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Looking to Reduce Your Market Footprint?

Look no further than market neutral.

Josh Charney, 05/17/2012

JPMorgan Research Market Neutral flopped in 2011, but its long-term track record should provide solace. A tidal wave struck this beta-, dollar-, sector-, and style-neutral large-cap equity fund in late 2011. The fund fell 5.0% in November and December, capping off an already dismal year. It finished down 7.0%, when the average market-neutral fund dipped only 0.3%. Portfolio manager Terance Chen attributes the fund's dismal performance to "one-off'" events, including record-high correlations among equities, making stock-picking extremely difficult. The most troubling reason for the poor performance, however, is that the team of 23 senior analysts failed to generate alpha in all but one sector (media). The team's stock-ranking process turned on its head, as both the longs and the shorts lost money, more than in any other year. But the fund's investment process has proved its worth over a much longer time frame than most market-neutral funds.

This fund has a 13-year track record, and although Chen has managed the fund solo only since 2006, the fund's processes have remained largely unchanged. The team of 23 analysts has been with JP Morgan for an average of 15 years and contributes research to JPMorgan's long-only JPMorgan US Equity fund, rated 4-stars (for the Institutional share class). The team ranks all stocks in each sector according to bottom-up, long-term fundamentals (three to eight years out). Chen’s job is to manage the fund's volatility constraint (about 4%) and to weight sector gross exposure based on how much alpha he believes those analysts can generate. For example, Chen has consistently overweighted REITs and semiconductors relative to the S&P 500. The two categories (exposure weighting 23.1% and 15.6%, respectively, as of Dec. 31) have resulted in sizable positive gains to the portfolio over time.

Overall, since Chen has taken the lead role, the fund has delivered solid annualized returns of 3.2% since February 2006 through March (compared with 3.8% for the S&P 500 and 0.3% for the category). It's likely that this will continue.

Purely Bottom-Up
The fund utilizes a hybrid fundamental/quantitative approach. The team of 23 analysts builds valuation models and ranks stocks in each sector. Analysts look at industry trends and seek price catalysts in their long and short picks, which are generally the top 40% (long) and bottom 40% (short) ranked stocks. They meet to determine their best ideas and final portfolio allocation. Chen determines the gross exposure to each sector based on how confident he is in his team's ability to generate alpha. Management attempts to maintain a 4% volatility target and limits positions to 3% of assets.

The fund's portfolio allocates to between 250 and 350 large-capitalization U.S. stocks, balanced among long and short positions on a dollar basis. The fund seeks to maintain dollar neutrality, as well as to maintain market beta, sector, and style (growth versus value, etc.) neutrality. Its beta over the past three years, ended in March 2012, is 0.12 to the S&P 500.

Stocks are selected by bottom-up, fundamental analysis. The models are based on the analyst team's long-term (three- to eight-year) fundamentals forecasts and rankings. As of December, 45.7% of the fund's gross exposure was from top-quintile stocks, which are selected from areas where analysts believe they have a forecasting advantage. For example, in 2011, the fund held Amazon.com AMZN because it looked undervalued on a long-term basis, though it ultimately was a top detractor for the year. Also during 2011, Sprint S resulted in a negative 0.3% contribution as management's short-term earnings and valuation forecasts were off. One of the fund's top contributors in 2011 was CBS CBS, which was selected because of solid ad revenue across various business segments.

Portfolio manager Terance Chen overweights sectors relative to the S&P 500 that he believes can generate more alpha. As of Dec. 31, the portfolio underweighted energy (7.1% of gross exposure) because the group's performance has largely fluctuated with oil prices. 

Solid Long-Term Track Record, Though Stumbled in 2011
This fund has exhibited decent risk-adjusted returns over the past five years, as measured by a 0.20 Sharpe ratio, relative to its category (through March 31). The fund has produced alpha above three-month Treasuries, the mandate of a true market-neutral fund, over the past five years, and the fund has demonstrated a 0.26 correlation to stocks and a 0.06 correlation to bonds (as measured by the S&P 500 and Barclays U.S. Aggregate Index) over the past five years (ended March 31). This fund will likely offer investors good long-term diversification.

Josh Charney is an alternative investments analyst at Morningstar.
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