As of 03-31-2018

Looking Back

During the first quarter of 2018, the S&P 500 returned -0.76%. The quarter was a tale of two halves in many ways. The first part was marked by higher equity prices and risk assets generally, and the second half was the opposite. Volatility increased notably and expectations for economic growth declined.

Performance

The first-quarter 2018 return for Federated Absolute Return Fund was -0.20% (Class A Shares at net asset value, or NAV). This was below the benchmark return and above the fund’s peer group median return. The median Lipper Absolute Return category fund return was -0.91% and the total return for the fund’s benchmark, the Bank of America Merrill Lynch 91-Day Treasury Bill Index, was 0.36% 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 helped by net gains on the long/short equity holdings. The fund holdings produced gains from both the long and short equity positions, as well as put option positions. These gains were larger than the losses produced from the fund’s call option and short index futures positions. The fund’s Long Equity portfolio outperformed the S&P 500 in the period, and the Short Equity portfolio underperformed the S&P 500, both of which contributed positive alpha to the fund. The fund was positioned net long during the entire period.

Currency forward positions (some of which represented hedges on international equity positions, and some of which represented bets) produced losses in the period, driven by a weaker U.S. dollar. Fixed-income short positions produced losses in the period driven by slightly lower interest rates in the eurozone. Commodity holdings produced modest losses in the period. 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

Fund management positioned the fund net long equities 28% to begin the quarter, thinking that forward earnings estimates need to go higher for most U.S. companies and the favorable liquidity backdrop remained supportive of valuation multiples.

During the quarter, markets became volatile as investors worried about rising interest rates, weakening global growth, the risk of a trade war and the impact of tightening financial conditions as global central bankers attempt to normalize monetary policy.

Upon the volatility spike in February, fund management took gains on the put option positions and implemented call option positions because of the much lower (cheaper) implied volatility, and fund management’s belief that that the market pullback had produced a better risk versus reward backdrop for equities generally (cheaper valuations and beatable expectations for economic growth and earnings).

At the same time, fund management significantly increased the amount of individual stock short positions in the portfolio. The thinking was that there were good short opportunities in interest-rate sensitive equities like REITs, Utilities, Staples and highly leveraged names in other sectors. We also found compelling short opportunities in high-growth companies that we viewed as overpriced, such as cloud software, as well as select internet and consumer discretionary names.

As we expected, interest rates, credit spreads and volatility levels increased in the period, consistent with normalization of these metrics from below-equilibrium levels that were caused by the massive amount of global monetary stimulus (quantitative easing, or QE) to fixed income and general risk assets.

The fund continues to be positioned to benefit from increases in European interest rates. The rationale for the interest-rate view is that global central bankers (most notably in Europe) have suppressed interest rates below normal levels with their massive bond purchase programs. Now that the European Central Bank (ECB) has committed to reducing bond purchases (QE) beginning 2018, price-sensitive bond buyers (who should demand higher interest rates) will have to replace the price-insensitive ECB. Also, as the Federal Reserve continues to slow reinvestment of maturing bond proceeds, we believe that other global central bankers will follow with a lag, pressuring interest rates upward.

The fund long position in the dollar was removed during the period, and it maintained modest long exposure to precious metals and precious metals mining stocks.

The fund exited the quarter 49% net long equities, with the majority of this net long being comprised of call options with a fixed amount at risk. The idea is to position for the base case of positive equity markets, but to attempt to manage the amount at risk should the market plunge to new lows.

Fund management continues to believe the financial markets will drive the global economy, versus the more consensus thinking that the economy will drive the markets. This means we see two primary scenarios. One, the markets overcome the current market risks and move higher, driving a reflexive benefit to the global economy and risk assets; or two, the markets succumb to the current market risks and fall to significant new lows, driving a reflexive decline in the economy and risk assets. Our current investment positioning is for the former scenario, and our risk management process is designed to try to reduce fund losses in the latter scenario.


Key Investment Team