JPMorgan Hedged Equity A JHQAX

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

The strategy aims to provide smoother equity returns by tempering both downside and upside returns via a systematically implemented options strategy. The managers start with an equity portfolio that closely mimics the S&P 500 but with small tilts toward stocks they believe are attractively priced. To temper downside risk, the team purchases put options with strike prices 5% below the S&P 500’s market value at the start of each quarter. To offset part of the cost of the put option, the team first sells put options 20% out of the money. This structure should generally protect the fund from quarterly losses between 5% and 20%. If markets fall less than 5%, the fund should closely track the S&P 500. If the market falls more than 20%, the fund will begin participating in losses once again, maintaining a roughly 15-percentage-point advantage over the market.

To further offset the cost of the long put position, the team also sells call options that generate enough option premium income to cover the remaining cost of the hedge. As designed, the options overlay tempers upside returns in exchange for downside protection, limiting drawdowns to 5.33% for the second quarter of 2022 and 4.9% during the first quarter of 2020. This translated to nearly 11 and 15 percentage points in excess returns over the S&P 500 in these respective periods. Still, returns on the institutional share class have been robust. Five-year returns through August 2023 sat at just over 8.1% compared with the S&P 500’s 11.1%. The strategy has shown positive alpha to our category index over all rolling three-year periods bar one since inception, highlighting its ability to add value to a diversified portfolio.

Hamilton Reiner runs the show here. The lead manager and architect of the strategy joined JPMorgan in 2009 and has more than three decades of equity and options trading experience. He is supported by comanager Raffaele Zingone and more than 20 JPMorgan 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 concerns about capacity. The fund has added around $2 billion in new assets since, but the manager’s demonstrated ability to manage this increased capacity signals a thoughtful approach.

The fund earns an Above Average Process rating.

The fund’s option overlay strategy narrows its outcome path and provides a smoother ride to equity investing. It starts with an equity portfolio that resembles the S&P 500 before overlaying an options strategy that limits downside at the expense of forgoing upside. The team then 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 in the range of negative 5% to 20% in a given quarter. 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 a call option to cover the price of the put spread so that the full options position does not incur a cost. The call options are usually sold 3.5%-5.5% out-of-the-money depending on the net cost of the put spread. Calls command a higher price during periods of heightened volatility, allowing the fund’s managers to sell calls at a higher strike price. The strike price at which the calls are written determines the strategy’s upside cap for the quarter.

The team intends to generate a small level of alpha in the equity portfolio by modestly overweighting attractively priced stocks and slightly 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 constrains tracking error to 1.5% annually. Though it aims to outperform the index, individual stock exposure can deviate only within a 1-percentage-point range. The strategy uses a dividend discount model that ranks stocks from most attractive to least attractive based on earnings forecasts and company-specific growth catalysts. The team creates a well-diversified portfolio that mitigates risks inherent to any one holding, with the resulting portfolio constituting around 200 stocks. Sector weightings resemble the S&P 500 with a slight underweighting in communication services and overweighting in consumer discretionary stocks.

The team constructs a zero-cost option overlay at the beginning of each calendar quarter and resets it at the end of the quarter. Call options fetch a higher premium when interest rates are higher, thus improving the strategy’s upside in the current market environment. The recent spike in volatility was also a tailwind for call option sellers. In the second quarter of 2020 and toward the end of 2022, call options had a strike price closer to 7% out-of-the-money. 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. Though it will lose about 15 percentage points less than the S&P 500, it is not completely insulated from large drawdowns.

The core team tasked with managing this strategy is small, but concerns about its size are mitigated by its access to a strong support team and its systematic implementation of the options overlay strategy. Lead portfolio manager and strategy architect Hamilton Reiner joined the firm in 2009 and has three decades of experience in derivatives markets. Before joining JPMorgan, Reiner held senior positions across Wall Street at Barclays Capital, Lehman Brothers, and Deutsche Bank, and he spent the first 10 years of his career at O’Connor and Associates, an options specialist firm. He is supported by two junior portfolio managers, who joined from the ranks of the equity analyst team, and a strong supporting institutional framework at JPMorgan.

Raffaele Zingone, the other named portfolio manager, joined the firm in 1991 and is responsible for implementing the equity strategy. He directs JPMorgan's deep bench of more than 20 equity analysts, who average 21 years 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.

As of 2022, this investment stalwart manages more than USD 2.5 trillion in AUM. Composed of various global cohorts and diverse asset classes, the firm has more tightly integrated its capabilities in recent years, notably through the development of proprietary analytical and risk systems. Investment teams are robustly staffed and helmed by seasoned contributors. The firm’s strategies tend to produce reliable portfolios, and several flagship offerings are Morningstar Medalists. Manager incentives align with fundholders'; compensation reflects longer-term performance factors, and portfolio managers invest in the firm’s strategies as part of their compensation plans.

The firm’s funds tend to be well-priced, but they aren’t as competitive as many highly regarded peers of similar scale. Recent product launches include thematic and single-country strategies, both of which carry the potential for volatile performance and flows, along with misuse by investors. The firm remains intrepid when it comes to developing an environmental, social, and governance-focused framework and continues to move into other areas such as direct indexing through its 55iP acquisition and China through its joint venture, but these complicated initiatives take time to assess any real and lasting effect.

Its risk-adjusted return(as measured by Sharpe ratio) was 0.89 over this period, beating the category average of 0.42.

The options overlay is designed to protect capital when the S&P 500 drops between 5% and 20% in a given quarter. While investors are exposed to the first 5% of losses by the S&P 500, it hasn’t stopped the strategy from achieving its goal of lower volatility relative to the index. From its 2013 inception through August 2023, its 7.3% annual standard deviation clocked in lower than the S&P 500's 15.04%.

Moreover, this strategy shines during extreme drawdowns. It limited its maximum drawdown to 13.9% relative to the S&P 500’s 23.9%, between January and September 2022. Prioritizing downside over upside does not mean the fund completely missed out on the market rallies in recent years. It captured more than 47% of the S&P 500’s upside returns over the past five years while limiting downside capture to 36%.

Investors should note that intraquarter 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 quarter-end return. For example, the strategy was down nearly 19% at one point in the first quarter of 2020 but ended the period with 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.