The third quarter of 2007 was quite eventful for financial stocks. Dominating the markets was the impact of the US sub-prime debacle, which is having deeper and wider implications than most originally believed. The direct fundamental impact on SA financial shares appears to be significantly lower than on developed-market stocks. Those SA companies with foreign listings, such as Old Mutual and Investec, have borne the brunt of developed-market investors who appear to have lumped all financial shares together and consequently treated them indiscriminately.

In SA the main concern remains inflation and the consequences for further interest rate increases. In this regard the banks continued to underperform while the life companies with the exception of Old Mutual fared somewhat better thanks to good new business growth and a lack of bad news flow. In addition to suffering from the sub-prime contagion, Old Mutual shares continued to underperform on the back of recurring problems in its US life operation. We believe that both Investec and to a lesser extent FirstRand have suffered as a result of very high investment banking profits that may not be sustainable due to the sub-prime impact on global debt markets. Apart from these specific issues the results announced during the period were largely in line with expectations and showed healthy earnings growth.

During the quarter the fund performed in line with the Financial Index. For the year to date we have managed an 8% outperformance thanks to a relatively lower weighting in banks. We have now started to rebalance the fund in favour of banks at the expense of some of our foreign investments and by taking profits on some of the smaller financial shares that have done very well for us.

With regard to the prospects for the fund, we believe we are at or near the top of the domestic interest rate cycle and that the diversified revenue streams of the banks are likely to benefit from increased economic activity from businesses that are experiencing capacity constraints and which should benefit from increased infrastructure spend. Life companies are experiencing better new business flows thanks to better value-for-money products and are benefiting from higher funds under management. Valuations for both banks and life companies provide a reasonable investment underpin.

During the second quarter of 2007 we saw almost a complete reversal of the first quarter as banks underperformed the life companies. As inflation fears became more pronounced and the monetary response of increasing interest rates more inevitable, sentiment towards the banks became more negative. This, together with rising consumer indebtedness, the enquiry into banking fees and the impending introduction of the National Credit Act, all conspired to derate the bank shares which had enjoyed a good run since September 2006.

Although positive on the fundamentals for the banks, we remained cautious about tilting the fund's exposure more towards the banks as we felt that the performance in the first quarter was completely ignoring some of the headwinds that were building. Strategically we preferred to increase our weighting in global financials, taking the weighting from 11% to 14% of the fund during the quarter. We had previously mentioned that our ability to invest in foreign financials through the Sanlam Global Financial Fund provides a very necessary diversifier for our sector-specific fund. The second quarter provided a good example of this, with the foreign component of the fund growing by 10% compared to a 7% decline in the banking index over the same period.

In contrast to the banks, the life sector seemed to benefit from less media scrutiny and even overcame the release of the planned social security reform proposals that will impact some of their retirement-related business. Sanlam, our largest holding in the life sector, did particularly well as management continued to deliver on their plans to diversify the business into a broader-based financial services group. During the period we increased our exposure to Old Mutual. The share has had a torrid time since the euphoria post the Skandia acquisition. A few glitches in the US and Nordic life operations as well as a muted outlook for 2007 have not gone down well with investors, but we believe that OML is well placed to take advantage of trends in the UK and that the issues in the US and Nordic business won't be repeated.

Regarding prospects for the remainder of the year, we believe that the negative sentiment towards the banks has been overdone. Despite the current investigation into bank fees and the introduction of the new National Credit Act, we remain confident of the robust nature of the diverse revenue streams of the large banks. We expect the NCA and increased interest rates to slow down credit growth and this should limit the need for further rate hikes. We also believe that the life company valuations are attractive and should be defensive should the overall market correct. We continue to seek opportunities to invest in good-quality smaller niche financial companies.

The good performance of the financial sector in the second half of 2006 continued into the fist quarter of 2007. The large-cap banks have benefited from a perception that the current interest rate up-cycle will top out well below previous levels. Recent bank results have also proved slightly better than expected and the earnings outlook remains robust on the back of a continued strong economy and expectations that the commercial sector will take up any slack from a slowing consumer.

Although bad debts are expected to tick up from very low levels there is still no evidence of undue duress. The fund has been well exposed to FirstRand, Standard Bank and ABSA, all of which provided about 13% total return for the quarter. The only blemish was that we could have been even more exposed to the banks. Despite the poor news flow in 2006, life sector shares did reasonably well although not as well as the banks. This underperformance of the banks has become more pronounced in the first quarter, probably due to the market taking a wait-and-see approach to Liberty and Old Mutual, which are both involved in internal restructuring.

The fund was more exposed to Sanlam and Metropolitan, which have performed well. However, the fund was perhaps too exposed to the life sector relative to the banks during the first quarter. In the past quarter some of the best return performances in the sector have come from the smaller niche financial companies such as JSE (+35%), Sasfin (+21%) and Santam (+20%). The fund had considerable exposure to these three shares but no exposure to other good performers such as Peregrine (+20%) and Coronation Fund Managers (+18%). While the smaller-cap companies often provide excellent returns they can be very illiquid and the fund therefore seeks exposure to the better-quality small-cap financial shares. In addition to local financial shares, the fund may invest up to 15% of the fund value in foreign financial equities.

The fund does this through an investment in the SIM Global Financial Fund, which has an excellent track record among its peer group. Currently 11% of the fund is invested in the SIM Global Financial Fund. During the quarter the rand has been quite stable relative to the reporting currency of the fund ($), and while the underlying performance was in line with SA financials the fund has underperformed the SA banks. However, we remain of the view that exposure to foreign financials provides necessary diversification for this sector-specific fund. Regarding prospects for the remainder of the year, we believe that the sector has not reached the levels of overvaluation that afflict some of the other sectors.

Despite the current investigation into bank fees and the introduction of the new National Credit Act, we remain confident of the robust nature of the diverse revenue streams of the large banks. We also believe the life industry is well on the road to adapting to a new business model brought about by strong consumerism. In addition, the life company valuations are attractive and should be defensive should the overall market correct. We continue to seek opportunities to invest in good-quality smaller niche financial companies.