MARKET REVIEW
During the third quarter of 2009 there were many signs that confirmed the world economy is stabilising, with the focus shifting to the likely strength of the recovery. Global equity markets continued their recovery during the quarter, with the MSCIWorld returning 16.8% in dollar terms. This quarter also saw the continued outperformance of risky assets, with the MSCI Emerging Markets index delivering an even more impressive 20% in dollars. Along with other emerging market currencies, the rand continued strengthening against the dollar, appreciating 3.1% during the quarter. The JSE All Share Index gained 13.9% in rand terms over the period. Global yield curves remained steep as shorter-dated rates were kept low by central banks. In August the SA Reserve Bank surprised the market by cutting the repo rate further to 7%. This decision was taken on the back of a stronger rand, lower inflation outlook and weak domestic economy. Our bond market initially reacted positively to this news, with the result that nominal bonds outperformed all other fixed interest asset classes for the quarter. Participants in the bond market are, however, still concerned about government's increased funding requirements. For the quarter, the All Bond Index returned 2.96%, cash 1.98% and inflation-linked bonds 1.44%. Property stocks delivered an impressive total return of 12.15%.

ASSET ALLOCATION
For the first time since the beginning of the year we reduced our equity exposure through the implementation of a protective derivative overlay. According to our valuations, equities are now close to fair value and have reached these levels quite rapidly. At levels closer to 8.1% on the R157, we reduced our nominal bond exposure slightly. During the first week of October, we started adding some selective bond exposure after a sell-off in the domestic bond market. We got another opportunity to add to the inflation-linked bond exposure through senior Nedbank credit trading at a real yield of 3.9%. Over the past six months we have increased the inflation-linked bond component of the portfolio significantly at very attractive real yields. At levels below R7.50 to the dollar we increased the international exposure of funds allowed to invest offshore.

INVESTMENT STRATEGY
We reduced equity in the third quarter after market valuations approached fair value. We will introduce more equity downside protection if the equity market appreciates significantly from these levels. We do remain cautious over the near term due to uncertainty surrounding future company earnings. There has been a definite increase in demand for high yielding incomeproducing assets over the past few months. As a result credit and property stocks have performed exceptionally well. We see little value in local property stocks, but still consider domestic credit to be cheap relative to historical standards. We will continue to look for attractive credit opportunities in the primary and secondary fixed interest market. The short-dated inflation-linked bond (R189) looks expensive at 2%, while the longer-dated R197 is more attractive at 3% and would be our preferred stock in the inflation-linked bond market. During the last few weeks of September, nominal bonds weakened and we will continue to add nominal bond exposure to the portfolio at higher levels. At current levels, nominal bonds are implying real returns of more than 3%.

EQUITIES
The local equity market ended the quarter on a winning note, delivering exceptional returns. Year-to-date the Shareholder(?) Weighted All Share Index (SWIX) has gained 19.2% and is 13.9% ahead for the third quarter alone. The INDI25 is up 19.3% for the year and 15.8% for the quarter, the FINI15 is up 19.8% for the year and 14.9% for the quarter, with the RESI20 up 16.1% and 11.2% for the year and quarter respectively. These are strong returns in tough times, albeit off a low base.

For the quarter ended Sept:
Imperial was one of the main contributors to the performance of the fund, advancing by 37% on the back of excellent results, which saw the group benefit from having disposed of its more capital intensive businesses. The fund also benefited from our holding in Naspers, which advanced by over 30% and whose investment in Tencent, the leading Chinese internet service provider, is proving to be more than resilient in current times, with reported earnings for the first half of the year up close to 90%! Judging by our bottom-up assessment of the long-term intrinsic value of the market, the local stock market is now trading at close to fair value. We can still justify some 8% upside to the fair intrinsic value in the financial and industrial sector. While we increased our exposure to select resource shares during the course of this year (Anglo in particular), after the recent sector rerating the resource sector is now offering only about 5% upside to our assessment of its fair intrinsic value. However, unlike June last year - when we believed resource shares in aggregate were 80% overvalued sector valuations have converged. In SA, although the economy is likely to suffer from a highly indebted consumer (with further increases in bad debts); a struggling manufacturing sector and a strong rand in the short term, low interest rates should provide some relief as we enter the new calendar year.

INTERNATIONAL
International markets continued to rally in the third quarter as it became clear that the liquidity crunch had eased considerably and signs of green shoots started to become more convincing in the global economy. Investor confidence returned and money continued to move out of low-yielding cash into the riskier asset classes. Global equity markets continued their recovery during the quarter, with the MSCIWorld returning 16.8% in dollar terms. This quarter also saw the continued outperformance of risky assets, with the MSCI Emerging Markets index delivering an even more impressive 20% in dollars. The "flight-to-quality" premium in sovereign bonds re-emerged towards the end of the quarter and government bond yields contracted as a result. The JP Morgan Global Bond Index returned 6.1% in dollars during the quarter, with the US bond market delivering performance of 2.2% and the European bonds between 6% and 7% (although most of the difference in return came from the euro strengthening against the dollar by 4.3%). Credit and emerging market sovereign spreads continued to contract over the quarter in line with a general disappearance of risk aversion. The dollar remained on the back foot against most currencies excepting for the UK sterling.

MARKET REVIEW
The global recession loosened its grip slightly on world financial markets during the second quarter of 2009. Many economic indicators are pointing towards some economic stabilisation - but not yet a full recovery. Equity markets recovered strongly, while the US 10-year bond weakened by more than 0.5% on the back of increased risk appetite and a possible inflation threat down the line. On the domestic front, the Reserve Bank surprised many analysts by not cutting interest rates further in June. As a result, the SA yield curve flattened, with money market rates drifting higher following the announcement. Although we saw the rand strengthen significantly over the quarter, the bond market weakened. Sticky inflation and the possibility of the government needing to raise additional funding due to a 2009 revenue shortfall weighed on the bond market. The R157 nominal bond yields traded 0.3% higher for the quarter, with the All Bond Index returning 0.29% during the period. Cash delivered 2.31% and inflation-linked bonds 3.41%. We again saw strong demand for the short-dated R189 inflationlinked bond, while the longer-dated R197 weakened by 0.19%. Property stocks declined 0.88% during the three month period.

What we did
In our first-quarter commentary, we indicated that the market was implying at least a 21% decline in earnings and that much of the negative news was already "priced in" to the equity market. Since then, the All Share Index has rerated by 8%, the INDI25 has risen by 13.4%, the FINI 15 is up 12.6% and the RESI 20 is 2.6% higher. As a result, our decision to increase our equity exposure since the beginning of the year paid off during the quarter. We also added additional protected domestic equity exposure to the Fund during the period. While we still see slightly more value in the financial and industrial shares relative to the resources, the extent of the valuation difference has narrowed since May 2008. As a result we have reduced our underweight in resources significantly over the past year. So, for example, we added to Anglo because, after its share's decline, we now believe it is trading below its intrinsic value. We have, however, reduced our position in gold (in particular Goldfields) as we consider the sector overvalued. Within financials, we have retained our overweight position in the banks, particularly Standard Bank. We expect bad debts to get worse in the short term. This is likely to result in banks' return on equity dropping sharply in the short term. That said, we have already started to see some recovery in bank share prices. Our overweight position in Old Mutual also started to pay off, with the share price more than doubling since March 2009. Within industrials, we cut our shareholding in Telkom after the unbundling of Vodacom. We also reduced our position in Dimension Data. We used the proceeds of these sales to increase our shareholding in Barloworld, Liberty International, Liberty Holdings and Nampak. All four shares are trading well below their intrinsic value, with earnings below normalised levels. As mentioned last quarter, we've been adding inflation-linked bond exposure to all our absolute return funds. We've also seen some very attractive opportunities appearing in the primary capital market. Our view is that current credit spreads are offering value, especially some of the inflation-linked bonds issued recently. The addition of protected equity and inflation-linked bond exposure was funded from cash. Long-dated money-market investments are not offering value at the moment. We didn't change our bond or property exposure during the quarter. We are still somewhat concerned about property valuations, given the underlying weak domestic economy.

SIM strategy
After the recent equity market gains, we are now adopting a more cautious approach over the short term. During the past three months all additional equity exposure was implemented via protected equity structures. This provides investors with some downside protection in a falling market. Over the medium term, however, the opportunity for significant real returns still lies within equities as an asset class. We will add more corporate inflation-linked bonds if real yields are attractive but will make sure we are adequately compensated for credit and liquidity risk. We believe credit markets are presenting us with some attractive opportunities. We view property as slightly expensive given the state of the economy. Nominal bonds have weakened considerably and some value is now emerging for investors, thus we will increase the Fund's low duration into further market weakness. While international equities are now more fairly valued in the short term, we still see some value on a longer-term basis. Over the past few months we've been gradually increasing our equity exposure from a low base. We've also diversified our currency exposure away from being overweight US dollars to a more balanced position that includes sterling and the euro.

Market review
The volatility that characterised global equity markets in the second half of 2008 continued into the first quarter of 2009. The MSCI World Free Index was down over 11% for the quarter. Domestic equity markets followed their overseas counterparts and the All Share Index ended the quarter down 4.2%. The market recovered by just over 11% in March after being down over 10% in February. For the quarter the JSE Resources board rose 1.6% while the Industrial and Financial boards were down 9.2% and 7% respectively. International short-term cash and long-bond rates remained at historic low levels on the back of aggressive monetary easing by central banks and continued global risk aversion. Domestic inflation continued its downward trend, albeit at a lower than expected rate. Despite supporting factors like lower inflation etc., the domestic bond market weakened during the quarter. Significant lower inflation was already discounted in the bond market at the end of December 2008 and the weaker bias came as no surprise. The yield on the bellwether R157 nominal bond rose 0.96% over the quarter. The weak bond market is reflected in the All Bond Index having returned - 5.1% for the quarter. Cash returned 2.8% and inflation-linked bonds 2.4% for the first 3 months. There was strong demand for inflationlinked bonds in the latter half of the quarter. Property stocks traded roughly flat over the quarter, returning -1.40%.

Asset Allocation
After last year's dramatic equity market sell-off, value emerged in local and international equity markets from a long term perspective. Over the quarter we increased our domestic equity exposure, as well as some foreign equity exposure at the margin. Some of the exposure was added via protected equity structures. These structures protect the fund against moderate equity market declines at the expense of full upside participation in market rallies. This was effected in order to fulfill our capital protection mandate. After initially reducing the nominal bond exposure in January this was again increased slightly after the significant bond market correction. We are in the process of adding some inflation-linked bonds to the fund which are currently providing very attractive real returns of approximately 5%. The increase in equities and nominal bonds was at the expense of our cash exposure.

Investment Strategy
Absolute Return funds have two requirements i.e. to produce inflation beating returns over the medium term and to protect capital over any rolling twelve month period. After the 2008 equity market collapse (which is probably a once in 50 year event statistically speaking) the preservation of capital has become the overriding requirement over the short term. But the opportunity over the medium term lies in having exposure to attractively priced equities that will provide high real returns (7% plus). Over the next few months these requirements will be balanced by cautiously taking on some equity exposure. Some of this equity exposure will again be via protected equity structures that will limit losses if the equity market declines further. Currently we estimate our equity market to be about 20% undervalued based on our bottom up analysis. On a price to book basis the market also appears to be attractive and thus we favour equities from a real return perspective over the medium term. We will increase our core inflation-linked bond exposure if further opportunities arise. Cash and nominal bonds are fairly valued, as are property stocks. International equities are also cheap on a number of valuation measures, whereas cash and government bonds appear to be on the expensive side. The strategy over the next few months will be to increase the current low equity position into market weakness. Credit markets are also pricing in a very high rate of company defaults and might provide opportunities over the next few months.

The FTSE/JSE All Share Index lost 9.2% during a tumultuous fourth quarter, as economic news from developed economies confirmed that the world was entering a recession and emerging-market growth indicators continued to deteriorate. Resources (-12.9%) and financials (-11.4%) led the ALSI down, while industrials (-4.1%) were relatively unscathed. A clear defensive style-bias emerged looking at crosssector performance, as non-cyclical sectors outperformed. Global equity markets also had a rough quarter, with the S&P500 losing 22.4% and the MSCI World Index falling 21.7% in US dollars.
The Federal Reserve lowered the target funds rate from 2% to between 0% and 0.25%. Indicators of a sharply slowing global economy came thick and fast, with the most notable probably being a steep drop in US employment. Official measures to protect the financial sector continued and US automakers also sought public sector support. Meanwhile fiscal policy was stepped up in a number of countries. In South Africa, the SARB cut the repo rate by 50 basis points to 11.50% at its MPC meeting in December on easing inflation pressures.
Local bonds had a strong quarter, returning a healthy 11.3% for the period. Listed property was also a feature, producing 8.5% for the quarter. These returns were in response to a strong belief that the repo rate was likely to be cut meaningfully during 2009.

What we did over the quarter
In general we had a quiet quarter in terms of making any significant changes to the portfolio. Within equities, our belief was not to take big stock bets as the short-term outlook and sentiment remain highly problematical. Overall, for the same reasons, our net equity exposure was little changed over the quarter, although more downside protection was introduced. The actions taken during the quarter were mainly confined to fixed income, where some exposure was added but again sold in late December, leaving the net exposure in bonds little changed. We added cautiously to our listed property exposure. Our inflation-linked bond exposure was unchanged.

Major performance value adders and detractors
The position that added most value over the quarter was our low weighting in equities relative to what we believe the long-term strategic exposure ought to be. Within equities, our low exposure to resources paid off but the key detractor was that we did not have a large enough holding in the food and retail sector, which produced a stunning 16.2% return over the quarter. The major detractor from value over the quarter was our relatively low weighting in long bonds. All in all, it was a fair quarter in terms of how the portfolio was structured relative to what returns the main asset class components delivered.

Investment strategy going forward
We maintain that the ultimate fallout of the US-led financial crisis will be a sustained period of below-trend global economic growth for at least the next two to three years and the key question now is: Is this correctly priced into the equity markets? There is no doubt that pockets of value are emerging within the equity markets so the only challenge, given the no-loss capital constraint (making the time horizon much shorter), is when the value will begin to be unlocked. Regrettably it is impossible to predict this, so we believe it would be prudent to take advantage of our low weighting in equities and start adding some exposure cautiously. We believe bonds have more than fully discounted all the positive inflation and short-term interest rate movements and are now expensive. Given our low weight in this asset class, we are likely to be buyers on any material weakness.