Market review
The third quarter was dominated by the subprime housing crisis in the United States, widespread credit concerns and the growth prospects of the US economy. The general reluctance of banks to lend to each other was not confined to the US, and global banks saw a severe squeeze in liquidity. A full-blown implosion of the US credit market was narrowly averted when the US Federal Reserve (the Fed) first cut the rate at which it lends to commercial banks and later the benchmark federal funds rate, from 5.25% to 4.75%. Amid the turmoil, global equity markets ended the quarter well in positive territory to reach record highs; bouncing off their intra quarter (August) lows. The MSCI World Index gained 2.5% in US dollar terms over the quarter. The MSCI Emerging Market Index extended its positive performance (up 14.5% in US dollars) over the quarter, mainly on the back of a very strong performance out of Asia (up 19%).

Global events reflected in the SA market, causing bonds and the currency to weaken and equities to sell off as risk appetite waned and uncertainty with regard to the global outlook grew. However, the bears seemed to lose the battle yet again as US Federal Reserve governor, Ben Bernanke, provided some monetary relief.

Equities recovered strongly from their August lows, gaining 6.7% over the quarter. The local market was led higher by resources (up 13.5%) and industrials (up 3.3%). Financials, which were caught up in global credit concerns were down 1.6% over the quarter. Bond and property yields pushed lower and the currency gained strongly against a falling dollar. Over the quarter the All Bond Index was 3.4% higher, listed property rose by 9.5% and cash (as measured by the STeFI) earned a return of 2.3%.

Fund performance
The Investec Cautious Managed Fund had a good quarter in absolute and relative terms, earning a return of 2.7%. The improving trend in relative performance which started in the middle of May, culminated in the third quarter as the market finally moved in favour of our conservative positioning. Over the 12-month period the fund generated a return of 12%, representing a very acceptable real return, particularly when considered relative to the risk assumed. The fund's high cash weighting, enabled us to take advantage of the equity sell-off (from mid-July to mid-August) and ensure adequate participation in the subsequent rally towards the end of the quarter.

The fund's equities held up phenomenally well in the sell-off. However, due to their inherent defensive qualities, they lagged the market in the upswing. The fund's lack of exposure to the mining and construction sectors detracted from performance. Both these sector significantly outperformed the All Share Index over the quarter. In addition, the fund was hurt by rand strength and the relative underperformance of the fund's offshore equity holdings.
The fund's contrarian position in Japanese yen was the star performer over the quarter. In addition, the fund's exposure to the rand gold price (via the NewGold ETF) added value.

The cash component performed well. The fund's 4% allocation to bonds, which is significantly less than the average fund contributed to relative underperformance.

Portfolio activity
The equity weakness that occurred in the first half of August enabled the fund to buy stocks that at the time of purchase offered significant value relative to cash on a medium-term view. We increased our exposure to MTN, Telkom, Standard Bank, Remgro and Implats. New positions were established in Sun International, PPC, Anglo American and Billiton. The net result was a significant increase in the domestic equity weighting (at the expense of cash).
The fund took meaningful profits on its Japanese yen position (as the repricing of global risks brought about a strong and sudden reversal of the yen carry trade). The fund retains a small yen position, based on the view that the yen remains the most undervalued currency in the world and that the unwinding of global imbalances still has a long way to go.

Market outlook
We remain positive on the longer-term outlook for equities and hold a portfolio of stocks that are both defensive and cheap relative to the market. However, we do remain cautious due to the high level of downside risk in margins and in particular commodity (mostly base metals) related earnings.

It appears that the domestic bond market has finally adjusted for higher inflation and interest rates. We continue to believe that bonds will struggle to meaningfully outperform cash in the medium term but we are encouraged by the recent increase in yields and we have started to marginally increase our weighting. The rand is marginally overvalued and at risk of a sudden bout of weakness as a result of emerging market jitters and our large current account deficit. After a seven-year bout of weakness, we could easily see a period of sustained dollar strength as the US current account deficit diminishes on the back of increased US exports.
Portfolio positioning
Our positioning should adequately protect capital in a declining market and enable us to participate meaningfully if the market surges ahead from here. We remain very bullish on selected areas of the US stock market and global defensive stocks. The equities we are invested in offer significant value both in absolute terms and relative to equivalent domestic stocks. Furthermore, the fund's positioning is unhedged and consequently hard currency strength (relative to the rand), should augment future returns in rand terms. The fund continues to be significantly underweight bonds and listed domestic property. The cash weighting remains intentionally high and places the fund in a good position to exploit future opportunities. The positioning of the fund is consistent with the following expectations:

- The ALSI runs out of steam and corrects strongly as a result of derating (PE multiple contraction) and a decrease in risk appetite.
- Commodity prices (especially base metals like copper) decline or remain flat at best.
- Domestic interest rates rise (against current expectations) and provide a headwind for domestic stocks.
- Global defensives and US large cap stocks outperform local stocks.
- The rand weakens relative to the US dollar and the Japanese yen, and to a lesser extent against other currencies.
- The US Federal Reserve cuts US interest rates at a measured pace and allows the recent excesses to normalise in a systematic fashion.

Market review
The domestic inflation outlook has deteriorated over the quarter. Rising yields globally and domestic inflation concerns led to the local government debt curve rising sharply. Over the quarter the benchmark R153 and R157 peaked at 9.15% and 8.58% respectively. The All Bond Index lost 1.7% over the three months ended June. We expect CPIX inflation firmly above the targeted inflation band until year-end. This is likely to force the South African Reserve Bank (SARB) to tighten rates further. However, early signs of some moderation of consumption led growth, coupled with a potentially negative impact of the recently implemented National Credit Act are likely to moderate the SARB's stance on the extent of further tightening. Rising bond yields and deteriorating inflation expectations put pressure on domestic listed property. The sector was up marginally over the quarter (0.3%) but remains firmly in the black year to date at 16.1%.

After a strong first quarter, domestic equity market returns moderated slightly over the past three months. The FTSE/JSE Index gained 4.3% since the end of March. The market was driven higher by general mining (up 12.5%), oil and gas (up 9.9%), construction (up 9.9%) and life insurance (up 6.9%). Interest rate sensitive counters, in particular banks were down 6.9% and retailers lost 6.7%. This reminded investors of a similar occurrence last year, when diminishing global risk appetite coupled with higher domestic borrowing costs, caused a massive sell-off in domestic oriented sectors.

Fund performance
The Investec Cautious Managed Fund earned a return of 1% over the quarter. For the twelve months ended 30 June 2007, the fund generated a return of 14.2%. This represents a very acceptable real return, particularly when considered relative to the risk assumed.

The relative weighting of the various asset classes detracted from the relative performance over the quarter. In particular, the lower equity weighting and consequent higher cash weighting (in a period where equities have significantly outperformed all other asset classes) has been the chief contributor to the relative underperformance. The lack of exposure to Anglos and Billiton detracted from performance. In addition, the fund's domestic interest rate sensitive holdings (banks and retailers) all lagged the FTSE/JSE All Share Index significantly.

On the positive side the fund managed to sell all of its listed property holdings just days before the recent large scale sell-off (a market timing success that will be very difficult to repeat). The fund's low weighting in bonds also contributed to meaningful performance as bonds continued to lag cash returns over the quarter.

The fund is fully weighted offshore, of which the bulk is allocated to offshore equities. Within the offshore equity portion the most meaningful allocation is to global defensive businesses with a strong quality bias.

Market outlook
Risk appetite remains the single biggest factor in determining future returns. Real interest rates should remain low and earnings (economic) growth should be strong. However, any increase in risk premiums will cause an end to the seemingly endless party currently experience by equity investors.

We remain positive on the longer-term outlook for equities and hold a portfolio of stocks that are both defensive and cheap relative to the market. However, we do remain cautious due to the high level of downside risk in margins and in particular commodity (mostly base metals) related earnings.

It appears that the domestic bond and listed property market has finally adjusted for higher inflation and interest rates. We continue to believe that bonds will struggle to meaningfully outperform cash in the medium term but we are encouraged by the increase in yields and we have started to marginally increase our weighting. The rand remains at risk of large-scale capital flight by disillusioned foreign investors. The local currency may also have to contend with sustained dollar strength, as the US current account deficit diminishes on the back of a strengthening US economy and strong portfolio flows into the US equity market.

Portfolio positioning
The portfolio composition reflects our continued concern about equity index valuation levels and high investor optimism. For that reason, the domestic equity weighting remains below average and well below that of other similarly mandated funds. While we may currently appear to be out of step with prevailing trends, we remain comfortable that our positioning will adequately protect capital when the market inevitably runs out of steam.

We remind you that the fund has an unrelenting focus on opportunities at the individual stock level. The criteria necessary for an idea to be included in the portfolio, is strongly biased towards quality, safety and undervaluation. The current paucity of domestic equity ideas that meet our stringent criteria is a strong indication that the market is close to full valuation and that the downside risk is higher than most commentators are willing to admit.

In contrast, we remain very bullish on the US stock market and global defensive stocks. In particular, we are invested in selected global defensives and big cap US stocks that are offering significant value both in absolute terms and relative to equivalent domestic stocks. Furthermore, the fund's positioning is unhedged and consequently hard currency strength (relative to the rand) should augment future returns in rand terms.

Individual stocks have been selected on the basis that they are both safe and cheap and should adequately protect investor capital over the medium term. We remain significantly underweight bonds and listed property. The cash weighting remains intentionally high and places the fund in a good position to exploit future opportunities. The fund continues to have a full offshore weighting, in line with our rand view and to gain exposure to high quality global businesses that are currently available at very attractive prices.

The positioning of the fund is consistent with the following expectations:

- The ALSI runs out of steam and corrects strongly as a result of derating (P/E multiple contraction) and a decrease in risk appetite.
- Commodity prices (especially base metals like copper) decline or remain flat at best.
- Global defensives and US large cap stocks outperform local stocks.
- The domestic currency (rand) weakens relative to the US dollar and to a lesser extent against other currencies.

Market Highlights
In rand terms, SA Equities (ALSI) advanced by 4.16% on a total return basis in December 2006 (this represents a phenomenal gain of 41.2% for the year). The All Bond index gained 1.5% over the month, while Cash delivered it's steady dose of 0.6%. Listed property gained 1.9% for the month and inflation-linked bonds generated a positive return of 0.4%. The rand continued it's strength against the US dollar in December 2006 (driven mostly by dollar weakness). From a foreigner's perspective, the strength of the local equity market augmented by the rand's strength, resulting in a 7.0% return in US dollars (a USD return of 27.9% for the last 12 months)

Within equities, the better performing sectors were Mobile Telecoms (+16.3%), Media (+11.8%) and Banks (+9.4%). The worst performing sectors were Gold (-3.7%), Pharmaceuticals (-4.2%) and Technology Hardware (-1.6%).

Outlook
The domestic equity market continues to perform exceptionally well, on top of some outsized gains over the last three years. Over the last two years, the ALSI has generated a real return of just below 40%. These real returns are simply unsustainable and particularly when you consider that earnings themselves are at peak levels (in real terms). Domestic equities are now in the upper range of historic valuation levels, on peak earnings and the outlook is great. We continue to re-iterate the need for investors to tone down expectations of a continuation of recent equity returns. It is our view that we are experiencing a welcome recovery in asset prices that may very well continue, but that this is neither the start of a bull market or a pre-cursor to a sustained bear market. The recent increase in global risk appetite and concomitant decrease in spreads, are both reminiscent of the emerging market sell-off in May 2006. Investor complacency has returned and while not a prediction, it does indicate that unsustainable risks are steadily building up within global financial markets While we remain positive on the longer-term outlook for equities and hold a portfolio of stocks that are both defensive and cheap relative to the market, we remain cautious due to the high level of downside risk in margins and in particular commodity related earnings. For the moment, the domestic bond market has shrugged off any inflation and deficit fears. We remain of the view that both Bond and Property yields are reasonable but may be inadequately discounting future uncertainties and remain equally vulnerable to changes in interest rate and inflation expectations. The rand remains at risk of large scale capital flight by disillusioned foreign investors, as well as sustained dollar strength as the US current account deficit diminishes on the back of a weakening US economy and strong portfolio flows into the US equity market. Our views in this respect have remained unchanged, notwithstanding the recent US dollar weakness.

Portfolio Strategy
The portfolio composition reflects our continued concern about equity index valuation levels and high investor optimism. For that reason, the domestic equity weighting remains below-average and well below that of other similarly mandated funds. While we may currently appear to be out-of-step with prevailing trends, we remain comfortable that our positioning will adequately protect capital when the market inevitable runs out of steam. We remind you that the fund has an unrelenting focus on opportunities at the individual stock level. The criteria necessary for an idea to be included in the portfolio, is strongly biased towards quality, safety and undervaluation. The current paucity of domestic equity ideas that meet our stringent criteria is a strong indication that the market is close to full valuation and that the downside risk is higher than most commentators are willing to admit.
In contrast, we remain very bullish on both the US economy and the US stock market. In particular, we are invested in selected mega-cap and bi-cap US stocks that are offering significant value both in absolute terms and relative to equivalent domestic stocks. Furthermore, the fund's positioning is un-hedged and consequently a reversal in the recent weakness of the US dollar (relative to the Rand), should augment future returns in rand terms.
Individual stocks have been selected on the basis that they are both safe and cheap and should adequately protect investor capital over the medium term. We remain significantly under-weight bonds and listed property. The cash weighting remains intentionally high and places the fund in a good position to exploit future opportunities.
The fund continues to have a full off-shore weighting, in line with our rand view and to gain exposure to high-quality global businesses that are currently available at very attractive prices.