2008, threatened to destabilise financial markets around the world. Ongoing uncertainty about the sovereign debt crisis in Europe was overshadowed during August by the bipartisan stand-off in the US regarding the lifting of the country's debt ceiling, culminating in the downgrading of US government debt to AA. In the meantime, anaemic economic growth and increasingly worrying numbers out of China scared the few remaining bulls out of equity markets by the end of the quarter. Whilst the US debt downgrade may have been the final trigger for the August equity sell-off, the solvency of the US government does not appear to be the primary concern of markets, as evidenced by the sharp fall in US Treasury yields following the rating change.

The result of this turmoil was that global equity markets lost 16.5% of their value over the quarter, with emerging markets leading the way with a 22.5% loss. Some developed market bond indices showed spectacular returns of over 10% as the cocktail of a flight to safety together with the completion of QE2 and the announcement of further government intervention at the long end of the US yield curve drove yields to new record lows. Currencies became victims of large capital flows, and units like the Brazilian real lost 16% of its value against the US dollar over the quarter. Even the Australian dollar was down 9.2% over the period, and predictably, the South African rand lost 19.7% of its value against the US dollar. Against the euro the rand dropped 10.5%. This currency weakness masked the performance of the JSE equity market, which dropped 5.8% over the three months in rand terms, but 21.3% in US dollar terms. South African bonds were initially positively impacted by the global trends, but sold off during the month of September on the back of rand weakness. Over the quarter the bond index returned 2.8%, and cash 1.4%. Commodities also fell foul of this aggressive move to reduce risk in all portfolios, with copper down over 23%, platinum down nearly 12% and oil down over 5%. Predictably the gold price rose by over 8% in dollar terms, and coupled with the rand weakness, South African gold shares had their moment in the sun, with positive returns of around 20% over the three months. South African listed property proved remarkably resilient during this period of financial instability, and returned 2.2% over the three months, taking the sector's year-to-date number to a positive 5.0%.

The fear expressed by global investors, retail and institutional alike, was almost tangible, leading to the VIX Index (a measure of market expectations of near-term volatility as expressed by S&P stock index option prices) surpassing levels achieved after the Lehman Brothers collapse in 2008. In fact, the index was at 48.0 after the debt downgrade, compared to 31.7 after Lehmans. The index ended the quarter at 43.0, highlighting the fear that the situation in 2011 will worsen way beyond what was experienced in 2008. Whilst it is understandable that investors are fleeing risky assets during times like these, we disagree with the view that the current scenario is comparable to that of 2008. Corporate balance sheets and levels of profitability are significantly stronger than then, mainly as a result of decisive actions taken by strong management teams at the time of the 2008 crisis. Considerable deleveraging has already taken place in the financial sector, and recapitalisations have strengthened some players' balance sheets. More will be required as events unfold. In addition authorities are standing by to provide help in every conceivable way to reduce risk in the financial system. This does not mean that we can avoid the inevitable hangover in the form of significantly lower economic growth after the credit binge of the noughties; it just means, in our opinion, that perspective should be maintained to spot the opportunities during this indiscriminate sell-off of perceived risky assets. We are pleased to report that your fund weathered the storm well. It returned a positive 0.7% over the three months, with a year-to-date number of positive 3.2%. Whilst this number is below the fund's benchmark and return objective, we are particularly pleased that the fund continued to grind out positive monthly numbers as fear took hold of financial markets during this quarter. The main reasons for this pleasing outcome were the significant amount of put options the fund held against its domestic equity holdings, the good performance from its holding in inflation-linked bonds, and the diversification benefits from holding the maximum portion of the fund in offshore currencies (25%).

The fund celebrated its 10-year anniversary on 1 July 2011. Over this period the annualised return of 14.7% handsomely outstripped the targeted return of inflation plus 4% which amounted to 10.4% p.a. The compounding effect of this outperformance would have resulted in the total capital base exceeding the target by 48% over the period! Whilst we celebrate this achievement, we continue to advise clients not to extrapolate these numbers into the future, as we remain downbeat on the prospects for super returns in the South African financial market environment. The fund's domestic equity holdings disappointed during the sell-off, not displaying the defensive characteristics that we believe are inherent in most of the investment cases. New holdings in Sappi and ArcelorMittal were particularly disappointing, even though we continue to believe in the asymmetrical return profile embedded in these companies. Our platinum exposures were also weak in the light of the uncertain global growth outlook, as well as the threatening noises coming from Zimbabwe, where Impala Platinum owns some attractive assets. Our investments in construction shares are yet to yield positive results; again we are patient investors and are comfortable with the investment cases, even if the macro story will take time to play out. We have used the weakness in equity markets over the last two months to increase exposure to resources shares in particular, where our assessment shows that these shares (especially the diversified miners) are discounting a very dire outcome for commodity prices, a scenario we think is unlikely to materialise. Currency weakness in many of the operating countries is also offsetting some of the price falls impacting the share prices.

We remain nervous holders of listed South African property, mainly because of the poor returns offered in the cash market. The same argument applies to our inflation-linked bonds, where we probably would have been sellers of these instruments if the alternative investments offered more attractive returns. We continue to avoid government nominal bonds as we remain negative on global nominal bonds and the potential inflationary pressures that could continue to plague the South African consumer. Our offshore holdings behaved in a rational way during the turmoil. The currency diversification more than offset the negative foreign equity markets, and the holdings added significantly to overall portfolio return, as well as risk reduction. Given the suddenness of the correction in the rand (and related emerging market currencies), we have repatriated some of our offshore holdings by entering into derivative contracts. We will continue to actively manage the offshore component of the portfolio, both from a currency and an underlying market perspective. We continue to work hard to generate returns within acceptable risk parameters. We have been warning investors about the potential for weaker future returns than what they have become accustomed to, but as this scenario seems to be playing out, the experience is still unsettling. Investors are urged to take longer-term views with regards to fund and manager selections.

Portfolio managers
Louis Stassen and Henk Groenewald

The second quarter of 2011 continued to resemble the pattern of market volatility seen since the start of the year. Despite some wild swings, the FTSE/JSE All Share Index ended back nearly where it started, losing only 0.6% for the quarter. It is also at similar levels to the start of the year. The developed world continued to experience an economic recovery, however, at a very pedestrian pace. The quarterend also coincided with the conclusion of QE2, with a lot of uncertainty around the future impact of lower liquidity on economies and capital markets. While a default has so far been avoided in the European periphery, the debt crisis in Europe are still far from resolved and remains a major risk to investor sentiment. The economic powerhouses of emerging markets and specifically China continue to outgrow the developed world. China's balance sheet looks very healthy and hence flexibility around monetary policy is much greater than their developed peers. Since October 2010, they have been using this flexibility to tighten policy to combat inflation and remove some of the liquidity that smoothed China through the financial crisis in 2009. This engineered slowdown however, weighed on commodity prices and our domestic resource shares.
For the quarter, the Shareholder Weighted Index (SWIX) returned 0.2%.The difference between the SWIX and the ALSI's performance was driven by the former's lower weighting in resource shares. The Resources Index lagged for the quarter (-5.7%) as concerns on global and Chinese growth intensified. The other two major market sectors - financial and industrial shares - delivered positive returns. World markets performed better than our local bourse, with the MSCI World Index returning 0.7% in US dollars for the quarter. Since the start of the year, the index has outperformed the All Share by over 7%. South African Bonds (as measured by the All Bond Index) delivered 3.9%, while cash returned 1.3% over the quarter. Property shares continued their outperformance, with the property sector returning 5%. In this environment the fund's return of 1.53% (after all fees) for the quarter was satisfactory, although lagging its inflationlinked benchmark. The fund is to a large extent dependent on equity returns to enable us to reach our return targets. While equities offer excellent long-term returns, returns can be volatile over shorter periods. The 12-month return of 13.4% is pleasing (helped by strong equity markets during the final four months of 2010) and comfortably ahead of our benchmark. More importantly, the longer-term returns of the fund are still looking healthy. The annualised returns for the three- and five-year periods are 12.6% and 11.2% respectively. We remain committed to our targets of inflation + 4% and no negative returns over any rolling 12-month periods. For the quarter, the major drivers of the fund's performance were holdings in defensive equities (British American Tobacco, Tiger Brands and Vodacom), inflation-linked bonds and offshore assets. The holding in resource shares detracted from performance, especially large holdings like Sasol and Anglo American.

Over the quarter we used weakness in resource and construction shares to increase exposure to these sectors. We think that much of the bad news is already reflected in the prices of these companies. We also started selling out of government inflation-linked bonds. This was only a small part of the inflation-linked bond portfolio that is concentrated in corporate linkers. The government linkers have rerated significantly over the past year (which benefited the fund), and hence we see less value in these instruments. We also own no nominal government bonds, being concerned about the potential of capital loss from their current yields. In both nominal and inflation-linked bonds, we prefer exposure to corporate bonds that offer higher yields and still reasonable safety of capital. The fund's small holdings in defensive property stocks performed well, but the small allocation to this sector means that the fund will not fully benefit from any continuing performance. We remain concerned about valuation levels in this sector. As mentioned above, world markets outperformed local equity markets and for the second quarter in a row the offshore holdings contributed to performance. This has certainly not been the case in the preceding decade where any offshore allocation normally dragged performance down. Over the last decade the outperformance of SA markets, poor performance from developed markets and a strong rand has led to what we believe to be an attractive entry point into international assets. We believe that offshore markets will outperform South African assets in the coming decade. Offshore equities is our preferred asset class and, coupled with the current levels of the rand, we believe that the maximum allowed offshore exposure of 25% is correct at this time.

Portfolio managers
Louis Stassen and Henk Groenewald

The first quarter of 2011 has brought a new set of challenges to financial markets. The standout event affecting markets was the tragic unfolding catastrophe in Japan during the month of March. It is important to separate the human impact and the economic impact of this event. From an economic perspective, Japan's short-term growth assumptions were reduced, but the result of the reconstruction programme may add to longer-term growth prospects in both Japan and the rest of the region.

As an indication of the volatility financial markets faced, the Japanese market fell by just over 20% over the three days subsequent to the earthquake, and rebounded by almost 19% over the following 2 weeks! Such volatility in one of the largest financial markets in the world is almost unprecedented, reflecting the fear and uncertainty facing such a large economic region. A reminder of the power of compounding reflects that a market that was down 20%, recovered by almost the same amount, but would still leave investors down 5% over the period - communicating the importance of preserving capital over periods of market volatility.

Your fund returned 0.96% over the quarter, a slightly disappointing performance against the backdrop of the positive 1.1% return delivered by the FTSE/JSE All Share Index over the same period, while the All Bond Index returned a negative 1.6%, the MSCI World Index a positive 4.9% (in US dollar terms), and the rand weakening by 2.0% against the US dollar and by 7.7% against the euro. The fund's return over the last 12 months has been a strong 10.2% (after all fees) compared with an estimated average inflation number of 3.8% over the same period. This highlights a reasonable outperformance of its inflation plus 4% target. The fund's longer term numbers show consistency with both the three- and five-year returns being around 10.5% - 10.8% per year.

The fund's equity positioning was below expectations over the quarter, with our increasing exposure to constructionrelated stocks hurting short-term performance. We used the market's disillusionment with the construction sector's poor profit outlook to increase exposure further. The current portfolio exposure to this sector is almost at 5%. We continue to believe that over the medium to longer term the sector will benefit from the government's commitment to continued infrastructural investment, and at current share prices we believe the downside risks in most of these shares are limited. We also increased the fund's exposure to the banking sector, with purchases in Standard Bank, Nedcor, and Absa. Other new positions include exposure to the pharmaceutical sector through both Aspen and Adcock. A combination of a jittery international investor base as well as results that were below expectations and followed by poor newsflow, has, in our opinion, created an attractive entry level into both these stocks. We also re-introduced platinum counters like Impala Platinum and Northam, with rand strength and concerns over global auto production after the Japanese disaster weighing on the metal price and the share prices. We also utilised the rand strength to add to our position in British American Tobacco, as well as the Capital Shopping Centres holding. We reduced our exposure to resource-based companies midway through the quarter, with notable sales in Exxaro, BHP Billiton and Anglo American. We also reduced the position in Naspers on risk considerations, given how large the exposure to Tencent, the Chinese instant messaging company, has become.

The fund benefited from the very low exposure to South African bonds, given the sell-off in this sector. Initially this was due to currency weakness in January, and later in response to the Budget Speech delivered in February, which the market (and ourselves) considered to be too expansionary given the issues facing the national economy. We have not yet committed new capital to this asset class as we remain nervous of the level of the rand and believe that the Reserve Bank is underestimating inflationary pressures building in the underlying economy. Whilst inflationlinked bonds have served the fund well in the past, we believe that their current valuation levels are discounting most of the good news we initially anticipated, and as such we have also not added to this asset class.

We have been very vocal in the past about our concerns regarding the listed property sector, and as such, the fund had little exposure to this asset class. Over the quarter this sector started selling off, eventually losing over 10% in capital value in response to higher local bond rates, a weaker outlook for distribution growth and some large capital raisings (both announced and mooted). We used this opportunity to increase the fund's exposure to the sector, although the sharp price recovery seen since the middle of March has dampened our appetite to continue buying.

For the first time in a long period, the fund's offshore exposure contributed positively to overall performance, thanks to both a weakening local currency and a decent performance from the offshore assets held in the fund. Towards the end of the quarter the strength in the rand has reduced the currency impact somewhat, but we utilised these levels to further increase our offshore exposure to close to the maximum level of 25%.

We continue to manage the fund with a significant amount of downside protection in the form of put options on the South African equity market. Whilst these instruments will cost the fund money in the event of them not being exercised, we believe that the principle of paying insurance premiums to protect investors against significant downside losses is the correct approach given the risk-averse nature of the investment mandate. We have added to these positions during the quarter under review and currently have put options covering about a quarter of the fund's domestic equity holdings, although many of these holdings are quite far out of the money. This means that in the event of a severe correction they should protect capital for unit holders. Our sensitivity analysis indicate that in the event of a 30% correction in the equity market, your fund should not lose more than 8.5% of its value, all other things being equal.

Portfolio managers
Louis Stassen and Henk Groenewald

The final quarter of 2010 concluded a volatile year on a positive note for both South African and international investors. The local equity market (as measured by the SWIX Index) delivered a total return of 8.1% for the three-month period. Much of this was driven by resource companies as commodity prices strengthened significantly, with notably copper and gold reaching all-time highs. This was one of the causes of the strengthening of the commodity currencies, with the rand ending the year below R6.60/$.

The fund returned 2.92% for the quarter. Performance was driven mainly by the performance of the South African equity market even though the equity holdings in the fund performed slightly behind the local benchmarks. International assets acted as a significant drag on performance, delivering a negative return (in rands) of over 2% for the period.

For the 2010 calendar year, domestic equities delivered 20.86%, domestic listed property 29.6%, bonds 14.96%, inflation-linked bonds 11% and average cash interest rates were 6.6%. The rand strengthened by almost 11% against the dollar over this period, and the FTSE All-World Index returned 12.7% in dollars. In this environment, the fund's annual performance of 12.89% was adequate and above our benchmark of inflation + 4%. Over the last five years your fund has delivered 11.96% per year.

For the 12-month period, the equity portion of the fund delivered a pleasing return of almost 7% in excess of the SWIX Index return. This was achieved despite a generally more defensive positioning. Shares that contributed to performance for the calendar year and quarter were MTN, Naspers, Vodacom and Anglo American. Equities remain our preferred asset class, but we sold some shares that approached fair value into strength.

Listed property was the best performing domestic asset class of the previous decade, and it has started the new decade in a similarly strong fashion. Unfortunately, the fund did not participate in this return as exposure to property shares is low and concentrated in defensive shares that lagged the property index.

Bonds sold off during the quarter, delivering a barely positive return of 0.75%. The fund's fixed interest holdings outperformed these indices for the quarter and year, mainly thanks to holdings in corporate nominal and inflation-linked bonds. Despite the selloff in the bond market, we are still cautious on the long-term outlook for bonds and still own no government bonds. We continue to own inflation-linked bonds as a hedge to the anticipated increase in inflationary pressures in South Africa over the next three to five years.

The international part of the portfolio again acted as a drag on absolute performance. For the year, the international assets delivered a performance of just under 4% in dollars, which was slightly disappointing considering the strong international equity markets. After conversion to rands our international exposure reduced absolute performance by almost 1.5% for the year. We remain convinced that the maximum position in offshore assets is correct, even though this has certainly not been the case for the past year (or even the previous decade). This view is informed not only by our view that the rand is currently too strong, but also by the diversification benefits, available opportunities and valuations we find in international markets relative to SA. We intend to take advantage of the additional 5% offshore allowance by National Treasury and intend to increase our offshore exposure to closer to 25% during the course of the year.

Happy New Year!
Portfolio managers Louis Stassen and Henk Groenewald