Can a Money-Market King Wear Two Crowns?

Federated's expansion into mutual funds from money-market funds has paid off for some investors in recent years, but its execution has been far from flawless. Now, the Pittsburgh-based firm finds itself in the middle of the mutual fund pack. 

Does This Midpacker Have an Inner Star? 
Federated's biggest strength may be its focus on capital preservation. This emphasis grows out of its core money-market fund business, which generates the majority of its revenues and where preserving capital is the investments' central mandate. The firm's conservative approach to its money-market business allowed it to steer clear of the blowups that hit the Reserve Fund and other money market funds in 2008. During the credit crisis, the U.S. Federal Reserve asked Federated to take over a rival's beleaguered money-market fund with $12.3 billion in assets, partly because of the firm's expertise and reliability with those investments.

Federated says it attempts to bring the same focus on capital preservation to its equity and fixed-income mutual funds through a generally conservative approach to investing. Its fixed-income funds--which generally have stronger returns relative to their Morningstar categories than Federated's equity funds--are buttoned-up, plain-vanilla offerings. They are devoid of leverage and use derivatives sparingly. Meanwhile, investors won't find outsized sector or individual security bets in Federated's fixed-income or equity funds.

Risk Is a Four-Letter Word
Federated keeps a close eye on the risks its fund managers take. A customized software program issues daily reports on volatility and sector exposure, and the reports are monitored by a host of senior officers, including a risk-management team created in 2004 and led by a chief risk officer who reports to the fund board's independent directors. Risk-management reports are common in the fund industry, but they don't always influence behavior. At Federated, however, most funds have taken on less risk than their peers. The overwhelming majority of Federated's funds have an average to below-average Morningstar Risk rating on a three-, five-, and 10-year basis for the funds for which the rating is available.

Other than an edict to avoid undue risk, Federated managers are otherwise allowed plenty of variety among their strategies, and this autonomy allows Federated's better managers to shine. For example,  Federated Capital Appreciation  manager Carol Miller drastically cut her stake in financials in 2007 based on a distrust of the sector that began years before the credit crisis hit. And in 2009,  Federated Equity-Income (LEIFX) manager John Nichol invested fund assets in Federated's high-yield bond fund to offset a raft of dividend cuts by stocks the fund typically invests in�a racy move for such a "sleep-at-night" fund. Even so, Nichol's overall conservatism still earns the fund a low Morningstar Risk rating.

Although Federated has a fairly strict risk budget, its lineup is not bland. In fact, the firm has acquired small boutique firms specifically for their unique investment styles. Since 2006, the firm bought the PrudentBear funds, which bet against dollar-denominated securities, value shop Clover Funds, and quant shop MDT. All together, Federated's patchwork of funds (with retail shares) has 37 equity and 18 fixed-income portfolio managers, with an average tenure at the firm of 10 and 14 years, respectively.

These boutiques and the home-grown Federated funds have separate sets of analysts. To prevent information silos, Federated encourages formal and informal communication among all of the portfolio managers and analysts across asset classes. These communications from diverse points of views have generated insights that have benefited shareholders. For example, Miller's move away from the financials sector in 2007 was partly based on input from her fixed-income colleagues.

Chinks in the Armor
Federated's lineup has its bright spots, including its recently acquired Clover funds and several of its fixed-income funds, but performance has been lackluster on some others, particularly on the equity side. It's doubtful that Federated's focus on risk holds it back, as other firms that are as mindful of risk, including T. Rowe Price and MFS, have created better-performing funds. Instead, mediocrity within its equity funds could stem from some weakness in Federated's equity analyst research, as many managers hinge their picks on these recommendations. The fault also could lie more with some of the portfolio managers.

Federated has made attempts to improve its research in the past. In 2006, it divided its equity analysts by investment categories, such as "core and growth" and "equity income," so that analysts were better matched to their investment temperaments. This restructuring has improved stock selection, but the funds still haven't had a meaningful performance edge over peers.

Manager execution has been uneven. For example,  Federated Market Opportunity  aims to be an absolute-return fund by using a wide array of securities and investment approaches. Yet, the fund has struggled to generate consistent returns over the years under the same manager. At the same time, the firm has been impatient with other managers. For example, David Cook of  Federated Mid Cap Growth Strategies (FGSAX) stumbled in 2009 after respectable relative returns in 2007 and 2008, and was moved to second chair, behind the previous lead manager.

Federated's sales of fund shares have been steady even though performance hasn't been best-in-class overall. For example, in 2009, most of Federated's fixed-income funds beat their category peers while most of its equity funds didn't, but inflows into both its equity and fixed-income funds gathered momentum as the year wore on. That helped offset fee waivers due to lower interest rates in its larger money-market funds. If Federated's funds are selling well with the lineup as is, the firm may have less incentive to change a mutual fund strategy or management team or to invest more heavily in analytical firepower.

A Wake-Up Call?
A reticence to change has shown up in other instances. In 2003, Federated was one of many mutual fund companies accused by the U.S. Securities and Exchange Commission and New York State Attorney General of allowing shareholders to quickly trade its funds, even though the funds' prospectuses said such trading wouldn't be allowed. While several of Federated's peers were quick to resolve the issue,  Federated Investors (FII), the funds' parent, didn't settle the matter until 2005. It agreed to settle by paying about $80 million in fines and restitution to shareholders. To its credit, the company used this time to create 50 reforms to Federated's trading and compliance procedures, which it has since carefully implemented.

Moreover, since this episode with regulators, Federated has been more transparent with shareholders. Previously, it poorly communicated fund manager changes and specifics about all of its funds' strategies. Now, Federated is clear and timely in its communication of manager changes, and it provides detailed information about the managers' work experience and other investment mandates within a clearly designed website. The site also provides a material amount of data about each fund, beyond just its holdings and returns, including sector allocations, portfolio valuation metrics, and a full description of the funds' strategies. Also, the firm proactively provides comprehensive information about new developments, whether it's an acquisition or a change in an individual fund's strategy.

To better serve fundholders, Federated could beef up its analytical strength and apply a more robust investment philosophy consistently across its funds, particularly on the equity side. Federated's tolerance of some mediocrity in its lineup suggests it's not as shareholder-focused as some key competitors. That said, Federated's ongoing focus on capital preservation and greater transparency are a good foundation for further improvement.