News flow in the third quarter was again dominated by the developed market debt situation, with European policymakers continuing to defer the inevitable. More importantly, the non-recurrence of further economic stimulus in the USA has predictably led to asset value declines in a number of markets. In dollar terms, European markets were down strongly (CAC 40 down 30.3%, DAX 30 down 31.0%, FTSE 100 down 15.5%). The FTSE JSE Top 40 Swix Index was down 21% in dollar terms.

Food inflation readings continue to trend higher with the August 2011 reading at 7.3% year on year, from 1.6% year on year in December 2010. If the Rand depreciation (19.7% depreciation to the dollar over the quarter) does not reverse, it is almost certain that inflation will breach the target bands next year. The deterioration in the inflation outlook has led to a strong rally in the yields of shorter-term inflation linked bonds.

Local markets were again very volatile over the quarter. The FTSE JSE Top 40 Swix Index was down 5.03% over the quarter with an intra-quarter maximum drawdown of 11.7%. Due to its defensive positioning, the fund's drawdowns were significantly lower, and the fund ended the quarter down 1.3%.

Implied option volatility (an indicator of the cost of protecting a portfolio at current market levels), as measured by the South African Volatility Index (SAVI), moved up dramatically to 32.7% from 22.7% at the start of the quarter. This means that the cost of new protection is now very high in our view. As always we will aim to minimise the cost of the fund's downside protection, through an optimal blend of our dynamic asset allocation model, outright puts and tactical cash overlays. Since inception, fund volatility has been 9.9% versus 19% for the FTSE/JSE Top 40 Index.

Going forward, we remain cautious about developed economies that face long-term challenges in the form of high unemployment, high government debt levels and negative demographic trends. In the short to medium term these economies will have to grapple with the implementation of austerity plans.

We remain defensively positioned. Our dynamic asset allocation model is complemented with outright put protection in order to manage drawdown risk. This defensive positioning is carried through into stock selection, where we favour companies with strong balance sheets, high franchise value and/or dominant market positions, low fixed costs and defensive earnings streams. We are avoiding companies which have strongly re-rated in expectation of high earnings growth in future - growth that we believe may be elusive in the tough economic environment we expect.

The second quarter of 2011 was dominated by economic developments in Europe, with the market digesting the effects of austerity measures and sovereign debt downgrades. In addition, it became apparent that the all-important Chinese contribution to the global recovery was not without risk: authorities began to aggressively tighten monetary policy in response to rising inflation, which will slow down their economy.

Emerging markets had only a mildly negative quarter, with gains in the first two months largely offsetting a sharp drop in June. In total return dollar terms the MSCI Emerging Markets Index was down 1% for the quarter and the MSCI China Index down 1.7%. Developed markets benefited from an element of safe haven buying and fared a lot better with the S&P 500 up 0.1%, the FTSE 100 up 1.7%, the Nikkei 224 up 3.3% and the DAX 30 up 7%. Local inflation readings have surprised on the upside, with the May CPI reading at 4.6% year on year, with food inflation the primary contributor at 6.6% year on year. The pick-up in food inflation was expected and was due to the lagged feed-through of high global agricultural commodity prices. South Africa's recent food inflation pick-up has been relatively mild compared to those of other countries as we have been shielded by a strong currency and a favourable maize crop surplus. We see higher South African inflation risk going into 2012 as these fortuitous factors roll off.

Markets were volatile over the quarter. Although the FTSE JSE Top 40 Swix Index was down only 0.7%, its intra-quarter maximum drawdown was a significant 7.9%. Due to its position in put options, the fund's intra-quarter drawdown was significantly lower. Implied option volatility (an indicator of the cost of protecting a portfolio at current market levels), as measured by the South African Volatility Index (SAVI), ended the quarter unchanged at 22.7% after spiking to 24.6% during the market fall in June. The cost of put protection remains reasonable in our view. As discussed in previous notes, the fund continues to look for opportunities to complement its asset allocation strategy with the selective purchase of put options so as to increase the downside protection. Since inception, fund volatility has been 9.9% versus 19.2% for the FTSE/JSE Top 40 Index.

Going forward, we remain cautious about developed economies that face long-term challenges in the form of high unemployment, high government debt levels and negative demographic trends. In the short- to medium-term these economies will have to grapple with the inevitable withdrawal of stimulus and the implementation of austerity plans.

We remain defensively positioned. Our dynamic asset allocation model is well complemented with outright put protection in order to manage drawdown risk. This defensive positioning is carried through into stock selection, where we favour companies with strong balance sheets, high franchise value and/or dominant market positions, low fixed costs and defensive earnings streams. We are avoiding companies which have strongly re-rated in expectation of high earnings growth in future - growth that we believe may be elusive in the tough economic environment we expect.

Portfolio manager
Jihad Jhaveri

The first quarter of 2011 was dominated by the tragic natural disaster in Japan, and the uprisings in North Africa and the Middle East. These events, though devastating from a human suffering point of view, should not (in our view) result in a major long-term derailment of the global economy.

Notwithstanding the above bad news, equity markets had a strong quarter. The S&P 500 index was up 5.4% and the MSCI World index rose 4.9%. Emerging markets underperformed developed markets in general although Japan was particularly weak (the Nikkei 225 fell by 18.7% in the aftermath of the earthquake, but recovered to end the quarter down 4.6%).

Oil prices surged over the quarter (Brent future up 24% to $117 a barrel) as the commodity began to build in a scarcity premium due the North African tensions. This, together with stubbornly high agricultural commodities, meant a strong rebound in global inflation levels, resulting in monetary policy tightening in China, India and the Eurozone. Should the "geo political" risk premium built into the oil price not unwind (or increase further), it would pose a significant threat to the world economy.

The local inflation reading remains subdued (3.72% p.a. year-on-year for February), and is not expected to exceed 6% by year-end as South Africa is shielded somewhat by a strong currency and a favourable maize crop surplus. As these fortuitous shields roll off, we see higher South African inflation risk going into 2012.

Implied option volatility (an indicator of the cost of protecting a portfolio at current market levels), as measured by the South African Volatility index (SAVI), was relatively flat over the quarter at 22.5%, spiking to 27% at the height of the Japanese earthquake uncertainty. The cost of put protection remains reasonable in our view. As discussed in previous notes, the fund continues to look for opportunities to complement its asset allocation strategy with the selective purchase of put options, so as to increase the downside protection. Since inception, fund volatility has been 10% versus 19.4% for the FTSE/JSE Top 40 index.

Going forward, we remain cautious about developed economies that face long-term challenges in the form of high unemployment, high government debt levels and negative demographic trends. In the short- to medium-term these economies will have to grapple with the inevitable withdrawal of stimulus and the implementation of austerity plans.

We remain defensively positioned. Our dynamic asset allocation model is well complemented with outright put protection in order to manage drawdown risk. This defensive positioning is carried through into stock selection, where we favour companies with strong balance sheets, high franchise value and/or dominant market positions, low fixed costs and defensive earnings streams. We are avoiding companies which have strongly re-rated in expectation of high earnings growth in future - growth that we believe may be elusive in the tough economic environment we expect.

Portfolio manager
Jihad Jhaveri

Further monetary stimulus and a better than expected US earnings season saw the S&P 500 index surge by 10.2% in the fourth quarter. Other major developed markets also showed strong gains and the MSCI Emerging Market index rose 7.1% over the quarter in dollar terms.

The local FTSE/JSE Top 40 SWIX index ended the quarter up 8.35% (after being up 14.86% in the previous quarter) and ended the 2010 year up 18.68%. The Kagiso Protector Fund finished the year 9.78% higher net of fees, and outperformed CPI+5%. Importantly the fund continued to participate more in positive equity return periods than in negative equity return periods. This asymmetry is key to our objective of producing strong real returns, whilst protecting the fund's downside.

Implied option volatility (an indicator of the cost of protecting a portfolio at current market levels), as measured by the South African Volatility index (SAVI) was erratic in 2010 - ending the year at 21.66% after dropping to below 20% in April and rising to above 30% during the European debt crisis in May. As discussed in previous notes, the fund continues to look for opportunities to complement its asset allocation strategy with the selective purchase of put options, so as to increase the downside protection. Since inception, fund volatility has been 10.5% versus 19.6% for the FTSE/JSE Top 40 index.

Globally, inflation is expected to remain subdued in the medium-term, primarily as a result of excess capacity. In South Africa, the upward pressure of administered price increases (electricity and municipal rates) should be countered by the strong rand. We expect CPI to remain below 6% over the next two years. A risk to this assumption is the recent trend of rising global energy and food prices, which, if sustained and coupled with a weaker rand, will result in higher inflation.

The current rating of the FTSE/JSE All Share index (priceearnings ratio of 17.4X and above its long-term average of 11.8X) suggests that the market as a whole is not cheap, even after accounting for strong future earnings growth, therefore reinforcing the need for judicious stock selection. We are wary of certain valuations in the local market, particularly in the sectors that have attracted the bulk of the foreign capital inflow. The fund continues to be positioned so as to produce long-term returns in excess of inflation, whilst protecting against any potential downside and high volatility in the equity markets.

Portfolio manager Jihad Jhaveri