After the tough second quarter our portfolios rebounded more in line with what typically could have been expected and has fortunately recovered all that was lost during May and June. The feature of the 3rd quarter was the weak rand, which depreciated by 7.6% against the US$ and 8.9% and 7.7% against the UK£ and the € respectively. The interesting feature was that the interest rate sensitive areas of our market, including bonds, held up relatively well over the period. This was most likely due to the fact that these sectors were severely sold down during May and June and the 3rd quarter was more a catch-up. In addition, all the currency variables and indicators point to a sentiment issue driving the rand rather than any fundamental issue. The shape of the yield curve also suggests that the rand will be stronger rather than weaker in 12 months' time.

Equity exposure remained low due to the many short-term risks that still abound. These risks are predominantly caused by the currency sell-off. At quarter-end we were still below our strategic equity allocation. However, some exposure to equities was added towards the end of the quarter. The main feature for us during the quarter was the introduction of a reshaping programme in the broad equity theme. From May 2003 to May 2006 South Africa experienced a sweet spot in terms of the broad macroeconomic drivers, the most important being disinflation, an appreciating rand and, of course, lower real and nominal interest rates. Basically, all of the SA equity market shares benefited from this benign environment particularly those that were plugged into the local economy. However, with the change in the trend of the rand this favourable environment is changing to a much tougher one with interest rates set to rise by at least another 100 points, with a distinct risk of further increases. Note that another 100 points increase is well discounted in both the equity and bond markets, but more than that will unfortunately introduce a further bout of downside volatility. This is, essentially, why we remain cautious with respect to our equity exposure.

We added a bit of bond exposure during the quarter in the middle-dated credit area. But fundamentally we remain cautious for the reasons outlined above. Over the quarter, the All Bond Index produced a positive return of 2.1% against the return of 1.9% on cash. Note that for the first nine months of the year bonds have been slightly negative producing -0.1% versus the 5.6% of cash. Our negative view on bonds has paid off so far. We have made our first meaningful investment in inflation-linked bonds for a long time. The instrument is a 5-year credit bond (FirstRand Bank) with a 40-point spread over the equivalent Treasury. This gives a real yield of 3% and, together with the high inflation carry expected, we anticipate that this bond will outperform cash over the forecast period. Given that the distribution in listed properties is set to remain around the 10% level over the forecast period we decided to start adding, cautiously, some exposure to this asset class. This was made even more compelling as this sector had a severe correction during the previous quarter and now offers fair value relative to cash.

In conclusion, we are happy with our defensive stance at present from an asset allocation point of view. We have begun to shift the focus of the equity stock picks to reflect the change in the overall macro-environment. Finally, if the rand stabilises, the markets should start to factor in a different but solid set of economic variables and we should end the year close to our respective upside targets.

This quarter proved to be an exceptionally tough one for our portfolios. May and June were an extraordinary period with regard to our portfolios as the equity component detracted value largely from a sector point of view. It was the worst two months since inception of these funds in 2001 and we believe it was due to a market aberration rather than any flaw in our approach to their management.

Equity exposure was trimmed in April and then again in mid-May, which in total came to a reduction of over 6%. Note that the total equity exposure reduction since the beginning of the year now stands at just over 10%. We are now running well below what we think is the optimal strategic exposure to equities. As has been mentioned often before in our quarterly reports the equity exposure has generally been confined to the Domestic Financial and Industrial sectors due to the relative consistency and reliability of future earnings and dividend growth.

Over the quarter the financial and industrial sector declined by -5.6%, while the resource sector actually went up by 21.3%. Therefore, over the three-month period there was a 26.9% difference in the performance of these two sectors!

Over the quarter our negligible exposure to long bonds paid off as the All Bond Index produced one of it worst quarterly returns - a negative -3.6%. However, this is an area on which we are increasingly focusing to try and extract real returns, so we may start adding to our nominal bond positions on any further weakness.

Quoted property was the big loser over the quarter declining by -22.3%, but fortunately the fund's exposure to this asset class remained very low.

The fund's large cash holding, while not producing great positive returns, proved to be a very important stabilising influence on the portfolio as a whole.

In summary, we were pleased with the overall asset allocation strategy of the fund over the quarter but, essentially, it was having only financial and industrial exposure in the equity portion of the fund that contributed to the quarter's poor return.

Going forward we are concerned about the uncertainty of where short-term interest rates are heading, which will undoubtedly put pressure on bond yields and interest rate sensitive domestic shares. Our fund is well positioned from an asset allocation point of view, being low in equities, viz. 21% and having virtually no exposure to the long bond area in addition to being low in quoted property. Within equities, however, our zero exposure to rand-"geared" shares, i.e. resources, is potentially a problem which we are currently addressing.

Despite the disappointing absolute quarterly performance we remain confident that we can achieve our dual objectives of not losing capital over a rolling 12-month period and achieving our upside objective over a rolling 36-month period. However, it is worth stressing that on a short-term, month-to-month basis, we can experience negative drawdowns when there are widespread sell-offs.

We are pleased to report, once again, a very solid quarterly performance to start the new year on a positive note. The fund achieved both of its objectives of not losing capital in the short term and achieving its upside target over the medium term, both over the quarter and over the past 12 months.

The main driver of performance was asset allocation as we were not "seduced" into buying more equity exposure in January. Our stock picks, as usual, were confined predominantly to industrial and financial shares. However, we caution that there might well be a short-term correction ahead in equities as price momentum is now running well ahead of forecast earnings momentum. As a consequence we are likely to sit tight as far as our equity exposure is concerned. Our exposure to equities was reduced by just under 3% during the quarter.

Over the quarter our low exposure to bonds paid off as the All Bond Index underperformed cash over this period. This is an area on which we are increasingly focusing in an attempt to extract maximum returns, so we might start adding to our nominal bond positions on any weakness. Our bond exposure was reduced by 2% during the quarter. Inflation-linked bonds, in our opinion, continue to look extremely expensive, especially when viewed against cash, nominal bonds and, interestingly, equivalent US securities. We will continue to avoid this asset class.

Quoted property was the big winner over the quarter but regrettably the fund’s exposure to this asset class remains low. In hindsight, this has been a mistake as we underestimated the interest rate cycle and the distribution growth. We added a bit more exposure during the quarter, upping our holdings by about one per cent.

In summary, we have stressed-tested our portfolio against various corrections or negative return scenarios and we are satisfied that we have a sufficiently diversified and defensive portfolio in place. For example, from the end of the first quarter to the end of calendar year 2006, the Financial and Industrial Index has to fall by 31% in order for the portfolio to suffer a capital loss. We think that downside protection is sufficient.

We are pleased to report a very solid quarterly performance to finish the year on a positive note in terms of absolute returns. For the full year the portfolio ended well ahead of is upside target.

The main driver of performance was stock picking, particularly Venfin, which was one of our largest equity holdings. Venfin jumped by over 29% on 3 November on the back of the announcement that UK-based Vodafone was to acquire Venfin in order to obtain its 15% stake in locally based Vodacom.

Besides that one-off boost to performance the core stock picks in which we believe, viz. solid blue-chip industrials and financials, also delivered as expected. We continued to avoid the volatile resources area of the market except for some exposure to platinum shares.

Our exposure to equities was higher at the end of this reporting period than at the end of the 3rd quarter, predominantly as a result of Venfin and market moves rather than a conscious increase in asset allocation. Fortunately, the small premium that we paid (approximately 51 points) for some downside protection, via our put option strategy, was not needed. However, despite being sanguine about the prospects for equities in the year ahead, we are likely to consider another "insurance policy" in the near future given the unpredictable nature of markets.

Bonds made a strong recovery and with hindsight we could have had more long duration bonds and less cash over this period. We did not buy into weakness, as we felt that levels were not attractive enough. Cash and bonds produced very similar returns for most of the year. Taking the capital loss risk associated with bonds into account, cash proved to be a much safer option. We avoided inflation-linked bonds as they were extremely overvalued.

In summary, there has been the shift in inflationary expectations, as the petrol price does not seem to be spilling over into core inflation. The market revised the outlook for short-term interest rates. At the beginning of the 4th quarter it was virtually certain that short-term rates would rise by at least 100 points during 2006. This has now changed to no further hikes during 2006 and in our opinion there is a growing possibility of a 50 point cut during the first half of this year. This has had a positive effect on the equity and bond markets.

In view of the above, we are positive on equities. The overall value of the equity market is arguably fairly full but still far from being irrationally expensive. However, as mentioned above there are always risks, with the main one being a totally unexpected harmful event. As a consequence we will stick to our tried and tested philosophy of having a modest exposure to equities. This is in line with trying to balance the dual objectives of achieving our upside target and not to lose capital over the short term.