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Q3 | 2012Putnam Absolute Return Funds Q&A

Easing of market volatility created positioning opportunities

Jeffrey L. Knight, CFA Head of Global Asset Allocation Portfolio Manager, Putnam Absolute Return 500 Fund and 700 Fund D. William Kohli Co-Head of Fixed Income Portfolio Manager, Putnam Absolute Return 100 Fund and 300 Fund

Portfolio management teams

Jeff Knight and Bill Kohli each lead a team of veteran investors responsible for day-to-day management of the funds.

Key takeaways The funds benefited from advances across a range of strategies, while maintaining a low volatility profile. The buildup toward monetary easing in Europe and the United States created a positive environment for risk assets during the third quarter, and valuations have increased across many asset classes. Markets must still work through the uncertainty surrounding the scheduled fiscal contraction in the United States, Chinas prolonged economic slowdown, and potential volatility in long-term interest rates. There was a positive shift in market performance and volatility during the third quarter. What did this mean for Putnam Absolute Return Funds? Markets ignored the economys weakness and instead responded to the introduction of new, easier monetary policy in Europe and the United States. Government bond yields experienced volatility but remained low, while agency pass-throughs were met with strong demand in anticipation of a new round of quantitative easing. Risk assets, including corporate credit, stocks, and commodities, benefited from the return of the risk-on trade. We have seen the decline in volatility as an opportunity to position the portfolios for near-term uncertainty. We incorporate multiple time horizons in our decisions, and when market volatility drops, or when interest rates seem to be bound within a certain range, we favor adding tactical strategies that benefit from future potential for increased volatility. With a mix of strategies, we can participate in range-bound markets as well as be prepared for a sudden breakout beyond the range.

100 Fund and 300 Fund

Kevin F. Murphy (industry since 1988)

Michael V. Salm (industry since 1989)

Paul D. Scanlon, CFA (industry since 1986)

500 Fund and 700 Fund

James A. Fetch (industry since 1994)

Robert J. Kea, CFA (industry since 1988)

Joshua B. Kutin, CFA (industry since 1998)

Robert J. Schoen (industry since 1990)

Jason R. Vaillancourt, CFA (industry since 1993)


Q32012| Easing of market volatility created positioning opportunities

What is your view of the new bond-purchase programs of both the Federal Reserve and the European Central Bank? The policy is a continuation of the efforts on the part of central banks to expand their balance sheets to keep rates low on the short end of the yield curve. Its focused on driving money out of high-quality securities and into risk assets. Indeed, we saw higher-risk asset classes rally both in anticipation of the policy announcement and in the initial aftermath during September. Non-government sectors of the bond market, as well as stocks and commodities, all advanced. Although markets have responded to the policy measures, we believe long-term macro risks in China, Europe, and the United States remain largely the same. In fixed income, we continue to see most of the opportunity set outside of the government sectors that are supported by the monetary programs. These sectors have had strong performance during 2012, and we continue to favor them. Looking ahead, we see the possibility that when the initial impact of the bond-buying programs subsides, the markets may look ahead to the eventual withdrawal of stimulus, and this could cause volatility in long-term rates. The ultimate impact on the economy will be modest, we believe, because Fed purchases have little likelihood of improving the labor market and consumer demand. What were the major drivers of fund performance in the 100 Fund and 300 Fund? Mortgage credit strategies provided the biggest contribution. This was one of the three primary strategies of the funds, which included those targeting corporate credit risk and mortgage prepayment risk. In mortgage credit, commercial mortgage-backed securities [CMBS] and a modest allocation to non-agency residential mortgage-backed securities [RMBS] performed well on the expectations of the Feds QE3 policy. The technicals of these markets helped results, as demand for both CMBS and non-agency RMBS remained strong, in the face of steady to shrinking supply. Meanwhile, a firmer housing market, which recorded both sales and price increases, provided a positive fundamental backdrop.

The second-largest active risk position in the portfolios was corporate credit, which included both investmentgrade and a smaller position in high-yield bonds. This sector advanced along side equities. The fundamentals remained neutral, in our view, as the advantages of a low default rate and cautious corporate acquisition activity were offset by concerns about a weak economy and sluggish corporate revenue growth. We pursued prepayment risk strategies through allocations to interest-only [IO] securities and mortgage pass-through securities. A robust rally tightened mortgage pass-through yield spreads from 80 bps to below 30 bps before spreads widened again in September. For pass-throughs, the Feds decision to make the new bond purchases indefinite provided a positive surprise. The Feds monthly purchases of agency MBS will represent approximately half of the markets gross new supply. This drove pass-through spreads tighter while arresting the advance of IOs, on concern that the Feds efforts would increase home refinancing activity and thereby increase prepayment risk. Where did you have disappointments? Term structure strategies had flat to modestly negative results for the quarter as a whole. Our term structure strategy favored a steepening yield curve, which benefited the portfolio in August. The 10-year Treasury yield rose quickly during mid August, although yields later fell back to previous levels by the end of September. However, in September, the term structure strategy featured a short duration stance and was hurt by falling rates on the front end of the curve. The portfolios also had a bearish position in Australian rates, which rose in July before rallying in August and September on economic weakness in China, which is Australias major export market. Overall, we have been conservative with the funds duration stance, and we still consider it unattractive to take interest-rate risk. Currency strategies had a small impact on results of the 300 Fund, 500 Fund, and 700 Fund, but not the 100 Fund. In the 300 Fund, short positions in the euro and in the Czech koruna performed well in July, but then retreated in August and September due to positive risk


Q32012| Easing of market volatility created positioning opportunities

sentiment and supportive comments from the ECB. The ECBs new facility, Outright Monetary Transactions, can buy government bonds of indebted peripheral nations that meet certain financial conditions. This program reduced the markets expectation of a tail-risk event in Europe, such as the exit of any eurozone members or a sovereign default. The koruna rallied with the euro because the Czech Republics economy is closely tied to that of the eurozone. In the 500 Fund and 700 Fund, currency strategies detracted from results, driven primarily by a short position in the euro which outweighed modest positive results from long positions in the Australian dollar and Swedish krona. For the 500 Fund and 700 Fund, you described in the second quarter that directional risk was becoming less attractive to you. What is your view today? How are you balancing directional and non-directional strategies? Putnam Absolute Return Funds will routinely mix directional and non-directional strategies because they are independent of traditional asset class benchmarks and do not try to keep up with a runaway stock market or any individual asset class. The directional strategies represent investments that have positive return expectations aligned with an upward market move or, in some cases, a downward move, but we generally do not deploy all of our strategies along these lines. Non-directional strategies have positive return expectations whether markets are going up, are going down, or are flat, and help to distinguish the funds from relative return approaches. In the third quarter, we achieved gains primarily from directional strategies. Near the end of the quarter, we took a cue from the fuller valuations we had seen in both equities and fixed income to reduce risk in these exposures. Heading into the fourth quarter, we have instituted some additional non-directional strategies while taking advantage of the hedging opportunities created by a rallying market. In general, when assets perform well, opportunities to hedge them become more affordable to execute. For example, purchasing put options on

equities in specific markets or sectors becomes less costly. Options afford investors an opportunity to put a floor under current investment positions in case there is a flare-up in volatility. If these assets then fall in value, the options can appreciate. By their nature, these are non-directional strategies. The protection we obtain helps to prepare the portfolio for the next time we see a flare-up in Europe, which has fallen into recession, or in China, where economic reports remain disappointing. Thats when the benefit of hedging would show. We believe absolute return strategies can demonstrate their value particularly well after periods of large market gains, like the third quarter of 2012, when volatility may be more likely to increase. A combination of directional and non-directional strategies can help to reduce overall volatility, and can be used within a larger portfolio along with relative return strategies to provide more stable returns. At this point in the year, with many asset classes having delivered substantial gains, the stable performance we seek in absolute return funds can be especially valuable for those who have a goal of preserving gains. Have you seen any change in the correlation of the different asset classes or strategies that you pursue? As a sign of a possible shift, Treasury yields initially rose in reaction to the QE3 announcement. Though they then stabilized and recovered some ground, this sudden drop may suggest a tendency toward rising inflation expectations. For a long period, the performance correlation of stocks and government bonds has been negative, and stable inflation expectations help to anchor this relationship. If the market consensus begins to reflect higher inflation expectations, it could cause losses for these two assets at the same time, which would give them a positive correlation. This would deprive investors of a powerful diversification tool. Thats why Putnam Absolute Return Funds have a variety of tools that can help to reduce volatility. While the negative correlation of stocks and bonds has been helpful, we are aware that this relationship could change, and we can prepare the portfolios for a different type of environment.


Q32012| Easing of market volatility created positioning opportunities

When it comes to global debt deleveraging, what inning are we in today? Since the problems originated in the housing market, does the recent improvement in housing offer hope on the horizon? Markets first began to feel the brunt of deleveraging in 2007 and 2008, which seems like a long time ago. However, if we were to measure deleveraging in terms of actual debt reduction, we have not made much progress. A baseball game is nine innings, but in terms of deleveraging we are only in the second or third inning of the process, the majority of which still lies ahead.

To this point, the process has primarily transferred bad private sector debts to the public sector. The task is to collect what can be recovered, and write off the amounts that cannot. As this process continues, it weighs on credit creation and job creation. While the U.S. housing sector has shown some improvement, the problems were far more widespread. For example, Dubai experienced a debt crisis involving its infrastructure projects, and China has seen problems from the debt created from stimulus efforts. Around the world, deleveraging remains a challenge and will likely be a factor contributing to periods of market volatility for years to come.

Fund quotrons
Absolute Return 100 Fund Class A Class B Class C Class M Class R Class Y PARTX PARPX PARQX PARZX PRARX PARYX Absolute Return 300 Fund PTRNX PTRBX PTRGX PZARX PTRKX PYTRX Absolute Return 500 Fund PJMDX PJMBX PJMCX PJMMX PJMRX PJMYX Absolute Return 700 Fund PDMAX PDMBX PDMCX PDMMX PDMRX PDMYX

Annualized total return performance as of September 30, 2012

Class A shares (inception 12/23/08) Absolute Return 100 Fund
Before sales charge 1 year 3 years Life of fund Total expense ratio What you pay 1.55% 0.88 1.42 0.97% 0.67% After sales charge 0.56% 0.55 1.15

Absolute Return 300 Fund

Before sales charge 2.97% 1.72 2.82 1.05% 0.87% After sales charge 1.99% 1.37 2.55

Absolute Return 500 Fund

Before sales charge 10.26% 4.38 5.50 1.29% 1.17% After sales charge 3.91% 2.33 3.86

Absolute Return 700 Fund

Before sales charge 11.67% 5.30 7.12 1.45% 1.37% After sales charge 5.27% 3.23 5.45

BofA Merrill Lynch U.S. Treasury Bill Index

0.09% 0.16 0.19

Current performance may be lower or higher than the quoted past performance, which cannot guarantee future results. Share price, principal value, and return will vary, and you may have a gain or a loss when you sell your shares. Performance of class A shares after sales charge assumes reinvestment of distributions and does not account for taxes. After-salescharge returns reflect a maximum 1.00% load for Putnam Absolute Return 100 Fund and Putnam Absolute Return 300 Fund, and a maximum 5.75% load for Putnam Absolute Return 500 Fund and Putnam Absolute Return 700 Fund. For a portion of the periods, the funds had expense limitations, without which returns would have been lower. What you pay reflects Putnam Managements decision to contractually limit expenses through June 30, 2013. To obtain the most recent month-end performance, visit


Q32012| Easing of market volatility created positioning opportunities

The views and opinions expressed are those of the portfolio managers as of September 30, 2012, are subject to change with market conditions, and are not meant as investment advice. All performance and economic information is historical and is not indicative of future results. The funds are not intended to outperform stocks and bonds during strong market rallies. Consider these risks before investing: Our allocation of assets among permitted asset categories may hurt performance. The prices of bonds in the funds portfolio may fall or fail to rise over extended periods of time for a variety of reasons, including both general financial market conditions and factors related to a specific issuer or industry. Our active trading strategy may lose money or not earn a return sufficient to cover associated trading and other costs. Our use of leverage obtained through derivatives increases these risks by increasing investment exposure. Bond investments are subject to interest-rate risk, which means the prices of the funds bond investments are likely to fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk is generally greater for belowinvestment-grade bonds, which may be considered speculative. Unlike bonds, funds that invest in bonds have ongoing fees and expenses. Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Additional risks may be associated with emerging-market securities, including illiquidity and volatility. The use of derivatives involves additional risks, such as the potential inability to terminate or sell derivatives positions and the potential failure of the other party to the instrument to meet its obligations. The funds may not achieve their goals, and are not intended to be a complete investment program. The funds effort to produce lower volatility returns may not be successful and may make it more difficult at times for the funds to achieve their targeted return. In addition, under certain market conditions, the funds may accept greater volatility than would typically be the case, in order to seek their targeted return. For the 500 Fund and 700 Fund, these risks also apply: REITs involve the risks of real estate investing, including declining property values. Commodities involve the risks of changes in market, political, regulatory, and natural conditions. Investments in small and/ or midsize companies increase the risk of greater price fluctuations. Growth stocks may be more susceptible to earnings disappointments, and value stocks may fail to rebound. Additional risks are listed in the funds prospectus. Request a prospectus or summary prospectus from your financial representative or by calling 1-800-225-1581. The prospectus includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing.
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