Please note that the commentary is for the US dollar retail class of the fund. The feeder fund is 100% invested in the underlying US dollar fund. However, given small valuation, trading and translation differences for the two funds, investors should expect differences in returns in the short term. Over the long term, we aim to achieve the same outcome in US dollar terms for both funds.

The third quarter, while traditionally quiet with investors in the Northern Hemisphere going on their summer vacation, proved to be even less eventful than in previous years. While the Brexit vote jolted markets towards the end of June 2016, the next three months were spent speculating on the nature of the UK's exit from the European Union, as well as ongoing changes in interest rate expectations in the US. The latest thinking around Brexit is that the UK will try to negotiate a fair, if slightly sympathetic deal, while European politicians are increasingly calling for conditions more aligned with a 'hard' exit. This has led to the pound continuing to weaken over the last few weeks, resulting in new 30-year lows as we speak. With regards to interest rate expectations in the US, the latest forward curve indicates a slight probability of a rate increase in November, and an almost certain rate hike in December. We concur with these views.

Equity markets performed well over the period, although it must be borne in mind that they were coming off relative lows after the Brexit vote. The MSCI All Country World Index (ACWI) returned 5.3% over the quarter, with the emerging markets index returning 9.2%. Year-to-date, the ACWI has returned 7.1%, significantly below the emerging markets return of 16.4%. Close to half of this performance has been due to emerging market currencies strengthening against the US dollar, after sustained weakness over the previous few years. However, over longer time periods, developed markets have consistently outperformed the emerging universe.

The fixed interest market had a tougher quarter, impacted by the change in investor expectations for interest rate normalisation. Markets are weary of the impact of quantitative easing, and yields moved up (and prices down) when it appeared that Europe might near the end of central bank intervention in the bond markets. Listed property underperformed equity markets for the same reason. It is interesting to note that property is now a separate category in the sector breakdown of global indices. In the short term, this has led to some additional demand for the sector.

The gold price barely moved over the period, although it has dropped quite sharply following quarter-end. Industrial metals had a strong quarter, propelling equities in the material sector higher. Oil prices, however, were basically flat.

The fund performed well over the quarter, outperforming its benchmark after all fees by a significant margin of 3.68%. Year-to-date returns are now 0.42% ahead of benchmark, again a noteworthy performance. Over five years, the outperformance is 1.51% per annum. In addition, it is pleasing to note the absolute performance numbers. Our one-year return of 13.48% net is a very strong number in a low return environment, as is our five-year return of 9.14% per annum.

Our equity holdings outperformed the ACWI handsomely over the last quarter, as well as over the last 12 months, and have contributed strongly to the fund's good performance. Over the last quarter or two our property holdings detracted in relative terms, but returns were still positive in absolute terms. In addition, over all longer time periods, property has been a very strong contributor. Our credit holdings did well over the short and longer term. As we keep emphasising, we hedge out the interest rate risk in these credit positions, as we continue to be very negative about potential returns from government bonds in a more normalised interest rate scenario.

Within our equity holdings over the last quarter, our holdings in alternative asset managers finally contributed positively, with some other long-term holdings like JD.com and Qualcomm also fulfilling some of their anticipated potential. Our other IT stocks like Amazon, Alphabet and Priceline also performed well. Measured since the beginning of the year the biggest contributors have been Estácio and Kroton, our holdings in the Brazilian educational sector, which announced a merger after an agreed takeover by Kroton (covered in an earlier commentary). Other winners included Apollo Global Management, Tata Motors, NetEase, Amazon and Urban Outfitters.

The biggest detractors year-to-date have been TripAdvisor (after disappointing results), Pershing Square (due to ongoing disappointment around the Valeant Pharmaceuticals holding), JD.com (resulting from competitive activity in the e-commerce space in China) and LPL Financial. Apart from LPL Financial, where we sold because we lost faith in management's ability to tackle their cost base in light of disappointing revenues, we continue to believe in these holdings. In most cases, we have used share price weaknesses to increase our holdings.

We reduced our equity allocation over the last few months, and ended the quarter with a 60% exposure to equity, in line with the benchmark. This is significantly below the 67% exposure we had after the sell-off in February.

We have also reduced our position in listed property, as we perceive stock prices around the world to be quite fully valued. The one exception is in the UK, where we continue to hold an overweight position in light of the price weakness in the sector after the Brexit vote. We have been alarmed by some of the more recent political utterances, and are monitoring the situation closely. We have also reduced our exposure to credit, as these markets have bounced back strongly after the February 2016 correction. We have increased the fund's exposure to physical gold, and intend to build this position as a portfolio risk diversification tool. In a world where the competitive devaluation of currencies seems to be viewed by politicians as a panacea to solving competitive pressures in the economy, we believe gold holds additional attractive qualities.

A relatively new stock in the portfolio, Tempur Sealy International, provided a lot of price action since its inclusion less than a year ago. The company is one of the two leading mattress manufacturers in the US - and for that matter, the world. It owns strong brands covering the whole spectrum of price points, but is particularly strongly positioned at the top end of the range with the Tempur brand. What attracted us to the stock was that an activist investor took control of the Board through a hostile proxy vote, and immediately replaced the incumbent top management. The new CEO, Scott Thompson, has an impressive track record. He had particular success at Dollar-Thrifty, where he managed to increase operating margins significantly before the business was sold to one of its larger competitors. The reason why we think his appointment is appropriate, is because we believe that there is a big margin uplift opportunity at Tempur Sealy. When Tempur bought Sealy, its biggest listed competitor, in 2012, poor execution led to a series of manufacturing hiccups at Sealy. This has resulted in current operating margins at Sealy being just over half of what they were at the time of the deal. We are confident that this situation can be rectified through better operational management. Scott has bought equity in the business using his own balance sheet, and has displayed sound balance sheet management. The company's more recent set of results (after June 2016) looked promising. The share price reacted positively by jumping over 20% in a few days. Unfortunately, just before this quarter-end, the company guided profit growth down again due to a very slow September. As a result of typical short-term investor orientation, the company's share price dropped by 25% in two days. We managed our position size down after the initial positive price reaction, and could thus take advantage of the price decline. While we acknowledge that pure online players pose a threat to traditional incumbents, we think that the strength of Tempur Sealy's brands and its innovation will endure. In our view, the company is offering a promising investment opportunity and it makes up about 2% of the fund.

Portfolio managers Louis Stassen and Neil Padoa as at 30 September 2016

Please note that the commentary is for the US dollar retail class of the fund. The feeder fund is 100% invested in the underlying US dollar fund. However, given small valuation, trading and translation differences for the two funds, investors should expect differences in returns in the short term. Over the long term, we aim to achieve the same outcome in US dollar terms for both funds.

Financial markets experienced a great deal of volatility during the first quarter of 2016. Equities continued to decline into early February, following on from the sharp falls seen during January. The low point was reached on 11 February, when the MSCI All Country World Index was 11.39% lower than at the start of the year. Following this low point, equity markets staged a sharp ‘V-shaped’ recovery that wiped out the quarter’s losses. For the full first quarter, global equities gained 0.24%, while bonds’ total returns rose by 5.9% (aided by a weak US dollar). Over the last 12 months global equities returned negative 4.34%. Within commodities, gold was the outlier over the quarter, rising by 16.2%, while the oil price increased - after much volatility - by 9.2%. The US dollar fell 4.1% against the basket of currencies. The reversals in the performance of gold and the US dollar were noteworthy: gold fell 10.4% in 2015, whereas the US dollar rose by 9.3% last year.

Listed property followed the fortunes of equity markets, also showing a remarkable turnaround after the February low point. Japanese property stocks performed the best, showing a return of 18.4% over the quarter, with about 8% of this return coming from the strengthening yen. UK property stocks were weak, returning negative 8.1%, of which negative 2.5% was due to the weakening pound. Overall the sector returned 5.4% in US dollars - a material outperformance of equities.

Fixed interest was strongly positive over the quarter as noted earlier. US bonds returned about 3.4%, with the other countries’ bond returns bolstered by the weaker US dollar. High yield bonds slightly underperformed the sector, as spreads continued to widen as concerns over corporate balance sheets continued to increase.

Within the US equity markets, the biggest gainers for the quarter were gold shares (up by 53%), while pharmaceuticals were the biggest underperformers (down by 9%). The March short-covering rally saw strong recoveries in oversold economically sensitive US equities such as Tesla and Apple, as well as in traditionally cyclical companies. Despite the revival in investor appetite for taking on economic risk during March, for the full quarter, money-flows still favoured safe havens such as utilities, telecoms, beverages and tobacco. Investors remained cautious of financials, industrial cyclicals, energy and many momentumdriven technology companies. Meanwhile, liquidity-sensitive emerging equity markets lagged during the early-year sell-off, but outperformed during the March short-covering rebound. While the Standard & Poor’s (S&P) 500 Index rose by 6.8% in March, the MSCI Emerging Markets Index jumped by 13.3%. For the quarter as a whole, emerging markets outperformed developed markets by around 6% - the first time in quite a while that this has happened. Over the last 12 months emerging markets have underperformed their developed counterparts by just under 10%. Europe continued to underperform the US equity market.
One of the major drivers of market unease over the quarter has been economic softness in China, with GDP growth slowing materially as the country attempts to transition from a manufacturing-based economy to being services-orientated. The fears are that unscrupulous lending and manipulation of reported leverage limits have placed many Chinese financial institutions, which are holding nonperforming or soon-to-be non-performing loans, in a precarious position. Accordingly, there has been elevated speculation in the Chinese yuan in the offshore currency market, which has forced the government to spend considerable foreign reserves to protect the value of its currency.

Another issue that troubled markets during the quarter is that growth in corporate profits has stalled. The first-quarter profits of S&P 500 companies are expected to be 6.2% lower than a year ago. Even if energy companies are excluded, profits will be 0.7% lower. This follows a drop of 2% in global corporate profits during 2015, while according to estimates, emerging market corporate profits were down by 12%. In response, firms have been cutting investment spending. Standard & Poor’s, a rating agency, estimates that global capital expenditure fell by 10% in 2015 and will drop further this year and next. Giving this perspective, in real terms, global capex is forecast to be no higher in 2017 than it was in 2006.

The fund performed well over the last quarter, returning 3.16% which was above the benchmark return of 2.56%. The March monthly net return of 8.5% was almost unheard of in the fund’s history. Over the last year, the fund return, however, remains substantially behind its benchmark; an unsatisfactory outcome which we are determined to change. Since inception in 2010, the fund has now returned 6.1% per annum after all fees, lagging the benchmark by -0.29% per annum. Over the last five years, the net return was a 5.33% per annum, outperforming the benchmark by 0.5% per annum.

The stock positions that contributed the most to performance were Kroton (strong recovery in Brazil due to increased probability that the president will be removed through impeachment proceedings), Urban Outfitters (improved operational performance leading to strong rerating in the share), and Apollo Global Management (most alternative asset managers rerated with better outlook for equity markets). It was also pleasing to note that some of our previous laggards (such as Harley Davidson, Discovery Communications, and a few of the other alternative asset managers) contributed positively. Detractors included Tripadvisor (weaker earnings numbers in the short term), LPL Financial Holdings (very poor earnings guidance, a major disappointment for us), and Pershing Square (a new position that continued to retreat on the back of increased uncertainty over one of the fund’s positions Valeant Pharmaceuticals which we discuss in more detail below).

In addition, our property stocks performed very well over both the last quarter and the last year, and the fund benefited from a reasonably high allocation. Our credit holdings produced reasonable returns for the last three months, but strong returns relative to the index over the last year.

Over the last 12 months, the fund’s below par performance was mainly due to poor stock selection. The subset of equity holdings underperformed the benchmark index by just under 5% over that period, with both stock positions in developed markets and developing markets contributing to this poor outcome. Since inception, our developed market stock picks have actually outperformed its subset benchmark return.

We used the weakness in the equity and high yield markets in January and early February to increase the fund’s exposure to risk assets. The equity allocation went from around 60% to 67% at its high point, and is currently sitting at around 66%.This material increase was due to perceived better value being offered after the sharp declines early in the quarter. The property exposure increased from around 5.5% to 8.1% currently. This was achieved mainly by adding more UK property companies and REITs to the portfolio. The UK counters sold off in reaction to the uncertainty presented by the EU referendum, as well as a worsening outlook in property fundamentals. We also initiated a few holdings in the high yield space at levels that we considered to be attractive in the medium term. In light of some of the macro developments regarding the Chinese yuan, we have deemed it necessary to buy currency protection for the bulk of our Chinese equity holdings. We have also taken additional currency exposure to the pound in light of its weak performance as a result of the Brexit uncertainty overhanging the market.

We continue to expect a strong performance from our equity stock picks, as evidenced from our perceived upside to fair value. This offers comfort regarding our overweight position in equity, although we acknowledge that there are some risks embedded in the global financial system. We will continue to monitor developments, and stand ready to reduce our exposure to risk assets if circumstances were to change. We continue to see no value in government bonds around the globe. A relatively new investment that might have caught the eye is Pershing Square Holdings. This actively managed investment trust is managed by the legendary Bill Ackman, who until recently has had an impeccable reputation as an asset manager. Of late, one of his larger positions, Valeant Pharmaceuticals, has been in the headlines for all the wrong reasons. This acquisitive group has been accused of misrepresenting its financials, and has had to delay the publication thereof. The flamboyant CEO initially went on sick leave, but shortly after returning has been suspended by the board. While we do not have any additional insight into the situation at Valeant, we do believe that the current share price is not an accurate indication of the company’s true value. In buying Pershing Square, we were buying into a portfolio of mostly high-quality equity holdings at a discount of more than 10%, managed by a great portfolio manager, and at an attractive fee schedule (seeing that the fund is so far below its high water mark). Taking a long-term view, we hope to generate good returns from this position.

Portfolio managers
Louis Stassen and Neil Padoa

Please note that the commentary is for the US dollar fund. The feeder fund is 100% invested in the underlying US dollar fund. However, given small valuation, trading and translation differences for the two funds, investors should expect differences in returns in the short term. Over the long term, we aim to achieve the same outcome in US dollar terms for both funds. In reviewing the performance of asset classes during 2015, it was clearly a year during which negative asset class returns dominated while those finishing in positive territory were scarce. In fact, of the 40-odd different assets monitored by broker surveys, only nine finished the full year with a positive return (in US dollar-adjusted terms). Of these, the big winner was the Nikkei Index (+10.6%) - boosted by the accommodative Bank of Japan and relatively stable yen. In addition, both Portuguese (+6.5%) and Italian (+3.9%) equity markets closed higher, while in China the Shanghai Composite Index (+6.2%) finished in positive territory for the year, but not without significant volatility over the 12-month period, and of course ending well off its highs posted in June 2015. In the US, the S&P 500 Index (+1.4%) also closed marginally in positive territory for the year on a total return basis, although that performance was the worst delivered by the index since 2008; largely weighed down by negative returns from energy stocks. As was the case with US equity markets, there was a similarly small positive return from US Treasuries (+0.8%) in 2015.

At the other end of the scale were some notable falls that need highlighting: oil stole the limelight, with significant declines in the price of both Brent (-44.1%) and West Texas Intermediate (-30.5%), while copper (-24.4%), wheat (-20.3%), silver (-11.7%) and gold (-10.4%) were also hard hit.

2015 was a particularly tough year for both emerging and frontier markets. Overall, the MSCI Emerging Markets Index recorded losses for the third consecutive year, with a return of -14.6% in US dollar terms (following -1.8% in 2014). This has impacted our fund as we have had notable exposure to emerging market stocks, which we discuss in more detail lower down. Listed property also had a difficult year. Overall the global index return was essentially flat. Some regions that performed well in local currency terms such as Europe (+18.8%), UK (+10.5%) and Australia (+14.0%) gave up all these returns (and some more) when converted into US dollars. Japanese and Singaporean property stocks performed poorly, by registering negative 5.2% and 7.5% respectively over the year.

US dollar strength was another big theme for 2015 - as evidenced by the dire returns from commodities. The US Dollar index rose by a significant +9.3% for the full year. All global currencies weakened against the US dollar in 2015, with material falls for, amongst others, the euro (-10.3%), the Australian dollar (-10.7%), the Canadian dollar (-16.1%) and the South African rand (-25.4%).

In credit markets, the divergence between European and US credit was most notable and reflective of the higher US exposure to energy credit. In the US, High Yield credit recorded a loss of 5.0% for the full year, while US Investment Grade Credit was down by a more modest 0.4%. By comparison, in Europe we saw EUR High Yield return +0.5% for the year, although EUR Investment Grade Credit was down slightly by 0.7%. Again, the effect of converting these returns into US dollar terms meant that any gains for European credit were wiped out, and that it underperformed US credit for the full year.

Within the US equity market, the most noteworthy fact was that a very small group of companies - essentially nine of them - kept the market afloat in 2015. This small grouping of stocks rose by close to 60%, while the S&P Index closed only marginally in positive territory. None of the ten main S&P 500 sectors rose by as much as 10%, the first time this has ever happened outside a bear market. Predictably, value investing fared poorly, as most of the narrow market leaders looked like bad value at the start of the year.

Looking back to the year 2014, we recall that this was an extremely difficult period for active equity fund managers to add alpha due to the very low dispersion of returns amongst shares as they all tended to move by the same amount in the same direction. Whereas in 2015, investors experienced much greater equity return dispersion, and will have needed to invest into an extremely small group of equity names to have been successful. This narrowing of equity sector performance in 2015 reflected concerns that the US economic recovery may falter in 2016 due to a combination of economic weakness in Europe and commodity-sensitive emerging markets as well as a cyclical downturn in the Chinese economy.

During the opening weeks of 2016, headlines have been dominated by the sharp falls in global stock markets, largely driven by extreme turbulence in China and on-going sharp falls in industrial commodity prices. Your fund performed poorly over the last 12 months. The fund's negative 7.0% return was significantly behind the benchmark, and has pushed the fund marginally behind its benchmark even over three years. Over the last five years the fund is still slightly above its target, although the actual return of 5.3% p.a. over the last five years has also been disappointing.

Our equity selection was poor over the year, and our stocks underperformed the index by a wide margin. This was mainly due to our exposure to emerging markets. The developed market stocks in our portfolio performed reasonably well. Notable winners included Amazon (which returned over 100% over the year), X5 (a Russian food retailer that we subsequently disposed of), Japan Tobacco, Google (now called Alphabet), and Mail.ru (Russian internet stock also disposed of recently). Besides our emerging market holdings, other detractors included the alternative asset management groups (Fortress, KKR, Apollo, Blackstone and Carlyle), and the media companies Discovery Communications and Twenty First Century Fox. Porsche also impacted returns negatively over the year, and we have written about this investment in the previous commentary.

Our property holdings outperformed the index, with poor returns from BR Malls in Brazil, offset by strong performances from JRIC (Japan Residential Investment Corp), a Japanese residential group being taken over by Blackstone (see commentary below) and the German residential groups. The overall allocation to property was however small at between 5-8% over the period. Credit holdings detracted very marginally over the period despite difficult conditions in the high yield market (discussed elsewhere), highlighting our very conservative approach to taking on risk elsewhere in the portfolio.

During the quarter, one of our property stocks, JRIC, was acquired by affiliates of Blackstone for a 32% premium to the undisturbed price, and a 26% premium to net asset value. JRIC was a smaller position in the fund given the poor liquidity in the counter. After a quarter century of price deflation in Japan's housing market, we considered prices to be cheap and rents affordable. Furthermore, JRIC's Japanese residential properties (with a concentration in Tokyo) were attractively valued, yielding around 5% after maintenance expenses (leveraged returns to equity holders were meaningfully higher considering the availability of low cost, fixed-rate debt). But the offer price, equivalent to our forecast NAV approximately four years out, represented an immediate crystallisation of value. As such, we voted in favour of the deal and tendered our shares close to year-end.

It has been a rocky start to the new year, and we expect volatility to continue. Anxiety around the further normalisation of US interest rates (following the first rate increase in nearly 10 years towards the end of 2015) should continue into the future. The domestic economic outlook for China remains murky at best, and we should expect investors to keep oscillating between greed and fear in this regard. We have maintained an allocation to risky assets of around 65-68% over the last year, and are currently sitting at the bottom end of this range. Our equity exposure (at 63%) is in line with the fund's benchmark, highlighting some concerns over valuation levels globally. This level has been quite consistent over the year. After the recent sell-off, markets are more attractively priced and we have started increasing our exposure to equities. Property stocks are also starting to become more interesting as potential investments. When evaluated against our view on global bonds, our preference very much remains property stocks. Over the last twelve months, our property exposure has declined by just more than 2%, and is currently sitting at only 5%. We have also used the current weakness in the high yield market to add to our credit holdings, which has increased by almost 7% since the beginning of 2015.

We remind our investors that we follow a philosophy of long-term investing, and while the recent poor performance is not comfortable, we have not changed our investment process or portfolio construction. We continue to scrutinize markets for new ideas that are attractively priced on a risk- adjusted basis.

Portfolio managers
Louis Stassen and Neil Padoa