Our investment strategy this year has been built on expecting a period where the asset inflation of the past two years would be consolidated and correlations realigned. We have referred to it previously as a "risk reset."

Our portfolios have managed the recent consolidation phase very well because we executed a broad-based de-risking of the portfolio ahead of the third-quarter's risk reset. This included: reducing exposure to investment-grade corporate credit and mortgage-backed securities; maintaining long-duration exposure in high quality sovereigns; hedging currency risk associated with richly valued, commodity linked currencies; and maintaining no exposure to the euro and a significant overweight in the U.S. dollar. These actions were the right move for the risk reset that took place in the third quarter.

As well as our portfolios did by not owning the euro and overweighting the dollar, our non-dollar currency investments outside of the euro and yen succumbed to the fear of another Lehman-style meltdown. The result was that the biggest contributors to returns came from holdings in sovereign long-term debt especially in the US, UK and Australia.

Going forward the immediate judgment call is on European economic policy. The European financial crisis is clearly a systemic risk. Yet, the potential for a complete unravelling of the financial system seems to us a non-trivial but low probability outcome.

From a valuation perspective, it is clear that price risk is building up in high-quality duration. Many of the developed-country long term sovereign credits that helped with performance this year have become very expensive. We have started to shed some duration exposure and under more normal circumstances we would move to shorten maturities. Conditions, however, are anything but normal.

Fund Review
Peripheral European government bonds continued to underperform and spreads relative to German government yields (the risk-free benchmark in Europe) moved to their widest levels for the year. Meanwhile, after a multi-month rally in developed market sovereign debt driven by slowing global growth, high real yielding non-G7 markets started to outperform as investors reached for yield. The break in commodity prices also helped nonG7 markets since lower commodity prices will mitigate the risks of rising headline inflation pressures driving up core measures of inflation too. Greek bonds performed poorly, however they are no longer part of the Citigroup World Government Bond Index.

Overall, it remains to be seen what will happen with respect to these peripheral European bond markets; currently there is not much visibility. Due to this uncertainty we remain underweight European Monetary Union (EMU) government debt and are monitoring policy developments closely. We prefer to own U.S. Treasury securities where possible, or high quality European government debt instead, such as that from Norway and the United Kingdom.

Looking Ahead
We remain overweight the U.S. dollar based on valuation and also due to our expectations for a reacceleration of U.S. GDP growth in the second half of 2011. We believe a reacceleration of U.S. growth would raise market expectations for a Fed exit strategy from their zero interest rate policy. Slumping risk sentiment hurt U.S. corporate bonds in June. Fears about slowing growth in China and the United States appeared to prompt investors to take profits on their corporate bond holdings and move the money into high quality sovereign debt instead. Emerging markets (EM) bonds and currencies delivered mixed performance during June. Despite heavy intra-month volatility, many EM currencies and bonds ended June near unchanged levels.

Fund Review
The greatest period of reflation in modern economic history is coming to a close. Since late 2008, the right tactic has been to bet that these reflationary tactics would not only work to prevent a depression but would re-ignite global growth. Risk assets ranging from equities to emerging markets, corporate and high yielding debt along with commodities have rallied strongly. The world economy has rebounded and, in our opinion, is on the path to an unbalanced but self-sustaining expansion.
The key risk to our view is the price of energy. The prospect of another major energy shock is a significant and disheartening risk. Prices cannot keep rising indefinitely. Many analysts including the IMF have concluded that the world can withstand even higher energy prices. This is not our view. We are concerned that debt levels and unemployment rates remain very high in the developed world. Rates may not have to go up at all for consumer spending firepower to be exhausted by a surge in energy prices.

Looking Ahead
The majority of the duration in the portfolio comes from holding of our U.S. corporate bonds and non-agency Mortgage Backed Securities. This may seem controversial in view of the near universal bearishness that currently seems to exist regarding the outlook for U.S. debt. However, the spreads between the short and long end of the yield curve had reached historic extremes. Moreover, the prospect of the Fed beginning to exit some of its exceptional stimulus programmes seemed more constructive for bonds than negative.
We remain underweight the Yen and Euro in favour of the British Pound Sterling.