Dynamic Risk Asset Allocation: Annual Report - Putnam Investments

growth has begun to show up as the overallhealth of the U.S. economy has been improving.Companies are reporting that sales are growingslightly. It is my belief that corporate earningsshould continue to grow as the U.S. economicrecovery continues to gather strength.What is your view on central bank activityaround the world, specifically the Fed andthe European Central Bank [ECB]?My feeling is that as the Fed continues on itscourse of reducing its quantitative-easingprogram, its zero-interest-rate policy will notgo away anytime soon. I believe that we willlikely see the Fed increase the federal fundstarget rate sometime in 2015. By that time,the hope is that the U.S. economic recoverywill have gained enough traction to offset anyassociated rise in financing costs as a result ofhigher short-term rates. The recent move bythe ECB to slash its overnight deposit rate intonegative territory is something that I wouldcharacterize as a highly unusual move. TheECB is having difficulty getting the Europeaneconomy to move in the right direction. Thishighlights some of the differences of theUnited States, relative to Europe.I believe the U.S. recovery is solidly on track,and Europe is doing everything in its powerto get its economy moving. Japan’s economy,meanwhile, has been doing satisfactorily, withsteady job growth, for example. However,there is concern about what effect therecently instituted consumption tax will haveon Japan’s overall economic growth.What is your outlook for the markets andthe economy?I expect equity markets to continue to moveforward. Valuations, of course, are not wherethey were a year ago. Stock prices may befully valued but they are not overvalued, inmy opinion. I believe that the economy willcontinue to grow and corporate earnings willcontinue to be strong. I do think it would beunrealistic to expect that markets will advanceABOUT DERIVATIVESDerivatives are an increasingly commontype of investment instrument, the performanceof which is derived from an underlyingsecurity, index, currency, or other areaof the capital markets. Derivatives employedby the fund’s managers generally serveone of two main purposes: to implementa strategy that may be difficult or moreexpensive to invest in through traditionalsecurities, or to hedge unwanted riskassociated with a particular position.For example, the fund’s managers mightuse currency forward contracts to capitalizeon an anticipated change in exchange ratesbetween two currencies. This approachwould require a significantly smaller outlayof capital than purchasing traditional bondsdenominated in the underlying currencies.In another example, the managers may identifya bond that they believe is undervaluedrelative to its risk of default, but may seekto reduce the interest-rate risk of that bondby using interest-rate swaps, a derivativethrough which two parties “swap” paymentsbased on the movement of certain rates.In other examples, the managers may useoptions and futures contracts to hedgeagainst a variety of risks by establishinga combination of long and short exposuresto specific equity markets or sectors.Like any other investment, derivatives maynot appreciate in value and may lose money.Derivatives may amplify traditional investmentrisks through the creation of leverageand may be less liquid than traditionalsecurities. And because derivatives typicallyrepresent contractual agreements betweentwo financial institutions, derivatives entail“counterparty risk,” which is the risk thatthe other party is unable or unwilling to pay.Putnam monitors the counterparty riskswe assume. For example, Putnam oftenenters into collateral agreements thatrequire the counterparties to post collateralon a regular basis to cover their obligationsto the fund. Counterparty risk for exchangetradedfutures and centrally cleared swapsis mitigated by the daily exchange of marginand other safeguards against defaultthrough their respective clearinghouses.Dynamic Risk Allocation Fund 9