As of 06-30-2018

Market Overview

During the second quarter of 2018, the S&P 500 Index returned 3.43%. The U.S. dollar strengthened versus most world currencies, as markets perceived the U.S. to have the upper hand in global trade/tariff dynamics. Volatility decreased during the period despite potentially important breakdowns globally in Financials, Transports and Semiconductors, as well as breakdowns in Emerging Markets, Chinese and Italian securities generally.

Fund Performance

The second quarter 2018 return for Federated Absolute Return Fund was -7.33% (Class A Shares at net asset value, or NAV). This was below both the benchmark return and the fund’s peer group median return. The median Lipper Absolute Return category fund return was 0.03% and the total return for the fund’s benchmark, ICE BofAML 3-Month Treasury Bill Index, was 0.45% for the same period.

Performance data quoted represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than what is stated. Other share classes may have experienced different returns than the share class presented. To view performance current to the most recent month-end and for after tax returns, click on the Performance tab. Performance does not reflect the maximum 5.5% sales charge for Class A Shares. If included, it would reduce the performance quoted.

Click the Performance tab for standard fund performance.

The fund’s return was hurt by net losses on the long/short equity holdings, as its long equity holdings went up less than the market and the short equity holdings went up more than the market. The majority of the fund’s quarterly loss came from short stock and ETF positions, which lost 5.04% at the fund level (10.6% return on an average short position of 46.7%). Highly shorted stocks and REITS, two of our largest short concentrations, both contributed heavily to the losses. The other material contributor was equity call options (which lost 1.58% at the fund level), as fund management’s view of a large market return in the second quarter fell short of most of our strike prices.

Fixed-income short positions produced gains in the period, driven by higher interest rates in Italy. The fund’s total return reflected actual cash flows, transaction costs and other expenses which were not reflected in the total return of the index.

Positioning and Strategy

The fund was positioned 49% net long equities to start the quarter, with the majority of this net long being comprised of out-of-the-money call options with a fixed amount at risk. The idea was to position for the base case of positive equity markets, but to attempt to manage amount at risk should the market plunge to new lows. Unfortunately, the market did not move significantly higher or lower during the period, and volatility fell, so the impact of the call options on the fund was negative for the period.

Fund management’s view for higher forward-earnings estimates and higher valuation multiples did not play out in the quarter, especially when taking a global perspective, as markets seemed to narrow and exhibit signs of downside risk. As trade and tariff risks increased during the quarter, the market began to ponder a reversal of some of the gains of decades of globalization. Examples of investors reducing risky securities were in global Financials (especially in Europe), Transports (especially Airlines) and Semiconductors sectors. In addition, Emerging Market, Chinese, and Italian securities all flashed signs of deteriorating market internals and risk appetite.

Toward the end of the quarter, fund management’s view of the markets became bearish, primarily on the opinion that declining global quantitative easing no longer is sufficient to push asset prices higher. Secondly, the timing for a tougher trade/protectionist stance by the U.S. comes at a time when global markets are vulnerable. So far, global investors have rotated into U.S. securities, particularly those less affected by trade risks. It is fund management’s opinion that market internals have weakened sufficiently to warrant a short equity position for only the second time (the first was in the middle of the first quarter of 2016) in the 5½ years running the fund. Fund management is now using out-of-the-money put options to take a net short position while attempting to limit market exposure related losses should the market move higher.

The main trading during the quarter was to transfer some short positions from shorts into put options to attempt to avoid another large negative alpha outcome, but at the same time adhere to the process of shorting securities that we deemed to have the worst forward expected return.

For the most part, we have stayed with our concentrations on the long side despite a bit of a cyclical and beta tilt versus the overall market. Fund management continues to position for rising sovereign interest rates across the eurozone, not just the periphery.

Fund management ended the second quarter of 2018 41% net short equities, with the vast majority of this coming from put options in the S&P 500 and Russell 2000 ETFs.


Key Investment Team