The Property Equity Fund experienced a very strong quarter, delivering a return of 11.45%, well in excess of the 1.95% return on cash and 6.9% return on the All Bond Index. The return for the fund now stands at 14.74% for the year to date, and 23.94% over the past year.
Security selection was a significant contributor to fund performance over the quarter, with the fund delivering a return in line with the property trust and property loan stock indices, despite having a cash component and hard currency exposure through Liberty International.
Listed property performed well on the back of lower bond yields and a continuation of strong physical property market fundamentals over the past quarter. The retail sector, being our preferred exposure, continued to perform well buoyed by strong consumer spending and investment demand for retail properties. The fund benefited through exposure to Hyprop, Grayprop and Sycom on the retail side. The strong performance in retail property looks set to continue in the medium term. The industrial sector continued with steady improvement, reflected in the results of fund holdings such as Pangbourne, Martprop and Resilient. It is encouraging to note that the first concrete evidence of a change of fortunes in the office market has started to appear. The worst rental reversions in the listed companies have occurred, and there are tentative signs of good new lettings, a stabilisation of rental levels, and improved investment demand. We know that office properties are trading well below replacement cost levels, and will continue to invest in well located office exposures with well structured lease profiles.
The fund benefited from the exposure to Liberty International, mainly on the back of a very strong performance and re-rating in pound terms. We are retaining this exposure given the current level of the currency and the diversification benefits mentioned many times before.
Looking forward, the recovery in the distribution growth of listed property companies is happening in line with expectations, and expected to continue in the medium term.
We remain concerned that the current low level of bond rates is unsustainable in the medium term. While there is still a reasonable spread in property yields over bond yields, one has to realise that the risk of capital loss has increased compared to six months ago. We do expect the strong underlying distribution growth in the listed companies to partly mitigate this risk, but we believe the prudent approach is to start increasing liquidity levels in the fund, which we started doing towards the latter part of the quarter.
Taking a longer term view, on a three year horizon we still expect the fund to keep producing returns that are attractive in real terms.

The listed property market held up well in an environment where bond yields continued to rise. After a quarter of negative performance, the performance of the All Bond Index was marginally positive at 0.4%. The Property Equity Fund returned 3% for the period, outperforming both bonds and cash (2%).
It is interesting that the strong positive correlation between property and bond yields has broken down over the past quarter. We believe this is due to the market starting to recognise the strong underlying growth in the physical property market, and the fact that this growth is sustainable in the medium term. While we remain bearish on the outlook for bond rates, and believe that the positive correlation with property yields will re-assert itself over longer periods, the underlying growth in property distributions will continue to cushion listed property prices against increasing bond yields. For this reason, we continue to expect positive real returns in the listed property market over the longer term.
In light of this, we have continued to increase exposure in the fund as opportunities have presented themselves. We have increased exposure to Grayprop and Growthpoint into price weakness, and to Redefine as we believe the recent price decline has been overdone.
Fund exposure to Liberty International has also been increased as we believe it to be a quality long term investment. While this holding dilutes the fund yield, we have always managed the fund with a total return philosophy, and believe it to be a very attractive investment at the current exchange rate level. Liberty International is also entering a period of renewed earnings growth due to the nature of their rent review cycle, with Braehead in Glasgow, for example, being subject to rent reviews in September of this year. In addition, their development pipeline is looking increasingly attractive, with exciting projects such as Norwich, Braehead, Eldon Square, Cardiff, Watford and Oxford underpinning NAV growth in the years leading up to 2008/2009.
We believe that the Property Equity Fund has done well to protect capital in a challenging year to date, and remains well placed to do so going forward.

The fund experienced an excellent quarter, showing a return of 15.29%. The strong run in listed property was driven mainly by the anticipated tightening in the yield spread between listed property and bonds. This is demonstrated by the fact that the All Bond index showed a return of only 2.8% over the quarter.

The return for the fund now stands at 30.11% for the 2003 calendar year and 20.87% since inception, which compares very favourably to any other asset class over the corresponding periods.

It has been the fund manager's strategy to improve the quality of the fund as the property cycle becomes more mature, and this was continued during the past quarter. The fund manager's have further increased holdings in Sycom and Martprop, which the fund manager's believe to be good quality core investments for the long term. Holdings in Redefine and ApexHi B shares were further reduced, which will also serve to enhance the liquidity of the fund. The holding in Grayprop was traded opportunistically during the quarter, with the fund selling as the price overshot fair value and buying back again at more attractive valuations. The fund manager's believe that this counter has some very attractive retail assets, and as a fairly extensive renovation and expansion programme is slowing down in the medium term, is once again becoming poised for growth.

Looking forward, the fund manager's believe that underlying fundamentals in the property market remain positive. The fund manager's expect positive distribution growth for most of the counters on the back of lower funding costs, strong retail performance and lower vacancy rates. While the fund manager's are perhaps not as positive as most market commentators on a recovery in the office market, they agree that the cycle has bottomed, and the prolific pace of development has slowed significantly. The worst impact on distributions caused by rentals reverting to market has also been felt. On this basis, the fund will consider well located office exposure, with well spread lease expiries, which are still trading well below replacement value as a reasonable long term investment.

The fund manager's concern over the longer term is the current level of bond rates. While the local currency remains strong, and inflation is still on a downward trend, they believe that long run inflationary expectations of less than 5% embedded in bond valuations may be too optimistic. Inflation is expected to reach a lower turning point early in the first half of 2004, and the declining short term interest rate cycle must also be coming to an end.

Given the high levels of correlation between listed property and bond yields (probably around 80%), this is thus a risk area. The fund manager's do however believe that the spread between listed property and bond yields is still reasonably attractive, and given the positive fundamentals for the property market discussed above, they favour listed property over bonds currently. In addition, the fund manager's will continue to increase cash levels and liquidity within the fund. The expected forward yield on the fund is currently approximately 10%. While the fund manager's can increase this yield by investing in higher yielding properties, they are taking the more prudent approach of managing for total return, and ensuring that capital is protected.

The fund manager's will also continue holding the funds investment in Liberty International, and increase opportunistically as they did in the past quarter, as this provides an ideal hedge in an otherwise homogenous asset class with respect to bond rate sensitivity.

In conclusion, the fund manager's believe that through their prudent approach and careful share selection, they can continue to deliver attractive real returns to investors going forward.