Breaking the Mold of Balanced Funds

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JPMorgan Global Allocation GAOAX is anything but a run-of-the-mill balanced fund. With wide swings in its holdings of stocks and bonds, and a heavy dose of options, it's a far cry from traditional allocation funds that plod along with largely static mixes of plain-vanilla investments.

While many allocation funds hew closely to a 60% stocks, 40% bonds mix, the J.P. Morgan strategy has in its five-year life had stocks comprise as little as 30% of the portfolio and as much as 79%.

But the fund's managers' aren't aiming to make it a rocket ship. The wide-ranging, active approach is all in the name of controlling the risk of the portfolio as it takes the J.P. Morgan fund group's highest-conviction investment ideas from around the world and puts them into one bucket.

For example, the fund will at times have more exposure to changes in interest rates through government bonds. But it will do so as ballast against higher stock or high-yield bond positions. If there's a corner of the markets the managers don't like, they won't just underweight it like most managers, they'll take the fund's exposure down to zero.

Even the fund's underlying investments break the mold from most balanced funds; rather than spread the portfolio out among a long list of the company's funds, its holdings are relatively concentrated with a few managers, including separately managed accounts on the bond side that are essentially customized to match the Global Allocation team's investment views.

Performance on the $1.4 billion fund since it was launched in May 2011 suggests the approach is working. The Global Allocation fund is in the top quartile of the Morningstar World Allocation category the last three and five years. Over the last five years through Aug. 11, the fund has returned an average of 7.4% per year, compared with 6.0% for its peer group.

Meanwhile, it has posted these returns by falling less in down markets than the category average and capturing more of the rallies.

Jeff Geller, chief investment officer for U.S. multi-asset solutions at J.P. Morgan Asset Management in New York, leads the team of managers on the portfolio. He says they've taken the usual approach to running balanced funds and turned it on its head in order to allow for the kind of flexibility that matches its global mandate. At least 40% of the fund is held in non-U.S. investments.

"The traditional way of building a balanced portfolio is to come up with a strategic allocation--say 35% in large cap, so much in small cap and so on--and the way of making active tilts is translating them into small overweights and underweights," he says. "But really 90% of your return is driven by the policy portfolio you came up with."

"What we want to do is think about the neutral portfolio (allocation) as a risk level similar to a 60-40 stock and bond portfolio," he says. "It's the same opportunity set, but as soon as you say that what you care about is the risk in the total portfolio, as opposed to tracking against the policy portfolio, you have a lot more flexibility."

As a result, "what we own will look very different from a broadly diversified 60–40 portfolio, but the risk profile is the same."

Strong Background Geller brings to the J.P. Morgan fund a background in derivatives that's become a central part of the Global Allocation fund's approach. Geller's investment experience began 38 years ago in Chicago at a time when the derivatives markets were exploding. He joined money-manager BEA Associates where he specialized in using derivatives for hedging and arbitrage for large institutional clients. He rose through the ranks and was a partner in the firm when it was bought by Credit Suisse in 1990.

"Because I was running these large hedging programs, it brought me into the broader discussion...of where these hedging strategies fit into how they were moving assets across their portfolios," he says.

After a stint at Russell Investing Group, where he gained experience in manager due diligence as director of hedge fund investments, Geller joined J.P. Morgan as chief investment officer for the allocation group. As part of the team setting global allocation strategies, he's partners with London-based James Elliot, chief investment officer for international multi-asset solutions, who has been with J.P. Morgan since 1995.

Conviction Counts Central to the fund's strategy is the aim of building the portfolio around the strongest-conviction ideas from across the firm's global investment operation.

The foundation for the investment process combines two main channels. One pillar is the views of J.P. Morgan's fundamental strategists who use traditional business and economic indicators to assess the relative attractiveness of asset classes and regions. The second pillar is quantitative analysis, which screens through some three-dozen fundamental data points, risk factors, and market technicals to make asset-class calls.

These views are discussed in quarterly strategy summits, which also invite input from J.P. Morgan's portfolio managers and even outside managers to whom the fund can allocate a portion of the portfolio. They review investment themes monthly and will drill down into specific ideas at weekly meetings. "We have a very active dialogue and debate is important," says Geller. "We want to make sure it's all factored in... and it's not just listening to the loudest guy in the room."

The actual allocation decisions for the fund, however, lay in the hands of Geller, who spells out the asset-class views in a "tick chart" where he checks off a spectrum of negative, neutral, and positive views on 28 different asset classes.

Central to the process is a willingness to make meaningful changes in the portfolio. "It's important that our process evolves as the markets are changing," says Geller.

A Wide Array To construct the actual portfolio, they can choose from over 500 active strategies plus third-party passive strategies through ETFs, funds, and derivatives.

But unlike many other asset allocation funds that spread out investments among a large number of funds, Global Allocation tends to concentrate its investments with just a handful of managers who ultimately make the decisions on individual securities. As of the end of March, equities were in the hands of four managers.

Bonds were also allocated to just four managers. In another differentiating factor, the fund does not invest in traditional open-end mutual funds and instead invests via separately managed accounts that can be tailored to the team's views. For example, the fund's high-yield holdings recently were in an account focused on higher-quality junk bonds that are lighter on energy-related debt, reflecting a wary view on oil prices.

The dynamic nature of the fund can be seen in its tilts over the years. The year of its launch in 2011 was a tumultuous one for the markets, with the eurozone crisis raging and the credit rating downgrade for U.S. debt. The team, however, saw positive signs in the U.S. economy as the housing market staged its recovery from financial crisis. In August of that year, equities were approaching 60% of the fund but the portfolio took a hit from the market turmoil. "It was a scary time," he said. The question "was how do we stay long risk but do it in a more prudent way?" For them, the answer was a bigger weighting in high yield.

They reset the portfolio, taking stocks below 50% for a time and lifting high yield up to 35% of the portfolio by year end.

Zeroing Out When the team doesn't like the outlook for an asset class, there's the flexibility to completely exit it. By contrast, many benchmark-tracking funds will underweight an asset class but still keep a portion of the portfolio invested in the group even if they think its prospects are dim.

That was the case last year with emerging-markets stocks. "When we had a negative view on emerging-market equities in early 2015, we just zeroed it out," says Geller. The MSCI Emerging Markets Index lost 17% in 2015.

"The whole idea is that if we like it, we should own it in a big way and if we don't like it, don't own it," he says.

These moves are made with a careful eye on the risk profile of the fund. One tool for managing risk has been to raise and lower the duration of its bond portfolio as ballast. Using the basic framework that government bond rates are inversely correlated to many risk assets, when they need more cushion against riskier assets, the fund will extend the interest-rate sensitivity of the portfolio.

With 52% in equities and roughly 27% in U.S. and European high yield as of the end of March, the fund has lengthened its bond duration out to 2.4 years. In contrast, Geller says, most retail allocation funds keep duration between a half and one year.

"When you are in those periods of high uncertainty... it provides a very effective hedge against risk assets," Geller says.

Another tool the fund employs to manage risk is currency hedging. The global mandate of the fund means investors have exposure to swings in currency rates.

In early 2015, the team felt that the U.S. dollar was likely to be stronger, in part because of a view that the U.S. economy would be healthier than much of the rest of the world--a call on the dollar that turned out to be correct. A stronger dollar would inflict losses on holdings of foreign-currency denominated investments; as a result they hedged away all their exposure to non-U.S.-dollar currencies. In November, the team lifted its hedges, feeling the currency risks were more symmetrical and amid expectations that the Japanese yen could be poised for a rally. But then ahead of the June U.K. "Brexit vote" they felt the potential for currency volatility was high and put the hedges back on against their exposures to the British pound and the euro.

"It's an active risk we have to deal with," Geller says. "But because it's an active risk, we feel it's got to be a risk that we are going to be compensated for."

A third-risk management tool the fund puts to work are options, harking back to Geller's days in Chicago. The team will often express a view on stocks by owning calls, which are bets that stocks will rise. While this strategy adds an element of leverage to the fund, it has the effect of swiftly reducing the fund's stock exposure during a downdraft (the options expire worthless, losing only the premium paid). But in a rally, the options have the effect of magnifying gains. "The options do the hard work," says Geller.

All this has added up to a portfolio that has tended to fare better than the competition in both down markets and up markets. Over the past three years, Global Allocation has captured 102% of the market's upside compared to 90% for the world allocation category. But the fund captured 108% of the market's downside, while the peer group took 120% of the hit.

By another risk measure, the fund has had higher monthly volatility than its peer group and 60-40 blend of the MSCI World Index and the Barclays Aggregate. But the team says that's a function of a "pro-risk" tilt to the fund in the last few years, and that over a complete market cycle its volatility measures would be more in line with the index blend.

When it comes to the focus on risk, Geller says, "Part of it maybe is my derivatives background... but it's very much ingrained."

This article originally appeared in the June/July 2016 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.