As of 12-31-2017

Market Overview

During the fourth quarter of 2017, the S&P 500 returned 6.64% as global risk assets ended the period higher. The passage of tax reform in late December helped to raise forward earnings expectations, while low interest rates continued to support valuation multiples. Volatility, credit spreads and financial conditions all remained favorable for risk assets.

Fund Performance

The fourth quarter 2017 return for Federated Absolute Return Fund was 2.97% (Class A Shares at net asset value, or NAV). This was above both the benchmark return and the fund’s peer group median return. The median Lipper Absolute Return category fund return was 1.09% and the total return for the fund’s benchmark, the Bank of America Merrill Lynch 91-Day Treasury Bill Index, was 0.28% 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 gains from long equity and call option positions were greater than the losses from short equity positions (including put options and short index futures). The funds long equity portfolio outperformed the S&P 500 in the period, driven by Consumer Discretionary, Financials, Industrials and Materials stock holdings. The fund was positioned net long due to the constructive market backdrop. Low volatility and rising markets caused losses in the fund’s risk-management-related option positions.

Fixed-income short positions produced modest losses in the period driven by slightly lower interest rates in the eurozone. Precious metals holdings produced modest gains 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 31% net long equities to begin the quarter. Fund management believed that equity markets set up well for positive returns due to low credit spreads and volatility levels, attractive free-cash-flow yields in various segments of the equity market, as well as improving expectations for global economic growth and corporate earnings.

Additionally, it became fund management’s opinion that expectations for U.S. tax reform were low, and that the risk was to the upside regarding Washington. We adjusted our holdings somewhat to favor companies with high tax rates and increase shorts on some lower free-cash-flow (FCF) companies with low taxable income. The ultimate passage, albeit partisan, of tax reform was helpful to fund performance.

Volatility and credit spreads generally stayed very low during the period, allowing fund management to maintain steady net long equity positioning and benefit from the strong performance of risk assets. Fund management positioned the fund net long equities 28% at year-end, thinking that forward earnings estimates need to go higher for most U.S. companies and the favorable liquidity backdrop remained supportive of valuation multiples.

Fund management continues to be positioned to benefit from increases in European interest rates. The rationale for this 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, or quantitative easing (QE), beginning 2018, price sensitive bond buyers (who should demand higher interest rates) will have to replace the price insensitive ECB. Also, as the U.S. Federal Reserve continues to slow reinvestment of maturing bond proceeds, fund management believes that other global central bankers will follow with a lag, which will pressure interest rates upward. The fund’s long position in the dollar was reduced somewhat during the period, but fund management still has a bias toward thinking it should strengthen.

With market volatility near record lows exiting the reporting period, we continue to maintain put option positions in the portfolio that are designed to help reduce our equity-market exposure should the market decline materially for any reason. Fund management feels that return strategies that systematically short volatility (essentially writing market insurance) have become a crowded trade that could quickly unravel if risk markets were to decline abruptly for any reason. This means that volatility could spike very high at some point, which would increase the value of the fund’s put option holdings, all else equal. Federal regulation of the financial markets after the financial crisis has moved the chief market risk from capital requirements of large financial institutions to market liquidity, in the opinion of fund management, as large financial companies devote much less capital to making markets and more capital to bolster their balance sheets.

 


Key Investment Team