Please note that the commentary is for the retail class of the fund.

Despite generally chaotic and weak market returns, the fund had an excellent quarter, delivering a return of 3.4% versus the benchmark return of 0.6%. This capped off a great year for the fund, with the one-year return of 12.1% comfortably ahead of the benchmark return of 8.3%, and well in excess of inflation. When one considers the challenges that the world has faced over the past 12 months, it is a very pleasing outcome.

Markets remained challenging during the third quarter as they digested the surprise result of the Brexit vote and reflected on the number of elections coming up, and what a surprise outcome might mean from them. In addition, debate around interest rate levels and the state of the economic recovery continued, with the US once again failing to hike interest rates but also continuing to indicate that it was likely that they would.

The rand strengthened from the lows at the beginning of the year, and significantly against the pound, which has collapsed under the uncertainty of what Brexit will eventually mean.
Our strategy of investing in commodity shares and being overweight emerging markets has continued to pay off. Commodity shares have continued to rally, supported by broadly rising commodity prices and the significant reduction in debt levels across the industry. They have moved from incredibly oversold levels at the beginning of the year to much more reasonable levels, but are still cheap when valued using our assessment of normal prices.

Emerging market shares have rallied hard this year, but still lag developed markets over any meaningfully longer period. Despite this recent rally, ratings remain low and valuations attractive in the emerging markets space. The compelling argument for emerging market shares over developed market shares remains in place, as their regions' superior demographics and rising wealth per capita are continuing to be undervalued by the markets.
The fund's domestic property allocation has performed extremely well this year, delivering double-digit returns in the mid-teens. This has been due to a combination of good distribution growth as well as capital gains. The portfolio is exposed to mainly mid-cap property shares, which still offer yields in the range of 8% to 12%. These are extremely attractive in this low-growth environment.

In contrast, our UK property names have performed poorly in the post-Brexit aftermath. The weak pound was the main drag here, but the underlying pound share price performance has also been poor as the markets have struggled to price for what Brexit will mean for the fortunes of these companies. The fund's largest UK property holding remains Intu, the UK shopping centre portfolio, which we believe will be relatively unscathed by Brexit and is now trading at a significant discount to its net asset value, which is not warranted by the operating fundamentals.

The fund has had a low weighting in government bonds, given our expectations around rising rates globally and the tough state of the fiscus locally. We have, however, continued to invest judiciously in credit, and this enabled us to deliver very strong returns as the credit markets have mispriced risks in our favour.

The fund's overall equity weighting has remained high. We increased domestic equity exposure at the beginning of the calendar year when markets sold off aggressively, which has proved to have been the correct approach. As markets improved we have maintained the fund's exposure by selling down those companies that have exceeded their fair value. We do, however, still have a high weighting to risk assets overall (equity and property). We consider the term 'risk assets' to be a misnomer. Over the long term, the greatest risk faced by investors is that inflation destroys their capital, especially in a world of very low-return assets. Central banks around the world continue to punish savers by artificially maintaining very low rates of interest, and in fact negative rates across most of the developed world. By investing in appropriate equities and property REITs which we think have good prospects, we believe we have the best chance of growing real capital over the medium to longer term.

Portfolio managers Neville Chester and Pallavi Ambekar as at 30 September 2016

Please note that the commentary is for the retail class of the fund.

Global capital markets continued to exhibit the high levels of volatility in the first quarter of 2016 that we saw at the end of last year. While underlying economic data has not worsened significantly (in fact, in many cases it has improved), the general sentiment as expressed via the media is one of caution and concern that the next big crisis is about to happen. In this environment investors are nervous and we have seen extreme moves as prices react to any short-term news flow. Locally this nervousness has been compounded by the political ructions occurring within the ruling party and potential for this to speed up the downgrade of South Africa’s sovereign rating. Despite the challenging market conditions, the fund generated a positive return of 3% for the quarter, marginally behind its benchmark of 3.2%.
The domestic equity portfolio was a strong positive contributor during the quarter as a number of our positions delivered a strong return. Resources in particular contributed to the positive alpha that we experienced over the period, but so did some of the domestic shares that we were able to buy very cheaply in December following the replacement of the minister of finance.

This quarter saw a strong rally in bonds where we are underweight both locally and globally. Offsetting this is our large position in property, which should benefit from the same drivers of the bond market; however, we have seen a lag here where bond yields have declined, but are yet to see a meaningful rerating in our property holdings. In the interim, these holdings continue to deliver solid earnings growth and concomitant growth in distributions.

Our global equity contribution detracted from the overall return during this period as the rand strengthened; although, relative to the benchmark in US dollars it made a positive contribution, given our increased emerging market exposure which performed well during this quarter. The divergence of returns between developed and emerging markets remains wide and we believe the investment opportunity in the out-of-favour emerging markets remains compelling.

Following the rand blowout in December and January we took the opportunity to significantly reduce our offshore exposure, pulling it back by around 5% by means of a currency overlay as we felt the underlying assets were attractive. This has proved to be a good investment as the rand has strengthened from those very oversold levels reached during the crisis period, which was a particularly illiquid time in currency markets. While there is much debate around the proposed downgrade of South Africa’s foreign credit rating to below investment grade, we think that most of this is reflected in the level of the rand and would not be expecting it to move sustainably weaker on the back of an inevitable downgrade. More concerning is the progression of the politics around corruption and whether this will be addressed sufficiently to prevent a further deterioration in the country’s finances. This is far more likely to be the driver of the direction of the rand from these levels.

In the local equity portfolio we have trimmed back some of the dual-listed, rand hedge positions in favour of some of the domestic shares that were hard hit in December. The financial sector in particular offers a lot of value, trading on single-digit multiples and offering greater than 5% dividend yields. A lot of highly-rated local shares have de-rated significantly as concerns over growth have continued and the weaker rand as well as the prospect of further depreciation have been raised as major issues by the foreign investors who had been the main buyers of these shares. As the shares start to offer the prospect of better returns, we are looking at these companies that we have not owned for some time due to their unrealistic valuations.

The only constant that one can forecast is that markets will remain volatile in the foreseeable future. In this environment a focus on the long term is absolutely essential to ensure that long-term value is created. We remain steadfast in our long-term investment philosophy, which has driven our excellent long-term track record in the fund.

Portfolio managers
Neville Chester and Pallavi Ambekar

The past year has been an incredibly challenging one for all asset classes. The global equity markets have been incredibly volatile as participants have tried to digest a slowing China, rising rates in the US, a migration crisis in Europe and the collapse of global energy prices. Bond markets have been similarly turbulent as the opposing forces of an improving economic outlook in the US and deflation from collapsing oil prices have resulted in a see-saw action depending on the direction of the most recent data point. The move in interest rates in the US, long telegraphed by the Federal Reserve, saw the dollar outperform all other currencies last year, despite the actual rate rise being marginal at best. Emerging market currencies bore the brunt of the pain, either driven by the outlook for falling commodity prices, mismanagement of the local economy or just plain sentiment.

For the year the fund managed to return 6%, which slightly underperformed its benchmark return of 7.7%. The underperformance was driven mainly through poor stock performance in the domestic market and an overweight position in emerging markets in the international allocation. What did help the fund was our overweight allocation to international assets, and a high allocation to the offshore property stocks listed on the JSE. Our very low exposure to bonds globally and locally also supported the fund’s return as bonds sold off in the second half of the year.

The overall positive contribution to the fund’s return from the international allocation was 6.5%, with our property allocation adding another 1.5%, proving once again the value of flexible asset allocation funds to find significant sources of return for investors. Bonds and other yielding assets added just over a percent on top of this, with domestic equity being the detractor that brought down overall returns. This was a surprising result as a large portion of our domestic equity holdings is of a rand hedge nature, and we expect this to filter through to results over time, which should drive a positive equity return in 2016.

The domestic equity's performance was dragged down by resources predominantly, as lower dollar-based commodity prices put the shares under pressure. The weaker rand impact, which should buffer the earnings of the local producers, has not yet been factored in and should be supportive of earnings in the new year. Towards the end of 2015, the local market suffered massively following the dismissal of SA’s minister of finance which shook the capital markets. While this was partly rolled back four days later, the damage had been done and foreigners have been dumping local shares ever since. Over R40 billion of foreign selling occurred on the JSE in the last quarter of the year, with banks and local industrials bearing the brunt of this selling. The banking sector was down 10.8% in the month of December as they are most at risk should our overall debt rating be downgraded to junk. This is certainly possible given the direction of our finances, and could be hastened by what occurred in December. Having said that, a number of local shares, particularly in the financial space, look very cheap on mid single digit PE's and 6%+ dividend yields.

Our international allocation remains mainly exposed to equities, where we feel the best return opportunities are available. We also finished off the year with a takeout of our position in Japanese residential property, which boosted our fourth-quarter returns and provides us with cash to recycle into some new opportunities. Global bonds, with the exception of some SA company's offshore issues, remain unattractive from a total return perspective. Our local bond portfolio is almost exclusively exposed to floating rate instruments and inflation-linked bonds. The local government bond curve remains exposed to the risk of further selling by foreigners, especially as we get closer to a ratings downgrade. And given the poor state of the fiscus the risk of further debt issuance remains. Yields will need to rise to issue more debt, especially if we proceed with the nuclear build programme, which will make the returns from these bonds decline.

The fund’s exposure to Intu, the UK shopping centre portfolio, performed really well for us this year and remains a large holding in our property allocation. In the domestic space we have avoided the highly-rated mega cap property stocks, focusing instead on good quality mid caps with decent yields. Unfortunately this doesn't seem to have protected us any more in the market sell-off in December, where these stocks declined by similar percentages to the large cap property stocks. They are now, however, trading on double-digit yields, which are paid out bi-annually in distributions, implying the prospect of good double-digit returns from these stocks in the year ahead. The past year has been exceptionally difficult, and we expect times to remain so. Our first and foremost goal remains to add significant long-term value through identifying mispriced assets. At present, there appears to be far more of these opportunities given the volatility in markets and the search for safe bets at the expense of all other assets. Since inception the fund has still significantly outperformed its benchmark through following its approach to identifying mispriced assets and going against the herd. We firmly believe it will continue to deliver this high level of returns in the future. Thank you for your continued support through what is undoubtedly one of SA's most challenging periods.

Portfolio managers
Neville Chester and Pallavi Ambekar