Market review
The general accommodative stance of developed market central banks continued unabated in the second quarter of 2014. The European Central Bank (ECB) announced measures that effectively increase general liquidity, while further bank asset purchases are a real possibility down the line, again increasing 'easy money'. Also, for the first time, European banks will earn a negative interest rate if they don't lend out money. Good employment numbers and firming inflation from the US might get the very dovish Federal Open Market Committeeto rethink their current timeframe for policy normalisation. One interesting and worrying consequence of central bank policies has been very low asset market volatilities in recent months. Implied equity market volatilities are trading at multi-year lows; a positive is that insurance against equity market losses is fairly cheap. On the local front we had a sovereign ratings downgrade, but this was largely expected by the market. Local inflation came in at 6.6%, again highlighting the Reserve Bank's policy dilemma given the low economic growth. The rand weakened slightly over the quarter to close at R10.64 to the US dollar. Local nominal and inflation-linked bond yields were slightly lower over the quarter with the 10-year nominal bond closing at a yield of 8.2%. Inflation-linked bonds found plenty of bids in the market and the R197 real yield closed at 1.6%.The All Bond Index gained 2.5% during the quarter and added 5.4% year-to-date. Inflation-linked bonds returned 5.9%, while cash yielded 1.4% for the quarter. Inflation-linked bonds returned an impressive 7.6% year-to-date. Property stocks gained 6.3% year-to-date. Despite the encumbered local economy, the All Share Index closed on a record high and delivered 11.8% for the six months to 30 June. With the slight depreciation of the rand, the All Share gained only 8.8% in dollar terms during the first half of the year. Globally, stock markets extended their recent gains, with several indices ending the half year on fresh highs. The MSCIWorld Index delivered 6.5% in dollars for the six months to 30 June 2014. This performance was on par with the MSCIEmerging Markets Index's 6.3% over the same period.

Asset allocation
From a fixed income point of view it was a rather uneventful quarter. Marginal compression in fixed income yields and a fairly stable yield curve shape led to limited opportunities for the fund. Generally, the primary corporate debt that came to market looked fairly pricey. Over the past six months or so, the fund's had significant maturities of corporate inflation-linked bonds that were purchased a few years ago and hence the significant reduction in inflation-linked bond exposure. These maturities were not reinvested back into inflation-linked debt due to very limited issuances of non-sovereign inflation-linked paper. The fund's domestic equity exposure was reduced further over the quarter as the domestic equity market reached valuation levels rarely seen the past couple of decades. We rolled our hedged equity structures. This explicit downside protection is important in our aim to protect capital over any rolling one year. The cost of this protection is giving away some market upside. As with any form of insurance, there is always a cost involved. For funds with international exposure we sold our basket of diversified European telecommunication stocks and switched that into general emerging market exposure. From a relative valuation point of view, emerging markets are looking attractive when compared to developed market equities.

Investment strategy
We retain our preference for nominal bonds in the fixed income space. With the 10-year government bond trading above 8%, the implied real yield is approaching 3% when taking our long-term inflation assumption of 5.25% into account. The long-end of the nominal bond market looks even more attractive due to the steepness of the bond curve. Our preference for nominal bonds over inflation-linked bonds also becomes clear given that the 10-year real yield is at 1.6%. Domestic equities remain expensive from a longer-term perspective and prospective return expectations should be adjusted downward. We have a significant portion of the domestic equity exposure protected against some market downside and will maintain this defensive strategy given the stretched valuations. Keeping an eye on the capital protection requirement of absolute return funds has become more important over the past quarter or two. As mentioned last quarter, we still prefer offshore equities to domestic equities and, more specifically, Europe. Equities
The FTSE/JSE All Share Index (ALSI) continued to show solid performance over the second quarter with the market posting a return of 7.2% for the three months to 30 June. The heavyweight Top 40 shares posted the largest gains with a return of 7.4%. SA Industrials outperformed over the quarter with a gain of 9.1%, SA Financials continued to show strong steady performance, up 7.8%, while SA Resources added 2.9% after posting a return of 10.6% in the previous quarter. Year-to-date, the ALSI is up 11.8%. The SIM Houseview Fund enjoyed a quarter of positive outperformance with the overweight position in Steinhoff and underweights in Kumba Iron Ore, Assore and Shoprite contributing positively. The main detractors from performance were the underweight positions in Brait, Sibanye Gold, Pioneer Food and the overweight position held in Barloworld.

Our equity strategy
The JSE is around 10% overvalued on a bottom-up aggregated valuation analysis using our fair value estimates for the underlying shares. The sectoral bets of the fund are somewhat muted with a small overweight position in the resources sector, offset by underweight positions in both the industrial and financial sectors. Within resources, we maintain overweight positions in the higher quality diversified miners and Sasol, while we are underweight gold counters and the iron ore miners. Within financials we remain overweight the banks, including Investec and Old Mutual, offset by an underweight in property shares and Sanlam. Within industrials we remain underweight healthcare stocks on valuation grounds. We have started to reduce our long-held underweight position in the clothing retailers as they are now starting to offer value. We continue to maintain an overweight position in Steinhoff. While the speculative excesses that characterized the market in the lead up to 2007 are absent, we believe that the equity market presents more risk than normal. In the current market, as always, we continue to rely on a valuation approach to identify and profit from areas of mispricing that the market may offer.

Equity outlook
On a simple price to earnings (PE) ratio basis, the market is expensive, trading on a 16 times forward PE. When comparing the current PE ratio with history one has to bear in mind that Naspers (with a 10% weight) is trading on a 91 times historic PEratio, while the weight of the highly rated international diversified businesses, such as SA Breweries, British American Tobacco and Billiton, has increased. While this softens the level of perceived overvaluation, one cannot escape from the fact that most of the counters on the JSE trade at or above our estimate of fair value. At the current stretched valuation level, we believe that the downside protection that we have in place, through the use of derivative structures, is appropriate and necessary, given the capital protection requirement of our product suite.

International
Most global economic indicators reflected some acceleration in underlying economic activity over the past three months after a disappointing first quarter. The news from the US economy has been more positive after the weather-induced slowdown of the first quarter, which saw GDP shrink 2.9% quarter-on-quarter. Since April we have seen retail sales rising, new and existing home sales bouncing back and more jobs being added to payrolls. The ECB has delivered a number of policy measures designed to fend off the threat of deflation and, in the UK, most of the news remains relatively encouraging. In Japan, the gradual recovery continued given the ongoing monetary stimulus and prime minister Abe's recent promise of more decisive action on structural reforms, while in China the People's Bank of China reiterated its commitment to provide ample liquidity. Emerging market (EM) equities as represented by the MSCI EM Index gained 6.7% in dollar terms, outperforming the MSCI World Index by 1.6% over the quarter. The rebound in emerging markets seems to have been driven by a combination of lower funding costs, favourable political outcomes and better-than-expected Chinese manufacturing data. Global bonds, as measured by the Barclays Capital Aggregate Bond Index, rose 2.5% for the three months to end June. The rand softened 1.2% against the greenback to end the quarter at R10.64 to the US dollar. Within international equities, we continue to prefer Europe to the rest of the developed world. Europe is trading on a slightly lower PE multiple compared to the developed world markets, even though earnings remain suppressed after the 2008 financial crisis. International property is also relatively attractively valued in the international space. Currently our holdings have an average dividend yield of about 5%.

Bonds
Local inflation came in at 6.6%, emphasising the Reserve Bank's dilemma - balancing the low economic growth with inflation inching higher. On the local front we had a sovereign ratings downgrade, which was not unexpected. Local nominal and inflation-linked bond yields were slightly lower over the quarter with the 10-year nominal bond closing at a yield of 8.2%. Inflation-linked bonds found plenty of bids in the market and the R197 real yield closed at 1.6%.The All Bond Index gained 2.5% during the quarter and added 5.4% year-to-date. Inflation-linked bonds returned 5.9%, while cash yielded 1.4% for the quarter. Inflation-linked bonds returned an impressive 7.6% year-to-date. Fairly stable local fixed income markets led to limited opportunities for the fund. Over the past six months or so, the fund's had significant maturities of corporate inflation-linked bonds that were purchased a few years ago. These maturities were not reinvested back into inflation-linked debt due to very limited issuances of non-sovereign inflation-linked debt. We retain our preference for nominal bonds in the fixed income space. With the 10-year government bond trading above 8%, the implied real yield is approaching 3% when taking our long-term inflation assumption of 5.25% into account. The long-end of the nominal bond market looks even more attractive due to the steepness of the bond curve.

Market review

Ben Bernanke featured in most of the third quarter highlights. Towards the end of the quarter he surprised markets when he held back on the much anticipated tapering of the third Quantitative Easing program. Investors rushed back into risky assets with the news that 'easy money' was here to stay for a bit longer. Global bond and equity markets made impressive gains, particularly in September, which provided some relief for battered emerging markets. But investors are probably still concerned about how the market will respond when the inevitable tapering does take place and the second quarter gave us some indication of what could happen down the road. Overall global economic data reaffirmed a gradual recovery in economic activity. The next challenge for central banks will be the prudent cutting back in accommodative central bank policies.

On the local front, high inflation, a weak rand and a pedestrian economy leaves the SA Reserve Bank in a difficult spot and rates seem to be on hold for now. The rand weakened 13c during the quarter to end at R10.06 to the dollar. The FTSE/JSE All Share Index (ALSI) had a very strong third quarter, gaining 12.5%. Meanwhile, the MSCI World Index gained 8.2% in dollars and the MSCI Emerging Market Index increased by 5.9% for the quarter.

Domestic nominal and inflation-linked bond yields were largely unchanged, but this sideways movement hides some fairly dramatic yield movements during the quarter. The 10-year RSA bond yield touched 8.2% during the quarter and closed at 7.62%. The All Bond Index gained 1.9% during the quarter but has only added 0.5% year-to-date. Inflation-linked bonds returned 1.2%, while cash yielded 1.3% for the quarter. Property stocks lost 1.3% during the quarter and also proved quite volatile during the quarter. Compared to the last couple of years, fixed income assets have been exceptionally volatile over the past two quarters.

Asset allocation

As mentioned in the second quarter commentary, we added to the Fund's duration during the latter part of the second quarter. After the Federal Open Market Committee surprise announcement of 'no tapering', local bond yields dropped significantly and the yield curve flattened. We used this opportunity to reduce our long-dated bond exposure slightly. We still believe the yield curve is too steep and hold long-dated government bonds in the portfolio. Long-dated yields are between 8% and 9% compared to cash, which is offering just over 5%.

Currently domestic equities are starting to look expensive and are trading above our assessment of fair value. We reduced the fund's equity exposure significantly over the course of the third quarter. This was mainly due to our hedged equity structures reaching some of their caps and at these respective levels we effectively sold equity after achieving our required return. We also hedged more of the Fund's equities during the quarter. This lower exposure reflects our concern of an increased probability of capital losses from equities near term.

For funds with offshore exposure, we increased offshore equity further, while at the same time decreasing domestic equities. We maintain an overweight position in European equities based on attractive long-term valuations.

Investment strategy

Fixed income valuations are now closer to our long-term fair value, with nominal bonds still offering some value. Our preference for nominal bonds over inflation-linked bonds has diminished slightly, with the decline in breakeven inflation from about 6.4% to about 6% over the past couple of months. Listed property still looks expensive relative to nominal bonds. We have increased the Fund's duration risk from a low base and have ample scope to increase risk further should opportunities arise in the coming months.

Our 'lower-than-normal' exposure towards domestic equities reflects a concern that valuations are getting expensive. For absolute return funds that meant potential capital losses and thus the risk of capital losses is starting to outweigh the potential return generation from domestic equities near term. As mentioned last quarter, we continue to weigh the risk/reward payoff in all our investment decisions, while maintaining a well-diversified portfolio.

Equities | The FTSE/JSE All Share Index (ALSI) had a strong run during the third quarter and increased by 12.5% over the three-month period. The ALSI was led higher by a massive rebound in the resource sector, which gained 19.7%. SA industrials also delivered an impressive 11.3%. Financials lagged the market, with a return of 6.9% for the quarter.

SIM's houseview fund outperformed strongly during the third quarter, adding to the good outperformance enjoyed over the first half of the year. Our underweight positions in Shoprite (down 13%) and Life Healthcare (down 5%) added value. The Fund's overweight position in Steinhoff (up 35%) also contributed significantly, as did Anglo American, which rerated from low levels the previous quarter. Detractors from fund performance included resource shares with iron ore exposure, such as African Rainbow Minerals, Kumba Iron Ore and Assore.

SIM equity strategy

The JSE ALSI Index is in overvalued territory, trading at a forward PE of 16x, well above its long-term average level. We expect earnings growth of 15% over the next 12 months, driven by strong industrial earnings growth. On a sectoral basis, resources and financials are trading on attractive forward PE's in comparison to the industrial sector.

In our houseview portfolio, we have a slight overweight position in the resources sector with a preference for BHP Billiton, Anglo American, Sasol and Mondi. We are underweight the gold miners, which will struggle to be cash flow positive within the current lower gold price environment. We remain underweight miners with iron ore exposure.

Within the financial and industrial sectors, we remain overweight the banking sector on valuation grounds. The life insurance sector, excluding Old Mutual, still trades well above fundamental value hence our underweight position. We are overweight the construction sector where we see good relative value. We have underweight positions in clothing and food retailers and healthcare. These sectors have contributed strongly to the outperformance of the industrial sector and trade well above our estimates of intrinsic value.

Equity outlook On a bottom-up valuation basis, the domestic equity asset class is trading at a premium to our assessment of its fundamental intrinsic value. Given the current stretched equity valuations and to stay true to the conservative investment approach that we adopt in managing these funds, we have a defensive positioning in equities, with a reasonable exposure to hedged equity.

International | In September, the Federal Open Market Committee of the US surprised markets by deciding not to slow its large-scale asset purchase program. Chairman Ben Bernanke stated that the Fed decided to delay tapering as it wants to see more economic data, given the downside risks created by higher mortgage rates and the evolving US fiscal debate. This announcement helped buoy interest in emerging market assets almost immediately thereafter. On the data front, leading indicators of economic activity out of both Asia and Europe in the third quarter have been consistent with signs of a pick-up in growth in Europe and the US and a stabilisation of growth in China.

In dollar terms, the MSCI Developed Market (DM) Index returned 8.3% while the MSCI Emerging Market (EM) Index rose 5.9% quarter-on-quarter. For 2013 year-to-date, the performance gap between developed and emerging markets is even more pronounced with DM having gained 17.8% and EM having shed 4.1%. European equities (MSCI Europe Index) fared well this quarter, up 13.7% and 16.7% for the year-to-date. Global bonds, as measured by the Barclays Capital Aggregate Bond Index, increased 2.8% over the three month period. The local currency depreciated to R10.06 to the US dollar from a level of R9.93 as at the end of June.

We continue to favour equities and listed property in the international space and retain our preference for European and UK equities. Currently our international property holdings have an average dividend yield of about 6.5%, which is in line with the 6.5% dividend yield offered by SA listed property.

Bonds | High inflation, a weak rand and a pedestrian economy leaves the SA Reserve Bank in a difficult spot and rates seem to be on hold for now. Domestic nominal and inflation-linked bond yields were largely unchanged, but that hides some fairly dramatic yield movements during the quarter. The 10-year RSA bond yield touched 8.2% during the quarter and closed at 7.62%. The All Bond Index gained 1.9% during the quarter but has only added 0.5% year-to-date. Inflation-linked bonds returned 1.2%, while cash yielded 1.3% for the quarter.

As mentioned in the second quarter commentary, we added to the Fund's duration during the latter part of the second quarter. After the Federal Open Market Committee surprise announcement of 'no tapering', local bond yields dropped significantly and the yield curve flattened. We used this opportunity to reduce our long-dated bond exposure slightly. We still believe the yield curve is too steep and hold long-dated government bonds in the portfolio. Long-dated yields are between 8% and 9% compared to cash, which is offering just over 5%.

Fixed income valuations are now closer to our long-term estimate of their fair value, with nominal bonds still offering some value. Our preference for nominal bonds over inflation-linked bonds has diminished slightly, with the decline in breakeven inflation from about 6.4% to about 6% over the past couple of months. We have increased the Fund's duration risk from a low base and have increased the Fund's duration risk from a low base and have ample scope to increase risk further should opportunities arise in the coming months.

Market review

Investors were again treated to a highly volatile quarter across the board. Equity, fixed income and currency markets seesawed the world over as the US indicated it was considering tapering off its Quantitative Easing (QE) activities in the not too distant future. Investors initially reacted by selling off risky assets but soon there was no place to hide, as fixed income assets also incurred heavy losses. US treasuries weakened from 1.85% in March to 2.49% by the end of June. Obviously markets fear that the reduction in liquidity provided by the US Federal Reserve will jeopardise the global economic recovery and impact negatively on market confidence. But, contrary to popular belief, housing numbers, employment and general confidence in the US are in much better place than a year ago - and thus the inevitable talk of easing QE bond purchases.

The news was particularly bad for emerging markets, which experienced significant portfolio outflows during the quarter. The SA bond market experienced one of its worst selloffs in recent history. The 10-year RSA yield reached a low of about 6.2% in early May; only to touch 8% in late June, a massive 180 basis point yield swing from bottom to top. The All Bond Index retraced -2.3% during the quarter, inflation-linked bonds -4.9%, while cash yielded 1.3% for the period. As is evident from these performances, inflation-linked bonds were particularly hard hit, with the R197 ending the quarter at a yield of 1.62% from 0.77% at the end of March.

Like the bond market, the domestic equity market also experienced big inter-quarter swings. The FTSE/JSE Shareholder Weighted Index (SWIX) delivered a positive return of 0.7% for the quarter, but was up nearly 7% in May and down 4% in June. In dollar terms, the MSCI Developed Market Index just managed to deliver positive returns for the quarter (up 0.8%) whilst the MSCI Emerging Index fell 8% from its March close. The rand weakened sharply against the trade-weighted basket of currencies to end the quarter at R9.93 to the US dollar, another weak quarter for the currency.

What SIM did

During the past few quarters, we have highlighted the increased risk of fixed income assets experiencing capital losses and the Fund's defensive positioning reflected these fears. While the pace and suddenness of the market move surprised us, the Fund was well positioned to weather the storm and redeploy capital at more attractive valuation levels. The Fund's bond exposure was increased during the latter part of the quarter at very attractive levels compared to our calculation of fair value. We mostly bought long-dated bonds as we feel the curve is too steep, with investors being generously compensated for taking on RSA term risk (yields of between 8 and 9%).

The Fund's equity exposure increased markedly over the quarter. The reasons were twofold: 1) During the selloff in April (post the QE tapering news) we increased our equity exposure and 2) we had hedged equity structures that matured and the new structures enabled us to increase general equity upside while providing protection at a higher market level. Our multi-asset class approach, which includes hedged equity, provided good downside protection during the quarter resulting in solid performance for the period.

What added to - and detracted from - performance

During the quarter, the Fund benefitted from overweight positions in counters that have diversified income streams outside SA, such as MTN, Richemont and British American Tobacco. Our underweight in gold shares added value during the quarter.

On the downside, we were hurt by some of our resource overweights, especially Anglo American, which underperformed the SWIX by close to 20% during the quarter as the market grew increasingly dissatisfied at the pace of internal restructuring within the group.

During April and May, we reduced the Fund's ILB exposure slightly to take advantage of the low real yields compared to nominal bond yields. As mentioned previously, we saw bonds sell off significantly during May and June, which enabled us to increase the Fund's bond exposure during the latter part of the quarter at very attractive levels compared to our calculation of fair value. We mostly bought long-dated bonds as we feel the curve is too steep, with investors being generously compensated for taking on RSA term risk (yields of between 8 and 9%).

Risks and opportunities

Domestic equities are trading close to our assessment of their bottom-up intrinsic value and we maintain a reasonable exposure to hedged and unhedged equity. For the past few quarters, equities represented the best risk-adjusted real returns looking forward. This picture is now more balanced, with the fixed income asset classes also starting to show some value. We continue to weigh the risk/reward payoff in all our investment decisions, while maintaining a well-diversified portfolio.