO MANAGEMENT

THURSDAY: 25 April 2024. Morning Paper. Time Allowed: 3 hours.

Answer ALL questions. Marks allocated to each question are shown at the end of the question. Show ALL your
workings. Do NOT write anything on this paper.

QUESTION ONE
(a) Kemikali Ltd. is a locally incorporated firm operating in the field of investments and asset management with its
asset under management (AUM) in excess of Sh.5 billion. Teddy Kioko is a high net worth individual and is
seeking to invest Sh.150 million mainly in bonds and other long-term investments through the firm.

Required:
Evaluate the FOUR major steps in the portfolio management process that are expected to be followed while
investing the client’s funds. (4 marks)

(b) As a portfolio manager of XYZ Ltd., you have been tasked to prepare an outline to be used by new entrants to
portfolio management on investment performance standards.

Required:
Prepare the outline covering FIVE features of investment performance standards. (5 marks)

(c) James Kimani, a security broker gathers the following information relating to three securities:

Security Beta Current price Expected price Expected dividend

Sh. Sh. Sh.
Unix (U) 0.85 22 24 0.75
Nice (N) 1.25 48 51 2.00
Dent (D) -0.20 37 40 1.25

Additional information:
1. The expected risk free rate in 10%.

2. The expected market return is 14%.

Required:
(i) Determine the required rate of return for security Unix, Nice and Dent using the Security Market Line
(SML). (4 marks)

(ii) Determine the expected return using the holding period return for security Unix, Nice and Dent.
(3 marks)

(iii) Using appropriate justification, advise James Kimani on the appropriate action to take on security Unix,
Nice and Dent. (4 marks)
(Total: 20 marks)

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QUESTION TWO
(a) Stephen Kirumba, a private wealth manager is meeting with a client, Peter Kalibo, in order to create an Investment
Policy Statement (IPS) for Kalibo’s upcoming retirement. Kalibo estimates that he will require Sh.2 million per
year, with annual increases for inflation, during retirement. Kalibo’s primary spending goals during retirement are
to provide for his family’s needs and maintain his retirement style. His secondary goals are to fund his
philanthropic activities and leave a significant inheritance to his children. During his retirement, Kalibo will
receive union pension payments of Sh.500,000 per year with annual increases for inflation. In his spare time, he
runs a small business that provides him with an annual income of Sh.1.2 million and is valued at Sh.10 million. He
will continue running his business during retirement. Kalibo holds a portfolio of securities valued at Sh.40 million.
The portfolio primarily contains dividend paying securities and interest bearing bonds. Kalibo has reinvested all
these distribution back into his portfolio but anticipates that after retirement he may need to use some of the
distributions to fund his expenses. Kalibo plans to buy a vacation home in three years. His budget for the vacation
home is Sh.14 million. Kalibo has not decided yet how he will fund this purchase.

Required:
Prepare the investment objectives section of Kalibo’s Investment Policy Statement (IPS). (4 marks)

(b) Outline SIX principles underlying the ethical responsibilities relating to providers of portfolio management
services and clients. (6 marks)

(c) An investor has decided to invest Sh.1 million in two securities, namely; security KLM and security AQR. The
projections of returns from the two securities along with their probabilities are as follows:

Projected Returns
Probabilities Security KLM (%) Security AQR (%)
0.20 12 16
0.25 14 10
0.25 -7 28
0.30 28 -2

Required:
(i) Expected return of security KLM and security AQR. (2 marks)

(ii) Standard deviation of security KLM and security AQR. (4 marks)

(iii) Covariance of security KLM and security AQR. (2 marks)

(iv) The proportion of security KLM and security AQR to formulate a minimum risk portfolio. (2 marks)
(Total: 20 marks)

QUESTION THREE
(a) Describe THREE document classification systems. (6 marks)

(b) An investor is considering four individual securities whose active returns are assumed to be uncorrelated with each
other and have active return volatilities. The investor believes the first two securities will outperform the other two
over the next year and thus assigns score of +1 and -1 to the first and second groups, respectively. The scores and
the active return volatilities for the four securities are as follows:
Security Score Volatility (%)
1 1.0 25
2 1.0 50
3 -1.0 25
4 -1.0 50

Additional information:
1. The information coefficient is 0.20.

2. The investor wants to maximise the expected active return of the portfolio subject to an active risk
constraint of 9.0%.

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 The investor uses the following formula:
∆ W 1 = U1 x бA
б 21 IC BR

Required:
Calculate the active weights that should be assigned to each of the securities using the formula above. (4 marks)

(c) Consider the following annual returns generated by two different active equity portfolio managers, A and B as well
as those of the security index:
Period (n) Manager A (%) Manager B (%) Security Index (%)
1 12.8 13.9 11.8
2 -2.1 -4.2 -2.2
3 15.6 13.5 18.9
4 0.8 2.9 -0.5
5 -7.9 -5.9 -3.9
6 23.2 26.3 21.7
7 -10.4 -11.2 -13.2
8 5.6 5.5 5.3
9 2.3 4.2 2.4
10 19.0 18.8 19.7

Required:
(i) Determine whether any of the manager outperformed or underperformed the index subject to the
benchmark. (2 marks)

(ii) Calculate the tracking error for each manager in relation to the index. (6 marks)

(iii) Based on your answer in (c) (ii) above, explain which of the two managers performed better. (2 marks)
(Total: 20 marks)

QUESTION FOUR
(a) In relation to contemporary issues and emerging markets:
(i) Describe the concept of security lending. (2 marks)

(ii) Analyse THREE contemporary issues shaping the security lending practice in your country. (6 marks)

(b) Mwanahamisi Zaid is an investment practitioner with Wetu Capital Ltd. and is analysing the likely investment
performance for her clients’ accounts whose details has been presented below:
1. Account A11 – An investment account subject to accrual taxes only. Sh.100,000 is to be invested for 20
years and is likely to earn a before tax return of 10%. The estimated tax rate is 30% with no withdrawals.
2. Account A12 – An investment account with deferred capital gains taxes only. Sh.400,000 to be invested
for 20 years and likely to earn a pre-tax return of 10%. Capital gains tax rate estimated is 30% with no
withdrawals.
3. Account A13 – Effect of cost basis on capital gains taxes. Sh.500,000 is to be invested for 20 years at a
return of 10%. The estimated capital gains tax is 30% and a cost basis of Sh.375,000.
4. Account A14 – Account based on wealth based taxes only. Sh.1 million will be invested for 20 years and
is estimated to earn a return of 10%. The account will be subject to only wealth based tax estimated at
2%. No withdrawals.
5. Account A15 – Combined effect of multiple taxes. Sh.100,000 is to be invested at the beginning of the
year and it is estimated to earn 10% with no withdrawals or additional contributions. During the year,
estimated dividends of Sh.4,000 interest of Sh.300 and Sh.2,200 realised capital gains are highly likely
and all proceeds will be re-invested into the portfolio. The estimated tax rates on interest, dividends and
capital gains are 30%, 20% and 20% respectively.

Mwanahamisi Zaid seeks your help to determine the after tax value of each investment account to be estimated.

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 Required:
(i) The after tax value of investment account A11 in 20 years. (2 marks)
(ii) The after tax value of investment account A12 in 20 years. (2 marks)
(iii) The after tax value of investment account A13 in 20 years. (2 marks)
(iv) The after tax value of investment account A14 in 20 years. (2 marks)
(v) The realised after tax return (RATR) and the investment account balance after payment of taxes with
respect to account A15. (4 marks)
(Total: 20 marks)

QUESTION FIVE
(a) A portfolio manager has encountered the following situations:

1. Following a major security market crash, investors are less inclined to invest in equity funds and more
inclined to invest in bond funds.
2. An investor select investment funds on the basis of strong past performance.

Required:
Identify TWO behavioural biases and describe how they influence people’s decision making in the situations
described above. (8 marks)

(b) An investor uses a macro-economic model to calculate the tracking error and mean active return of the following
three portfolios:

Portfolio Tracking error (%) Mean active return (%)

1 1.50 1.50
2 1.30 -0.50
3 1.00 0.50

Required:
Determine which portfolio has the highest information ratio. (3 marks)

(c) A portfolio consist of equally weighted securities that has an identical correlation coefficient of 0.4 between all
pairs of securities. Each security has the same variance of 0.0625.

Required:
Determine the standard deviation of the equity portfolio for the following securities:

(i) 30 securities. (2 marks)

(ii) Unlimited number of securities. (2 marks)

(d) Berline Anyangwa, a portfolio manager, manages a portfolio that is 60% invested in security Apple and 40%
invested in security Bold. The following information is also available:

Security Standard deviation of daily returns Mean daily return Covariance of daily return
Apple 0.0158 0.0004 0.000106
Bold 0.0112 0.0003
Critical Z-value at 5% = 1.65

Hint VaR = E(RP) - (Z) (δ) x Vp

Required:
(i) The 5% daily value at Risk (VaR). (3 marks)

(ii) Assuming the distribution of daily returns is constant over the year, that there are 250 trading days in one
year and that daily returns are independently distributed. Calculate the 5% daily and annual VaR for a
portfolio of Sh.10 million. (2 marks)
(Total: 20 marks)
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