Global and domestic equity markets continued the rally from the lows established in early March this year and performed very strongly over the quarter. The fund also had a very strong quarter, returning 9.2%. For the past year, the fund return is now 15.1%, while the annualised return since inception is 15.4% - well ahead of the outperformance target of inflation plus 4%.

The equity component of the fund again outperformed general market indices, despite a very defensive positioning within equities. Strong performances include top holdings such as Naspers, SAB Miller, Woolworths, Remgro and Liberty International.

We have started reducing domestic equity exposure in the fund as shares have started approaching fair values. At the time of writing, effective exposure in domestic equities in the fund is 35%.

Positions in Impala Platinum, Truworths and Netcare have largely been sold out. We have also reduced position sizes in some of our larger holdings such as SAB Miller, JSE Ltd. and Woolworths. Liberty International, clearly a beneficiary from risk appetite returning to global markets, was largely sold out. The timing of this sale proved to be fortuitous as the company unexpectedly announced another large capital raising.

During the quarter we also established new positions in Hulamin and Tongaat, as well as continued building positions in Shoprite, Vodacom and Spar.

The domestic listed property component of the fund performed very well and was also a major contributor to fund performance. While we have become more cautious at current price levels, forward yields of around 9% remain attractive and based on our analysis, distribution growth prospects for the quality property companies remains intact. Our positioning here is very defensive, with a focus on quality retail and A-grade offices.

The fixed income component of the fund also performed well over the quarter. Based on the large sell-off in bond rates leading up to the start of the quarter we took a tactical position in corporate bonds which paid off. This exposure has subsequently been switched into floating rate exposure as long bond rates have declined. This allows us to retain exposure to corporate spreads approaching 300bp above equivalent government bonds, and is certainly a very attractive alternative to the current low yield on cash.

We have continued building inflation-linked bond exposure within the fund to the current level of 8%. These bonds offer attractive diversification properties given their low correlation to other asset classes, and are a natural fit in a portfolio striving to provide positive real returns with low risk. We continue to believe that the risks to inflation both globally and locally remain to the upside over the medium to longer term.

The international component of the fund benefited from strongly rising global equity markets in dollar terms, only slightly reduced by continued strength in the rand. While currencies are notoriously difficult to forecast, it is clear from our interactions with Corporate SA that the current level of the rand is proving to be very challenging to the competitiveness and profitability of many companies, and is hence probably unsustainable in the long run. We are certainly maintaining maximum offshore exposure within the fund.

Markets have rallied significantly over the past two quarters. We believe the prudent approach is to reduce risk within the fund. Many of the more cyclical shares are in our opinion discounting a too optimistic expectation of the magnitude and sustainability of economic recovery, with good examples being construction shares and clothing retailers. Earnings bases for these shares are already high after a number of years of economic prosperity and above average margins.

Within the fund we will continue reducing equity exposure into a rising market and remain very defensively positioned within the equity component of the fund. Fund exposure is well balanced across a variety of asset classes, which we believe is a strength going forward in a world of significant economic uncertainty.

Portfolio managers
Edwin Schultz, Gavin Joubert and Louis Stassen

Global and domestic equity markets rebounded strongly in the second quarter of this year. The fund performed well, returning 3.7% for the quarter and 8.9% for the past year. The fund has achieved an annualised return of 15.4% over the past five years, which is well ahead of the outperformance target of inflation plus 4%. This return was achieved with low risk as evidenced by low volatility of fund returns.

The equity component of the fund performed well above market indices, despite a very defensive positioning as described in the last quarterly. Strong performances include top holdings such as Naspers, SABMiller, Standard Bank, JSE Ltd, Woolworths and Spar. During the quarter we further increased positions in Spar and SABMiller, which remain attractively priced and also have defensive earnings streams. Despite tentative evidence of global economic recovery, we remain sceptical of the sustainability thereof. Quality and sustainable earnings will remain an important attribute of the portfolio going forward. In this regard, one of the poorest performers in the portfolio this quarter was British American Tobacco. With the ultimate defensive earnings stream, and a dividend yield exceeding 6%, we remain long-term holders. Post the Telkom unbundling we have also built a position in Vodacom, which we believe to be an attractive asset for the longer term. At the same time we have completely sold out of our holding in the fixed line operations. Other sales during the quarter were largely on the resources side into a strong market, particularly BHP Billiton and Impala Platinum.

The bond component of the fund has continued to prove its defensive characteristics, adding to performance in an environment of further rising bond yields. Our weighting in conventional bonds remains very low. Given the large sell-off year to date, we will start looking at attractive entry points, especially in high quality corporate bonds, where spreads are very attractive and corporates are desperate for funding. We have continued to build on our position in inflation-linked bonds, which at the time of writing is approaching 5% of fund.

The domestic listed property component of the fund added to performance, despite a tough quarter for listed property. Over the past year, domestic listed property has added materially to overall fund performance.

While the international component of the fund performed strongly in dollar terms, a much stronger rand (24% appreciation versus the dollar over the past quarter) has led to a negative contribution to overall fund performance. Hedging against a stronger local currency reduced this impact somewhat, but has since been closed out.

We continue to see good opportunities in the market, and thus good prospects for risk adjusted returns for the fund going forward.

Portfolio managers
Edwin Schultz, Gavin Joubert and Louis Stassen

Volatility in world markets continued unabated this past quarter, with the broad US equity market down over 30% (in dollars) at one stage. The introduction of the public-private investment programme (PPIP) by the US Treasury saw confidence return, causing markets to rally significantly and the US market closing down only 12%. Locally, the equity market followed a similar trajectory and closed at -4.2%. The fund was down 1.6%.

Although the equity component of the fund held up much better than the overall equity market (-1.6% vs -4.2%), the 36% allocation to local equity still detracted from performance. We continue to see an attractive opportunity in equity markets and will remain positioned to benefit from an ultimate recovery in share prices. Over the past quarter, we have added to the fund's holdings in MTN, SAB as well as the fund's bank holdings - Stanbic and Absa. At the same time, we have marginally reduced resources exposure into strength, particularly Billiton.

While volatility in equity markets is likely to remain high, and the economic environment is likely to get worse before it gets better, the stocks we have picked are defensive in nature. Large holdings include food producers, pay-TV, beer, tobacco and mobile operators where spend is expected to hold up well in tough economic conditions.

The defensive equity position and focus on limited downside have resulted in low beta in declining markets environments over time. This has been a cornerstone in achieving an annualised return of 14.8% since inception with low volatility.

This defensiveness is also reflected in other asset classes, with the listed property holdings of the fund flat in a negative environment for SA listed property indices over the past quarter. We remain positioned in a few selected counters with an emphasis on quality and robust distribution growth.

Our bond weighting remains low and declined by 1% over the past quarter versus a decline of 5% in the All Bond Index. We remain negative on the level of bond rates, with the risks to inflation on the upside over the longer term and rising issuance by government and parastatals. Given this view, we have also started building a position in inflation-linked bonds, where we can benefit from corporate spreads to achieve yields between 5% and 6% above inflation.

The international component of the fund also detracted from overall performance but performed well ahead of world market indices. Our strategy here remains one of a combination of cash and equity investments to achieve absolute returns with lower volatility than global equity markets. We will continue to run with the maximum offshore allocation as a means of reducing overall portfolio risk. We also believe the valuation opportunity in global equities is very attractive.

2008 saw the worst year for global equity markets since the market crash of 1929, with most major global indices declining by 40% (in dollars), or more. The depreciation of the rand shielded the South African market somewhat and the All Share index ended the year down 23%. Against this backdrop, the fund ended the year marginally positive (+0.71%) and has generated compounded annualised returns of 10.50% over the past 3 years and 15.30% over the past 5 years, with single-digit volatility.

The primary reason for the fund's reasonably good performance over the past year was the avoidance of the three key bubble areas; commodities, construction and small caps. The fund suffered early in the year by having almost zero exposure to these three momentum areas and, instead, holding and buying local industrial and financial shares that were being thrown out by go-go 'investors' as they gobbled up the good news commodity and construction shares. After having a torrid first half in 2008, the fund actually increased by 6.7% in the second half of the year; a period in which the All Share index declined by almost 30%. Truworths (+33%), Mr Price (+21%), Tiger Brands (+15%) and AVI (+11%) were the fund's 4 best holdings in 2008 and were typically the shares that no-one wanted to own earlier in the year (remember, oil was heading towards $200 a barrel, there was no end in sight to interest rate increases and the only companies with bullet-proof earnings were the construction stocks).

Today, of course, the picture is totally different: the commodity bubble has burst, interest rates have started to decline and the construction companies' earnings look quite vulnerable. As a result, investors are now chasing the interest rate sensitive stocks and selling the commodity and construction stocks. As the share prices of the interest rate sensitive shares are pushed up by momentum investors (which is most of the market) many of them are approaching their fair values and we have been reducing these positions. At the same time, we have been slowly and selectively adding to the fund's resource exposure and bought Anglo American for the first time in many years. We still hold no construction stocks as we don't believe that the margin of safety is adequate.

The largest purchase over the past few months has been that of MTN. The fund has held MTN for the past year or so but we substantially increased the position as the share fell below to the level of R75 to R100 over the past few months. We are attracted by the company's dominant position (largest or second largest operator) in several African and Middle East markets where penetration rates are low and, in our view, have many years of growth ahead. After having done extensive research on mobile markets in Emerging Markets across the world, we are of the view that MTN's prospects are amongst the best within its global peer group and that its valuation is by far the most attractive. More importantly, in absolute terms, we also find its valuation very attractive and the company is now trading on a 5 PE on what we believe it will earn 3 years from today.

We are finding decent value in selected equities and as a result the fund's South African equity exposure is around 36%. This exposure is below its maximum limit of 50% but still represents a meaningful position. The fund has also utilised its full foreign exposure of 20% and has just over half of this invested in global equities, which we believe are very cheap. We are still finding selected value in listed property stocks and the fund has a total of around 5% invested in property, with a concentrated focus on the higher quality companies. We also feel that preference shares are very attractive and almost 4% of the fund is invested in this area. In contrast, we feel that bonds are currently expensive and have sold most of our exposure, having been a large buyer earlier in 2008.

The year or two ahead will be very difficult, both in South Africa and globally, from an economic point of view. Additionally, South Africa has the challenge of political uncertainty, particularly as we approach the election. However, with our careful stock selection and considered asset allocation we believe the fund is well positioned to start moving towards achieving double-digit returns again, while at the same time protecting capital during the inevitable periods of volatility.

Edwin Schultz and Gavin Joubert
Portfolio Managers