As signs of the nascent economic recovery abound, global equity markets continued their phenomenal run, and the JSE was no exception. Risk appetite has returned with surprising vigour and the bystanders who moved to cash at the nadir of the market crash are being tempted back into equities and other risk assets. The fund delivered 11.8% for the quarter, comfortably ahead of the benchmark return of 10.3% and for the year to date has delivered a total return of 17.9% - well ahead of the benchmark return of 12.4%.

The benefits of a fully flexible fund have once again been borne out by the ability to increase equities appropriately when valuations were very attractive as well as to move quickly into other asset classes as these valuations have also turned. The fund benefitted significantly from having very little exposure to the expensive bond market at the beginning of the year, but we have now invested in a lot of attractively priced corporate bonds with yields that offer compelling inflation protection.

These special opportunities have not been limited to the SA market alone. We have used the fund's international allocation to successfully participate in very attractively priced issues from names such as Anglo American and Deutsche Bank. As a result of the financial crisis, investors have had a once-in-a-lifetime opportunity to make great investments in all asset classes.

As equities have re-rated we have started to reduce the fund's overall allocation to equity and mainly the SA equity portion. While value is still available, the relative attractiveness has reduced and as a result we have instead added to corporate bonds and increased the allocation to preference shares further. We still have a fairly full allocation to international equities given the fact that there has been less of a re-rating in these markets and on a long-term view they still offer compelling value. Within our equity positions we have tended back towards more defensive companies. These shares have not really participated in the recent rally and are once again offering compelling value. In the search for yield, that is once again at play, a lot of the more cyclical and higher risk companies have re-rated strongly and are fully pricing in a benign outcome to the global recession. This is by no means a definite outcome.

During this quarter we also increased the offshore allocation to close to its maximum, taking advantage of the rand's strength to externalise some more of the fund's assets. This was partly to increase the international equity weighting and partly to buy some of the interesting yield assets mentioned above. Our long-term outlook on the rand is that it will need to weaken from current levels in order to maintain SA's global competitiveness in the light of very sticky local inflation. While in the short term we find that the rand movement is unpredictable, over time measures such as Purchasing Power Parity (PPP) do hold true.

The fund now reflects a great balance between equities and high yielding bonds as well as preference shares which should deliver market-beating returns into the future.

Portfolio manager
Neville Chester

After three consecutive quarters of depression, we finally had a quarter with a more optimistic outlook; albeit off a low base. What the press rapidly took to calling 'green shoots' was merely a recognition of the fact that while the environment is definitely still tough, the rate of worsening is slowing and equity markets had been priced for a very dire outcome. This saw markets around the world rally quite sharply and risk appetite pick up appreciably. The fund had a great quarter, delivering a return of 8.8% - outperforming the JSE market return of 8.6% and significantly ahead of the benchmark return of 6.0%.

The fund entered the quarter with a high allocation to equity and in particular domestic equity. While sentiment was at all time lows, we felt valuations were far too compelling to ignore. While many market commentators were flirting with the concept of deflation, our view, given the vast stimulus packages being implemented, was that inflation was the biggest risk facing investors over the longer term. The best way to compensate for that risk is through equities and inflation-linked bonds. Fortuitously, the valuations of both these asset classes were low, affording us the opportunity to take big stakes in both classes.

While many investors are feeling bruised by the decline we have recently experienced in equities, the return on this asset class for any period longer than three years are still good. The fund has still comfortably beaten inflation over three years and significantly outperformed it over five years. We always anchor our portfolio based on our core investment philosophy of valuation driven investing. This tends to ensure that we focus on the long term and avoid getting caught up by sentiment swings and short-term newsflow. As our models showed that equity markets were very cheap on any longterm measure we kept a high weighting to SA and global equity. As markets re-rated we have started to reduce our overall equity allocation in favour of some high-yielding bonds to which we have had very little exposure to date.

We have fundamentally not liked the bond market due to unattractive valuations based on our longer-term outlook for inflation. We did, however, get the opportunity to add some very attractively priced inflation linkers. Now, however, after a sharp sell-off bonds are starting to look more attractive and selective credit is very compelling given the large spreads currently in the credit market. Once again, it all boils down to the valuation.

Finally, we have increased the fund's offshore allocation as we believe international equities are still relatively inexpensive and that the Rand is likely to weaken from its current level. Prolonged US dollar weakness and high interest rates in SA have helped the rand to strengthen significantly over the past 6 months and it has been one of the strongest currencies in the world year to date. Given the impact of lower commodity prices and higher inflation we believe the rand will weaken from this point onwards, although not as rapidly as we have previously seen.

We believe the fund, as it is currently structured, offers investors the best risk adjusted portfolio to generate consistent inflation-beating returns in the medium to long term.

Portfolio manager
Neville Chester Client

The year got off to a tumultuous start, much like the prior year ended. While the environment is difficult and share prices have fluctuated significantly, this level of irrationality does expose great investment opportunities. Bonds have also come to realise the reality of deficit spending will mean increased issuance, impacting negatively on their performance after a strong rally last year. In this volatile environment, the fund returned -3.1% against its benchmark down 4.0% - a great performance under these circumstances.

The criticism often raised against flexible funds is that they are never fully in cash at the beginning of a bear market nor fully invested at the start of a bull market. In our defence, this is obviously a pipe dream achievable only with hindsight vision. In our view, the objective of the flexible fund is to be underweight equity when it is expensive and overweight equity when it is cheap. The difference between these two statements is that often times the market will ignore what is expensive or cheap and track what sentiment is driving - either fear or greed. While we can never forecast sentiment with a great deal of certainty, we believe we can value businesses and looking at the long-term track record of the fund (even at this low point in global markets) is evidence of this. Since inception in July 2001, the fund has delivered 18% - comfortably beating inflation, its benchmark of 16% and pleasingly even the equity market of 15.5%. The bottom line of this explanation is that with the benefit of a long-term horizon we add significant value through stock selection and asset allocation to ensure that, based on our valuation of the various asset classes, the fund is appropriately structured at any point in time.

As we have mentioned earlier, what we cannot do is call market sentiment. A classic example of this is our investment in preference shares. We have long extolled the benefits of investing in quality preference shares given the massive selloff they experienced due to rising money market rates and uncertainty over changes to STC. Despite clear evidence that the tax changes will not impact returns, and the prospect of a declining rate cycle, preference shares remained under pressure. This is great for funds that are prepared to take a longer-term outlook and we filled up on preference shares. As the number and pace of interest rate cuts have accelerated, the market is finally appreciating the after tax yield pick-up these instruments offer. The preference share portion of the fund has delivered a positive return of approximately 4.5% for the quarter, comfortably beating all other asset classes even before taking into account the tax benefit.

Despite this strong run-up in performance, the preference share portfolio in the fund is currently yielding ±10%, equivalent to an 18% pre-tax yield vs money market rates around 9%.

In a similar vein but more difficult to dimension, we believe that a lot of listed equities are very attractive at current valuations. Equity market valuations have come back significantly due to the global turmoil but, once again, good companies as well as poor ones have been indiscriminately sold off. Despite what some global commentators might have you believe, inflation is still a very real risk and probably more of a concern now than it was previously. The unheard-of levels of liquidity created by global central banks will ultimately lead to higher levels of inflation. The only way to ensure that capital is preserved in real terms is to invest in equities and, given the attractive entry point the market is currently offering, we think it is important for the fund to be overweight equities.

Bonds remain unattractive although we have managed to add some inflation-linked bonds at very attractive real yields. Looking to the rest of 2009, high levels of volatility are likely but we believe the fund is well structured to continue to deliver inflation-beating returns over the long term.

The final quarter of 2008 was marked by panic selling globally as the fears of global recession were realised and owners of risky assets entered into a selling frenzy. Global equity markets were hard hit and SA fortunately less so, due to a better domestic economic outlook. However, resources were hit hard and the resource counters listed on the JSE suffered accordingly. The fund had a poor quarter, down 4.62% against its benchmark return of -2.74%. This was predominantly due to two factors, our overweight position in equities and our underweight position in bonds.

Perhaps the most absurd outcome of this unwinding of the credit bubble has been the performance of government bonds, especially those of the various large developed nations. In the desperate flight to perceived quality assets the yields on government bonds have reduced to ridiculously low levels. At one point for 3-month money the US could borrow at zero cost! The fact that these countries will need to issue trillions of dollars of debt to finance the various bailout plans and fiscal stimulus plans seems to be going unnoticed. This is the next bubble that will be popped.

Our own government bonds have also rallied sharply on the back of some sympathy trade with global bonds but also, rightfully so, because of declining inflation expectations. But even here they have overshot our estimation of fair value and we can't get excited about holding any government bonds. Corporate bonds, on the other hand, look very attractive. As the risk aversion grew the yields that corporate bonds have been marked to have, reached historic highs and the fund continues to hold positions in good name corporate credit. As was mentioned before, we still prefer holding preference shares at these levels given the tax-free nature of the income and the very high yields currently on offer.

On the equity front, our views expressed at the end of September still hold true. Equity valuation, both at home and abroad, reflects more than likely the outcome of the current recession. It is in times like these that great opportunities arise and it would be remiss for the fund not to be taking advantage of some of the great value on offer in the market. We have added to the cyclicality of the portfolio by increasing our resource position, but specifically by targeting those that have good demand from the SA economy. The portfolio overall, however, still reflects a fairly defensive exposure via businesses which are less cyclical than average.

2009 is likely to bring its own new challenges but the companies that we own, and the current asset allocation in place, we believe, is correct for the challenging period ahead.

Neville Chester
Portfolio Manager