We have been warning investors for some time to prepare themselves for lower returns from the financial markets. Our caution was based purely on valuation concerns and not on an ability to forecast either market sentiment or some major macroeconomic event. Bonds have already corrected from extremely overvalued levels following last year's now-famous speech by then Fed chairman Ben Bernanke, who warned that the central bank may reduce or taper its bond-buying programme. Listed property, which tracked the trends in bond yields, also corrected in the first half of last year. Equities however continued to surprise us by pushing ever higher. The long-awaited decline in stock prices finally arrived over the past quarter, with the JSE All Share Index losing 2.1%. This modest correction still leaves the market at an elevated valuation level and more weakness would not surprise us.

Commodity prices have been weak, reflecting concerns about Chinese economic growth. As a consequence, the resources sector was hit hardest during the correction, falling by 7.1% over the quarter, with platinum stocks doing particularly poorly. The South African economy continued to struggle, with many companies reporting disappointing results. The collapse of African Bank was the most dramatic evidence of the tough conditions in the lower LSM categories. Unemployment, strikes and general over-indebtedness brought the unsecured credit provider to its knees. Your fund, in keeping with its risk mandate, had zero exposure to African Bank's equities and debt instruments.

The fund's exposure to growth assets declined a little to 52.2%, well below the maximum target of 60%, reflecting our caution on the valuation of equities in particular. Within the exposure to growth assets we added to global equities through investments in our Global Opportunities Equity fund as well as a small addition to the Global Emerging Markets fund. Exposure to SA equities was reduced to 26.9% of the portfolio from 30.2% at the end of the previous quarter. The largest sales were of Aveng, AVI, BHP Billiton and FirstRand, while we added exposure to Richemont, Old Mutual, Impala and Exxaro. It is our view that bonds have become more attractive relative to equities. The lower maize and oil prices should contribute to somewhat lower inflation numbers for the remainder of the year and less pressure on the Reserve Bank to hike interest rates much further. We added modestly to SA government bonds towards the end of the quarter. In the light of the correction in stock prices the fund showed a return of only 0.6% for the quarter, but the one-year return is still a reasonably healthy 10.4%. The fund's longer term three-, five- and ten-year returns of 14.7%, 12.7% and 13.9% per annum respectively, all remain comfortably above the target of inflation plus 4%.

Portfolio managers
Charles de Kock and Henk Groenewald

Equity markets continued to be supportive of fund returns in the second quarter of the year. During the period, the local market and many international stock markets reached new highs. Over the last 12 months, both local and global equities (as measured by the MSCI World Index) returned over 30% in rand terms - a truly exceptional performance. Even more surprising is the fact that the return from local equities comes after a decade of already above-normal returns and despite weak economic news, the longest strike in South Africa's history, and a sovereign credit rating downgrade. Our caution to investors continues to be that returns achieved over the last 10 years are unlikely to be repeated going forward.

We have reduced our equity exposure and increased the use of put options during the quarter. We reduced holdings in AVI, Investec and BHP Billiton as share prices moved closer to our assessment of fair value. We initiated a holding in Old Mutual, as we believe the risks that the company faced during the financial crisis have dissipated, and the strong cash generation underpins the dividend yield.

Despite the recent conclusion of the five-month long strike, the platinum mining companies still face the difficult task of normalising production and right sizing their cost bases. We have used the weakness in share prices to add to our position in Impala Platinum and added to our holdings of platinum-group metal (PGM) ETFs as we believe the strike will lead to reducing abundant stockpiles.

Contrary to strong equity markets, income assets delivered low returns. Cash, government bonds and property stocks all underperformed inflation over the past 12 months. Preference shares and inflation-linked bonds performed better, with returns of 8.5% and 12% respectively for the year. We slowly started to buy government bonds as we no longer believe that a holding of zero is the correct position given their poor performance over the last year.

Given strong global equity markets and a generally weakening exchange rate, international assets contributed strongly to performance over the past 12 months. Our offshore holdings contributed 25% and 35% to the total fund return over the past quarter and year respectively. We maintain our full offshore position, but have hedged a small proportion of our US dollar exposure in rands.

The fund delivered a return of 4.3% for the quarter and 16.9% for the last year. More importantly, long-term performance remains good; the fund delivered 14.6% per annum over the last 5 years and 15% over the last 10 years, both comfortably ahead of our inflation + 4% benchmark.

Looking forward, we continue to think that the investment environment will be tough. Cash still yields negative real returns, and we do not foresee strong real returns from bonds. Global and domestic equities offer the best opportunity to generate inflationbeating returns, but even these are reducing given their recent strong gains. We continue to focus on managing risks within the portfolio and have hedged around a third of our nominal equity exposure by using put options.

Portfolio managers
Charles de Kock and Henk Groenewald Client

2013 turned out to be another year of better than expected returns. The top performing asset class for the year was global equities, of which the strong 27.37% in US dollars translated into an exceptional 56.97% in rands, courtesy of a significantly weaker exchange rate.
The calendar year also saw a significant derating in fixed interest and other interest rate sensitive assets in response to the US Federal Reserve's first hint at tapering in May and the confirmation thereof at their final meeting of the year. Global bonds sold off and our local assets did not escape. The All Bond Index return for the year was below cash and inflation, and the listed property sector delivered single-digit returns for only the third time this decade.

The South African equity market had another good year, delivering a total return of 21.43%. Returns were again driven by industrials (many benefiting from the weaker currency), while the resource sector again underperformed significantly.

Fund performance

We have long maintained a preference for global equities and consistently warned about the risks we perceived in the fixed interest market and listed property. Consequently, the fund was well positioned for the events that transpired in 2013. We had maximum offshore exposure, no exposure to government bonds and very little exposure to the listed property sector.

The fund delivered 16.76% for the year, well above our benchmark of inflation +4%. More importantly, longer-term returns are still satisfactory, with the fund delivering above benchmark returns of 13.48% and 13.75% over three and five years respectively.

Our 25% international exposure delivered over 40% of the total fund return for the year. Domestic equity also contributed handsomely, although our strategy of insuring with put options again reduced returns. Like insurance premiums, the value of these options will only become apparent in the inevitable tougher times.

The lower risk fixed interest and property assets owned by the fund performed admirably in the face of what was a significant adverse change during the year. We are happy that this portion of the portfolio has demonstrated its resilience during a true test.

Looking forward

We have warned investors for some time to expect lower returns in future, but markets again surprised us in 2013. It is easy to get lulled into a false sense of security given the fantastic returns South African investors have enjoyed over the last decade. We caution that markets are volatile and a period of exceptional returns should make you more fearful of future returns, not less.

Going into 2014, the fund is cautiously positioned. More than a quarter of the local equity exposure is hedged at different levels. We are still not attracted to government bonds and have taken very little interest rate risk. We maintain a close to full offshore exposure due to our view that global markets present more attractive opportunities and better valuations.

Fund manager changes

As has been announced before, Louis Stassen will assume a new role within Coronation from the beginning of 2014. Louis has managed and co-managed this fund for 8 out of the 12.5 years of its existence. He has been instrumental in establishing absolute return investing in the South African market and is responsible for a huge part of this fund (and Coronation's) success. Louis will be heading up Coronation's global equity initiative from this year and we are fortunate to be able to retain his skills and experience within the business.

The fund will also lose the direct involvement of Duane Cable. Duane has distinguished himself as an analyst and fund manager since joining Coronation and has recently been promoted to head of SA equities. He will be co-managing the Houseview portfolios (including the Coronation Equity Fund) with Karl Leinberger from 2014.

In future, Charles de Kock will manage the absolute return portfolios together with Henk Groenewald. Charles should be well known to the market for running the hugely successful Balanced Defensive unit trust fund. Charles has decades of experience in investing and we are very fortunate to be able to draw on the wisdom of a seasoned investment mind.

Despite the changes, this fund will continue to be managed with exactly the same process and philosophy that has been refined since inception under various fund managers.

We are acutely aware that investors have entrusted us with their capital and remain committed to the fund's mandate of achieving real returns within acceptable levels of risk.