During October domestic industrial shares (and to a lesser extent financials) continued to rally on the back of a booming domestic consumer economy. A stronger rand exerted pressure on resource stocks. Strong credit extension by retailers saw credit based retailers among the strongest performers. Although forward ratings of these shares do not appear excessive, we believe prospective earnings now to be well above normal levels. In line with our investment philosophy, the fund has cut its exposure to these shares, where we were previously very overweight, when their share prices exceeded our fair value targets e.g. the Fund bought Edcon in 2002 at R27.50 and sold the position earlier this year at R145. Although we can be criticised for selling out of the Edcon position too early, we believe the prudence of this philosophy is clearly illustrated by the fund's longer term performance and risk track record. Over 12 months the fund has delivered a respectable 21.7%.

The South African stockmarket appreciated strongly in September and is up 20% since July 2004 and 60% from its lows in April last year. Bonds also appreciated strongly since the interest rate cut in August. Although clearly not as attractive as in July or April last year, the fund manager's still prefer domestic shares to bonds and cash. The strongest appreciation came from industrial shares, especially retailers, on the back of strong earnings growth. In certain cases the fund manager's believe earnings now to be unsustainably high. The fund manager's continue to rotate the fund out of these industrial shares into banking and selected resource shares where they now find valuations more attractive. The fund continues to hold a reasonable exposure to resource shares and foreign assets, based on attractive valuations and what the fund manager's believe to be an unsustainably strong rand.

Allan Gray Balanced Fund (AGBF) has just marked its fifth anniversary by boosting total assets to more than R6bn. This makes it the largest fund in any SA sector (other than money market funds), a fitting tribute to a track record of 194% total annualised return generated since its inception in 1999. This is more than double the return of the average prudential fund.

This record is in keeping with a house tradition in which Allan Gray's institutional balanced portfolios have delivered above-average returns in 22 out of the past 26 calendar years. Yet manager Arjen Lugtenburg says net inflows into AGBF have slowed markedly.

The key reason is that performance is not as strong as in the past, as indicated by AGBF's comparatively low position in the sector rankings. Has AGBF grown too big to sustain its leading position? "No," answers Lugtenburg. "If you take equity holdings in all the Allan Gray portfolios, they represent only 3,5% of the total JSE free float market cap."

Though AGBF's size does preclude it from investing heavily in shares with smaller market caps, value is now spread evenly across the market, says Lugtenburg. This permits AGBF to pursue its investment objective of seeking out neglected, undervalued situations.

AGBF's top long-term returns have come from doing just that and the result has often been a portfolio differing radically from the norm. This is evident at present, as AGBF has cut its industrial exposure and built its financial and resource exposure in direct contrast to the general trend.

Retailers are benefiting from strong consumer spending, Lugtenburg says. So are banks, but with the advantage that the benefits for them are of a longer-term nature. "There is also a higher degree of certainty with banks' earnings than with those of retailers."

On resource stocks, Lugtenburg notes: "Resources look expensive but we believe the rand's strength is not sustainable." For this reason foreign exposure is being increased, he says.

By turning their backs on AGBF, investors could be in danger of taking too short a view as they chase after the latest fund and sector favourites.

The surprise during August came from the unexpected 0.5% interest rate cut. Although not the claimed intent, the rand immediately weakened, and resource and other rand-hedge shares appreciated in value. While this action may not be indicative of the future value of the rand, it does illustrate the risk to a portfolio of being underweight these shares, at a time when they are offering reasonable value and the rand is overbought. The fund manager's continue to believe the rand to be unsustainably strong and that selected resource shares offer good value. The fund manager's are also finding investment opportunities elsewhere in the world with competitive return expectations eg, Japan. The fund manager's therefore used the recent rand strength and Reserve Bank approval to increase the funds holdings in offshore assets and selected resource shares. In response to relative valuation moves, the fund manager's also continued to rotate the fund out of industrial shares, especially retailers, in favour of resource and banking shares.

Value remains broad based through the JSE. However, the ever strengthening rand and strong domestic economy is causing rotation in the market towards industrial shares away from resource shares. With industrial shares becoming more expensive, the fund manager's have continued to rotate the funds portfolio away from them (where the fund was very overweight 12 months ago), in favour of financials (mainly banks) and selected resource shares. These changes in the portfolio are being driven by relative value changes. The funds existing and increasing resource exposure has impacted negatively on the funds relative performance. The fund manager's however believe this position is prudent due to an unsustainably strong rand and the increasing value to be found in some resource shares. The fund manager's have also obtained Reserve Bank approval to take some funds offshore and with the current rand strength, the fund manager's thought it prudent to do so.

Value remains broad based through the JSE. However, the ever strengthening rand and strong domestic economy is causing rotation in the market towards industrial shares away from resource shares. With industrial shares becoming more expensive, the fund manager's have continued to rotate the funds portfolio away from them (where the fund was very overweight 12 months ago), in favour of financials (mainly banks) and selected resource shares. These changes in the portfolio are being driven by relative value changes. The funds existing and increasing resource exposure has impacted negatively on the funds relative performance. The fund manager's however believe this position is prudent due to an unsustainably strong rand and the increasing value to be found in some resource shares. The fund manager's have also obtained Reserve Bank approval to take some funds offshore and with the current rand strength, the fund manager's thought it prudent to do so.

In line with international markets, the FTSE/JSE All Share index had a positive return of 16.1% during 2003. The SA market's performance was tempered by the strong rand and returns in US dollar terms were dramatic. The fund benefited from the strong market through relatively high share exposure and superior stock selection, returning 23.2% over the year against the average prudential funds return of 16.1%. Looking forward the SA share market continues to offer attractive potential returns, both from an absolute basis and relative to competing asset classes. Although earnings will be under pressure in the short-term due to the strength of the rand, long-term growth prospects are good, interest rates have declined significantly and companies have ample room to increase gearing and hence return on equity. The fund manager's continue to favour a relatively high exposure to domestic equities.

Not long after the fund's launch in October 1999, the FM tipped Allan Gray Balanced Fund (AGBF) as "a leading contender for your retirement funds". It has yet to disappoint, sustaining a level and a consistency of performance unrivalled in its sector.

But with performance success has come asset growth to a point where, at R3,5bn, AGBF is now SA's second-largest unit trust. This raises the question: can Allan Gray still achieve optimum returns in a market with a restricted number of marketable shares?

"It is a question we are now being asked continually. And the answer is yes, we believe we can," says fund manager Arjen Lugtenburg. "Even with total equity assets of about R47bn managed by Allan Gray, we are still a relatively small fish in the JSE's R1,6 trillion pool."

To further allay doubts, Lugtenburg makes the point that about 90% of all Allan Gray's fees are based on performance, making group profits more sensitive to returns than to asset size. "If we thought total assets were growing to a point where they would detract from performance, we would not accept new institutional funds."

Lugtenburg also downplays a perception that small-cap shares have driven AGBF's returns. "In reality, our studies show that small caps have been responsible for under 5% of performance and midcaps for under 25%. And, though we can no longer play in small caps, there are still about 120-150 shares in our purchase universe, much the same as it has been for 15 years."

For now, Lugtenburg is convinced there is enough value to be found in that universe to generate further solid returns. However: "The past five years were an exceptional period in which valuation differentials were all over the place," says Lugtenburg. "Though [these are] gone to an extent, lower interest rates underpin value."

Though investors are told that past performance should not be seen as a guide to the future, AGBF's record, generated in some tough market conditions, is hard to ignore.