The Allan Gray Orbis Global Fund of Funds has trailed its benchmark in both US dollar and rand terms over the past year. More specifically, the Fund has returned 16.2% in rands, vs 20.9% for the benchmark (60% FTSE World and 40% JP Morgan Global Government Bonds). While this short-term underperformance is not easy for investors to weather, it is not unusual in the context of the Fund's history or our investment approach.

We allocate the Fund's capital across a mix of equity, absolute, and more recently, multi-asset class funds managed by Orbis. Over the past year, the net equity exposure has been about 46%. This compares to the 60% weight in equities in the Fund's benchmark. This decision to be underweight equities has been a detractor from the Fund's relative performance, with global equities continuing to rise; they are up 21% over the period.

As is well known, since the global financial crisis, equities across the globe have rallied. The US market has been the stand-out performer, with the S&P 500 roughly tripling since its 2009 lows. While valuations - i.e. the price we pay relative to the earnings of a business - have not reached the dizzy heights of the technology bubble, earnings are generally above average, and so valuations as a function of normalised earnings (the so-called Schiller PE or cyclically adjusted PE) are at levels consistent with previous peaks.

Combined with this, the low level of interest rates has brought prospective real returns on holding money market instruments, US Treasuries and many high-grade investment bonds to nearly zero. This causes investor to chase 'risky' assets, while becoming less mindful of the inherent risk. When sentiment is benign, and asset prices have risen, we become more cautious.

Warren Buffett noted that "the less prudence with which others conduct their affairs the greater the prudence with which we should conduct our own affairs". Our objective is to seek superior, risk-adjusted returns. This means that we try to strike the right balance between the pursuit of upside (including the risk of missing out on this upside), versus the risk of permanent capital loss. At current market prices it is hard to find value and the Fund's net equity exposure is substantially below the benchmark exposure of 60%.

This is not to say we are not excited about the selected opportunities that the Orbis team is uncovering - as described in more detail in the Orbis quarterly reports available via the 'Offshore' section of www.allangray.co.za. We balance these views through our allocation to the Orbis Funds, including into the Orbis Optimal SA Funds, where we can access the potential for these stocks to outperform their respective benchmarks and at the same time protect against the risk of a broader stock market decline.

We cannot reliably predict the precise timing of any turn in the cycle, nor do we try to. Irrespective of the environment, the approach remains consistent: we focus our time and efforts on ensuring the Fund is positioned in the areas, stocks and geographies that offer the most attractive, risk-adjusted returns. We are confident this will serve our clients well over the long term.

Commentary contributed by Tamryn Lamb

Since the Fund's inception in 2004 it has invested in a mix of equity and absolute return funds managed by our offshore investment partner and sister company, Orbis. Depending on our assessment of the potential upside from global stock markets relative to their risk of capital loss, we actively manage the Fund's net equity, currency and overall geographic exposure by varying the allocations to the underlying Orbis funds.

More recently Orbis has added a new dimension to our fund choice, in the form of the Orbis Global Balanced Fund. Launched in January 2013, this multi-asset class fund can invest directly in equities, fixed income and commodity-linked instruments to balance capital appreciation and risk of loss with a diversified global portfolio (for more detailed information please read our May GrayIssue, available via the 'Latest news' tab on our homepage www.allangray.co.za). Like with other Orbis and Allan Gray funds, the percentage of the portfolio that is allocated across the various asset classes is driven from the bottom up, drawing on the fundamental research process and capital allocation capabilities of the investment team.

The Orbis Global Balanced Fund is likely to include many of the same shares that the Orbis analysts recommend for the Global Equity strategy, for example Samsung and Chinese Internet company NetEase. Importantly, it can also invest in higher-yielding and more stable shares if they appear to offer a more appropriate balance of risk and reward given the Fund's overall objective. Examples of such shares today include BP and pharmaceutical company Merck.

Only 10% of the Orbis Global Balanced Fund is currently invested in fixed income. Following a multi-decade rally in bonds, in many regions their yields are lower than those of equities, and today Orbis has found few bond opportunities compelling enough to invest into. The Orbis Global Balanced Fund has been able to maintain a higher yield (and hopefully lower risk of permanent capital loss) from selected equities, bond-like preferred shares and a small helping of bonds and cash. However, this will not always be the case, and there will be a time when fixed income will merit a larger share.

The Allan Gray-Orbis Global Fund of Funds currently has a 47% net exposure to equities. This is at the lower end of the historical range since inception. Sentiment appears benign at a time that global stock markets have risen substantially. We remain positive on the selected pockets of value that Orbis has identified, but we have reduced the Fund's net equity exposure through our allocation to the Orbis Optimal funds. The Orbis Optimal funds essentially isolate performance of Orbis' securities compared to their local markets, while hedging against the risk of an overall decline in those stock markets. With this approach, we hope to provide you with access to Orbis' stock-picking skill while managing exposure to the underlying asset classes.

The Fund invests in a mix of Orbis Funds, with the weightings determined by our view of the most attractive global opportunities across asset classes, geographies and currencies.

Since its low in March 2009, the FTSE World Index has produced an annualised return of 20.2%. Corporate returns on equity have recovered dramatically off the lows tested during the global !nancial crisis. Valuations in many developed markets arguably look stretched and the downside risks to equities have consequently increased.

One of the levers that we use to reduce the overall stock market risk in the Fund is to invest in the Orbis Optimal SA Funds. The Orbis Equity Strategies provide access to Orbis' stock selection skills, combined with full exposure to the broader stock markets in which they invests. On the other hand, the Orbis Optimal Funds isolate Orbis' stock-picking skill by stripping out most of the stock market return through the sale of index futures. Allocating across the Optimal Funds and the other Orbis Funds enables us to balance the stock market exposure of the Fund in line with our broader market views, but still retain exposure to Orbis' stock selections outperforming their respective benchmarks. At the end of March, the resultant net equity exposure was 46% - the lower end of its historical range.

An interesting example of where Orbis is seeing a selected number of opportunities today is in China, where some trends appear increasingly problematic. Credit growth has expanded rapidly since 2008. Economic activity is decelerating and despite ballooning credit, many parts of the real economy have suffered from dif!culty in accessing bank loans and rising interest costs, while overcapacity issues have worsened in many capitalintensive industries. While Orbis does not invest based on a top-down macro view, neither does it ignore macroeconomic conditions that could affect client returns.

So why invest in Chinese stocks? A key principle underpinning the Allan Gray and Orbis investment approach is to look to avoid companies that derive pro!ts from unsustainable activities. For this reason there is virtually no exposure to Chinese banks, property developers, miners and investmentdriven stocks. However, the Chinese market is diverse and, amidst increasingly negative sentiment, one is able to !nd other appealing opportunities.

One such area is the technology sector, in particular Sohu.com and NetEase . These stocks, which combined comprise a signi!cant portion of the Chinese exposure, have strong balance sheets and derive most of their earnings from online games. They are also geared to the secular growth of Chinese internet usage, a trend we believe is largely independent of any concerns about the Chinese economy. Orbis believes these stocks are undervalued - both in absolute terms and relative to the broader market.

Since early 2009, global stock markets have more than doubled, and 2013 was another robust year. Valuation multiples now sit solidly above those seen in 2009, but below the highs of the mid-to-late 1990s. Similarly, corporate returns on equity are now solidly above the lows witnessed in the last few US and worldwide recessions, but below the inflated levels seen in the mid-to-late 2000s. On this basis, one could hardly argue that global equity markets are wildly cheap at this point, but there is also a case to be made that they are not wildly expensive either. Simplistically speaking, there is upside potential, but also downside risk from here.

Of course, what matters for the Orbis Funds is not the aggregate valuation of the stock market as a whole, but the stock selection opportunities within it. There is no doubt that many areas of the market currently look expensive and, as a result, will struggle to deliver satisfactory real returns over the medium term. However, while undervalued companies are less plentiful than they were a few years ago, Orbis has still been able to find pockets of value that they believe offer potential for reasonable risk-adjusted returns, especially when compared to other typical alternatives such as bonds.

Despite yields on 10-year US Treasury Bonds rising from what may prove to be a secular low of 1.4% in 2012 to 3.0% today, the bond market remains heavily distorted by the actions of the Federal Reserve and this has affected the behaviour of different types of stocks. One example is 'bondlike' equities - shares of companies with highly predictable earnings and dividend streams - which became inflated as a result of strong investor appetite for perceived stability and yield.

As a result, Orbis was finding the majority of opportunities in stocks with almost the opposite characteristics - a high degree of economic cyclicality, and in many cases, exposure to rising bond yields. Examples of these opportunities include insurers such as AIG and Aegon and managed healthcare companies such as WellPoint and Humana, which should all see the income on their investment books rise. General Motors should also benefit from rising yields, as it can apply a higher discount rate to its underfunded pension liabilities.

It is important to note that Orbis did not purchase these stocks because of any top-down view on the direction of interest rates or strength of any economic recovery. The movement of economic variables, or share prices themselves, is not a regular periodic cycle. At Orbis and Allan Gray, our key tool is independent, company-specific, fundamental valuation analysis. This is a challenging tool to use - and an imprecise one even when used well - but it is what our analysts focus on every day. The reward is that this process can often provide us with exciting opportunities to invest in companies at significant discounts to their intrinsic value.