Absolute and targeted return (ATR) funds continued to enjoy huge popularity in the third quarter, attracting net inflows of R2,44bn, exceeding the combined inflow into all 10 domestic equity categories (R2,03bn).

Steve Mills, Sanlam Inflation Linked Fund's (SIL) manager, shares investors' enthusiasm for ATR funds. He explains that not being pressured by the performance of a peer group or market benchmark means he can focus on the job at hand: delivering consistent inflation-beating returns with the minimum of volatility and downside risk.

SIL's target is to beat CPIX (inflation excluding mortgage bond rates) by 4%/year after annual management fees. This Mills has done well over five years by delivering a 12,2%/year average return against a target of 6,2%/year.

The key to success is to catch a good portion of the equity market's rising tide and not get swept away when it turns. Mills says he "rode equity until mid-August". But with the market having had an exceptional run, he then opted to err on the side of caution, hiking cash to almost half the portfolio and cutting equity exposure from over 40% to 35%.

Put options have effectively cut equity exposure further to about 30%, says Mills. Puts were cheap, he adds, and have snipped less than 0,5% off SIL's return. And Mills can certainly afford to take his foot off the pedal for now. "With a return of 13,5% to date, the fund is running well ahead of target," he says.

Mills has also stuck with financials and industrials as the dominant equity class.

"I don't need the uncertainty resources bring; they are great momentum plays while they are running but can hurt badly when they turn," he says. "Many may be getting sucked in at the wrong time."

A policy of "keeping things simple" and limiting downside risk dominates equity selection, says Mills. His rule is to avoid high-flyers and stick to top-name shares that generate strong, sustainable returns on equity and cash flow.

As a diversified, long-term investment SIL remains a front runner, especially in a market with so much good news already behind it.

Financial Mail - 11 November 2005

As mentioned in our first two quarterlies of this year, our philosophy of stock picking within the absolute-return environment naturally steers us away from the more unpredictable and volatile resource sector. This is because the biggest price driver of resource shares is the future rand price of the underlying commodities, which in general is always uncertain. From a relative perspective, our blue-chip financial and industrials offer far more certainty and visibility in key variables such as future growth in earnings, dividends and cash flows.

We ended the quarter with roughly the same net exposure to equities as at the end of the previous quarter, but during the period we were significantly higher. Our main strategy to reduce our equity exposure was to buy a put option on the Financial & Industrial Index. If this index falls from the current levels by approximately 8% over the next year, our exposure will decrease by 12%, which would result in a comfortably defensive position.

Bonds were the laggard this quarter, with the All Bond Index producing a modest return. On a year-to-date basis, cash and bonds have delivered the same total return. The major change on the fixed income side this quarter was the impact of the higher-than-expected petrol prices together with a rising base effect, which has resulted in a change in short-term inflationary expectations. The bond yield curve continues to flatten, implying that the long end is optimistic that the rise in inflation is of a transitory nature. Our view is that the shape of the yield curve is positive for the bond market and we will use any weakness to add selectively to the longer end of the curve.

Our future strategy will be based on our tried and tested philosophy of trying to balance the portfolio in terms of its dual objectives of not losing money in the short term while achieving the upside target. It is becoming more apparent that certain equities in the non-resource area are offering compelling value compared with the cash alternative, particularly when viewed on an after-tax basis. We see this as an opportunity to add selectively to our equity exposure. Within the fixed income area we are likely to accumulate bonds on any weakness.

Sanlam Inflation Linked (SIL) is best described as a low-volatility, targeted-return fund, says manager Steve Mills. His target for SIL is CPIX plus four percentage points over a rolling three-year period after deduction of the annual service fee. CPIX is consumer price inflation excluding mortgage bond rates but, in practice, consumer price inflation and CPIX differ only marginally over time.

CPIX+4% may not appear to be a tough target, particularly given SIL's 48 percentage point out performance of its benchmark over the past three years. In reality, even a long-term return of CPIX+3% from a well-diversified portfolio such as SIL's can be viewed as a solid achievement.

"There are no pats on the back for having done well recently," says Mills, referring to the equity market's doubling in value since May 2003. For Mills, what really counts in a fund such as SIL is its low volatility and resilience in periods of market weakness.

SIL passed this test with flying colours during the market's slide between June 2002 and April 2003. SIL's unit price fell a minimal 2,3% compared with the all share index's 37% fall and the general equity fund index's 24% fall.

Back-testing shows that an average equity content of about 30% is more than enough to achieve a return of CPIX+4%, says Mills. At present SIL's equity content is 50% but the portion exposed directly to market volatility is only 36%.

Though Mills views equity with some caution since the market's recent strong gains, he is optimistic that equity has entered a period in which it will outperform bonds, the reverse of the situation over the past 15 years. But Mills feels bond yields will remain relatively stable, underpinning equity valuations that are also being enhanced by strong earnings growth. Compared with bond yields, financial and industrial equity earnings yields are at almost their best value levels in 10 years.

SIL will appeal to investors who seek stable growth from a diversified portfolio. Mills' two decades of experience in markets adds appeal.

Financial Mail - 02 September 2005

Like the first quarter, the second quarter of 2005 proved to be challenging from an absolute return perspective given that the trend that started in the 1 st quarter continued in the second, albeit with significantly more volatility.

As mentioned in our 1 st -quarter report, our philosophy of stock picking within the absolute return environment naturally steers us away from the more unpredictable and volatile resource sector. This is because the biggest price driver of resource shares is the future rand price of the underlying commodities, which is generally always uncertain. From a relative perspective, our blue-chip financials and industrials offer far more certainty and visibility in key variables such as future growth in earnings, dividends and cash flows. Consequently we had another tough quarter in terms of our stock picks.

We ended the quarter with roughly the same net exposure to equities as at the end of the previous quarter. Apart from a small number of net purchases in equities our main tactic was the purchase of Sasol on a stop-loss basis, instead of using call options. We sold the Sasol shares and banked an 18% profit, which equated to 17 points for the entire portfolio. Another tactic employed on a similar basis was with regard to the All Share Top 40 Index futures where again, instead of using options, we set a stop loss and bought and later sold the instruments to bank a 12-point profit for the portfolio as a whole. It must be stressed that this tactic was to manage our exposure risk and not to speculate.

Quoted property had another extremely positive quarter. Unfortunately our strategy of taking profit (mainly on the back of liquidity fears) proved to be incorrect. Our basic assumption of having seen the bottom of the interest rate cycle was too premature.

Bonds again had an up-and-down quarter but in the end produced a decent positive return for the quarter. In hindsight we should have used the weakness in the 10-year area to accumulate more bonds when they were around the 8,5% levels. We still see better value in nominal than inflation-linked bonds.

Our future strategy will be based on our tried and tested philosophy of trying to balance the portfolio in terms of its dual objectives of not losing money in the short term while achieving the upside target. It is becoming more apparent that certain equities in the non-resource area are offering compelling value with regard to the cash alternative, particularly when viewed on an after-tax basis. We see this as an opportunity to add selectively to our equity exposure. Within the fixed-income area we are likely to accumulate bonds on any weakness.

The first quarter of 2005 proved to be challenging from an absolute return perspective. However, taking a cursory glance at the major asset class returns this does not appear obvious.

The All Share Index returned an impressive 5.9% for the quarter but this was driven almost entirely by resources, which produced 16.9% for the same period. The Financial and Industrial Index by contrast produced a modest 0.5% return.

Our philosophy of stock picking within the absolute return environment naturally steers us away from the more unpredictable and volatile resource sector. This is because the biggest share-price driver of resources is the future rand price of commodities, which is generally always uncertain. From a relative perspective, our blue-chip financials and industrials offer far more certainty and visibility of future growth in key variables such as earnings, dividends and cash flows.

We ended the quarter at 29.9% in equities but intra-quarter we peaked at just under 35%. Apart from a small amount of net selling in equities our main tactic was the purchase of call options in early January to manage the risk of an unexpected rise in the All Share Index. This strategy worked out well as we captured most of the rise in the market. We sold them out completely in late March. Although the logic of this tactic was to manage upside risk, the transaction itself yielded a handsome profit.

Quoted property ended the quarter on a strong note by returning 5.3%. Our strategy here was to start a programme of reducing exposure, the main reasons being valuation relative to bonds and the fact that we believe most of the good news is now fully priced into the sector.

Bonds had an up-and-down quarter, finally ending the quarter in negative territory returning -0.3%. Fortunately we resisted the early January and February euphoria and remained low in exposure and also kept the duration well short of the All Bond Index. We also introduced a small holding of 1.8% in a short-dated Inflation Linked Bond, bringing our total exposure in bonds to 10.5%.

Our cash holding rose to 49%, which in itself is returning a risk-free decent real return as inflation continues to very benign at just over 3%.

The balance of the portfolio (5.1%) was made up of preference shares and Bidvest Empowerment shares. The latter will deliver an effective 11.5% annual return to the end of December 2006 should the Bidvest Ords (Black Empowerment portions of Bidvest) end above R60.

Our future strategy will be based on our tried and tested philosophy of trying to balance the portfolio in terms of its dual of objectives of not losing money in the short term while achieving the upside target. We see this as a challenge as the markets, bonds and equities, are undoubtedly at some form of inflection point as they attempt to digest the end of the global reflation trade as the US raises interest rates. This is against the backdrop of continuing positive domestic fundamentals.

The quarter was characterised by a continued upward momentum in the equity market, driven mainly by domestically orientated financials and industrials. This suited the fund as we kept the equity portion at the maximum level in order to achieve the target return of CPIX + 5% and to ensure, to the best of our ability, that the fund does not experience any negative returns over any rolling 12-month period.

To this end the allocation to equities at the end of the quarter was again defensive.

We began to trim our exposure to equities during December as we banked some of the excess returns.

We should explain why our allocation to equities is so low. We are driven by the objective of capital stability and believe that the volatility of equities has not subsided. Therefore we are constantly asking and testing for what is the maximum exposure to equities required to meet the dual objectives of meeting the upside target and of capital protection over the short term. It is the second objective that causes us to run a low equity exposure.

Moving beyond equities, our exposure to bonds and quoted property in particular added value over the fourth quarter. We are likely to hold our positions in the short term given our inflation forecasts and positive momentum in these markets.

Our money market funds were predominantly invested in the short end of the money market curve as it offered the most value. This is likely to change, as it appears that a cut of 50 points is on the cards during the first quarter of 2005. This has now being discounted by the forward curves.

We are not likely to change the asset allocation too much in the quarter ahead, but will focus our efforts on stock picking with a possible rotation out of some the high-flying financials and industrials into some non-resource rand hedges in order to guard against an unexpected crack in the currency.