JPMorgan Hedged Equity 2 I JHQDX

JPMorgan Hedged Equity continues to deliver on its promise of a low-volatility portfolio that can help investors stay the course during volatile markets. Consistent implementation by an experienced team and a reasonable fee add to its strengths.

The strategy cushions downside loss by forgoing some upside returns. Every three months, it layers S&P 500 options on top of an equity portfolio that closely hugs the index. To offer downside protection, the managers buy put options with strike prices 5% below the S&P 500’s market value. They pay for part of that purchase with proceeds from selling put options 20% out of the money. This structure should protect the fund from losses between 5% and 20% during the options’ three-month period. If the index falls less than 5%, the fund should closely track the S&P 500. If the index falls more than 20%, the fund will begin participating in losses once again, maintaining a roughly 15-percentage-point advantage over the S&P 500.

To cover the remaining cost of the put purchase, the managers sell out-of-the-money call options, which caps the strategy’s upside. The call strike price moves dynamically with market conditions, averaging between 3.5% and 5.5% above the index value, historically.

As designed, the options overlay has effectively cut risk. In the first quarter of 2020 and the second quarter of 2022, the institutional share class of JPMorgan Hedged Equity limited its losses to roughly 5% and 6%, respectively, beating the S&P 500 by 15 and 11 percentage points. Despite its capped upside, it offered better risk-adjusted returns than the S&P 500 since its 2013 inception, as measured by Sharpe ratio. It will trail the S&P 500 during market rallies but should offer a smoother ride and reduce drawdowns during stress markets.

Hamilton Reiner runs the show here. The lead manager and architect of the strategy joined J.P. Morgan in 2009 and has more than three decades of equity and options trading experience. He is supported by comanager Raffaele Zingone and a broad team of J.P. Morgan equity analysts who implement the low-tracking-error equity portfolio the options are built around.

After a soft close in early 2021, the fund reopened in February 2023. The strong increase in average daily volume on S&P 500 options has been a positive sign for underlying liquidity and alleviated capacity concerns.

JPMorgan Hedged Equity Funds 2 and 3 follow the same portfolio construction process as Hedged Equity, but the three series reset their three-month options overlay on different months.

The fund earns an Above Average Process rating.

The fund’s option overlay narrows its outcomes and provides a smoother path to equity returns. On top of an equity portfolio that resembles the S&P 500, the fund overlays three-month index options that limit downside at the expense of upside. The team purchases 5% out-of-the-money put options and sells 20% out-of-the-money put options on the S&P 500. This structure, called a put spread, protects against S&P 500 losses from 5% to 20% during the options’ three-month duration. The put spread is cheaper than buying the 5% out-of-the-money put outright, but it saddles investors with S&P 500 losses beyond 20%.

The manager also sells out-of-the-money call options to cover the price of the put spread so that the full options sleeve does not incur a cost. The strike prices on the call options average around 3.5%-5.5% above the index value, depending on the net cost of the put spread. This determines the strategy’s upside cap for the three-month period. High volatility and interest rates push options prices up, increasing the calls’ strike prices and the fund’s upside exposure. Hedged Equity resets its options on the last business day of every quarter, while Hedged Equity 2 and 3’s three-month cadences start on the last day of January and February, respectively.

The team intends to generate a small level of alpha in the equity portfolio by slightly overweighting attractively priced stocks and underweighting expensive stocks based on fundamental analysis. Since the constitution of the equity portfolio closely resembles the S&P 500, the index options remain a representative hedge.

The strategy’s equity portfolio should track the S&P 500 closely as it targets a 1.5% annual tracking error. Individual stock exposure can also deviate only within a 1-percentage-point range. JPMorgan equity analysts forecast earnings for each eligible stock using a dividend discount model, incorporating company-specific growth catalysts. The equity sleeve leverages these forecasts to offer marginal improvement over the S&P 500 within its constraints. The resulting portfolio is well-diversified with around 200 stocks. Sector weightings resemble the S&P 500 with a slight overweight to consumer discretionary stocks.

The team constructs a zero-cost option overlay every three months. Call options fetch a higher premium when implied volatility and interest rates are higher, which improved the strategy’s upside in the recent market environment. The strategy can enjoy call strike prices up to 7% out of the money in periods of heightened volatility, as was the case in 2022. In recent calmer months, the upside cap has remained around 5%-6% owing to high interest rates and demand for call options. In periods of serious market stress where the index drops more than 20%, its short out-of-the-money put will expose the fund to additional losses. It should lose about 15 percentage points less than the S&P 500 during these periods, but it is not completely insulated.

Industry veterans head up the small team managing this strategy. Lead portfolio manager and strategy architect Hamilton Reiner joined the firm in 2009 and has three decades of experience in derivatives markets. Prior to joining JPMorgan, Reiner held senior positions across Wall Street at Barclays Capital, Lehman Brothers, and Deutsche Bank. His recent promotion to CIO of the US Core Equity team adds supervisory responsibilities, but this should not affect the strategy’s systematic process. Two junior portfolio managers help Reiner implement the options overlay and act as his backup. The managers also leverage a deep bench of operational resources and the institutional risk framework at J.P. Morgan.

Raffaele Zingone, the other named portfolio manager, joined the firm in 1991 and is responsible for implementing the equity strategy. He draws on fundamental research from J.P. Morgan's broad team of around 20 equity analysts, who average two decades of industry experience. Consistent with groups this size, there has been modest turnover on the analyst team. Reiner and Zingone both invest more than $1 million alongside investors, signaling a strong alignment of interest between management and fundholders.

J.P. Morgan is a well-resourced, diligent, and responsible steward of client assets. Investment teams are seasoned and stalwart, especially in equity and fixed income, the latter of which has successfully undergone substantial transformation in recent years. The firm offers competitive compensation that is aligned with fundholders and shows strong retention at senior levels of the organization. It demonstrates a culture of constant innovation and willingness to evolve. For example, J.P. Morgan recently expanded its investment committee process through which senior leaders review various teams and strategies, and it continues to develop proprietary portfolio management and risk oversight tools. Some funds still face high fee hurdles, but the firm has generally lowered expenses as it has grown.

The firm isn't without its complications. J.P. Morgan's product offering is extensive, and some areas need improvement. For instance, its multi-asset business has faced some challenges as a result of complex investment processes. The firm continues to build out its footprint in China, but its efforts there remain unproven. Although not every strategy is the best in its class, J.P. Morgan remains earnest in the pursuit of excellence, and investors are well-served.

Its risk-adjusted return(as measured by Sharpe ratio) was 0.9 over this period, nearly doubling its average category peer. The accumulating I share class on the UCITS vehicle followed a similar return pattern as its US sibling.

The options overlay is designed to protect capital when the S&P 500 drops between 5% and 20% in a three-month period. While investors are exposed to index losses outside of this range, the fund will offer a cushion in extreme markets. In 2022, the US institutional share class limited its maximum drawdown to 14%, 10 percentage points better than the S&P 500.

The fund will lag the S&P 500 during market rallies, but it should continue to provide better risk-adjusted returns. It captured more than 50% of the S&P 500’s upside returns over the past five years while limiting downside capture to 38%.

Over the long run, JPMorgan Hedged Equity Fund 2 and 3 should have a similar risk/reward profile to the original Hedged Equity fund. However, the timing of market performance will result in short-term deviations because of different expiration dates for the options of each series. For instance, Hedged Equity 2 built its edge by outperforming during drawdowns between February and April 2022. Meanwhile, Hedged Equity 3 hasn’t taken advantage of its defensive chops because the index’s worst drop during any of its three-month hedged periods was only 5.16%.

Investors should note that intraperiod performance will vary given that option pricing is dynamic until expiration. Options’ values are marked to market daily, which often results in deviations from the options’ values at expiration. For example, Hedged Equity was down nearly 19% at one point in the first quarter of 2020 but ended the period down by only 4.9%.

Based on our assessment of the fund’s People, Process, and Parent Pillars in the context of these expenses, we think this share class will be able to deliver positive alpha relative to the category benchmark index, explaining its Morningstar Medalist Rating of Bronze.