JPMorgan International Hedged Equity I JIHIX

JPMorgan International 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 MSCI EAFE Index 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 MSCI EAFE Index’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 on the index between negative 5% and 20%. If markets fall less than 5%, the fund should closely track the MSCI EAFE Index. 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 index. 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 but also cap the strategy’s upside.

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 Piera Elisa Grassi and a deep bench of equity analysts who implement the low-tracking-error equity portfolio the options are built around.

Performance divergence can emerge between this fund and its S&P 500-based counterpart, as each overlay applies to a different index. Nonetheless, the same investment philosophy holds. For example, the fund’s Institutional shares outpaced the MSCI EAFE Index by 4.93 percentage points in 2022 as it contained its loss to only 9.52%, compared with the MSCI EAFE's 14.45% decline. The fund still provides robust returns despite strong downside protection. From its 2019 inception through August 2023, the Institutional share class returned over 3.1% compared with the MSCI EAFE Index’s 5.25% return.

The same investment thesis and fees as the S&P-500-focused fund make this an interesting option for investors seeking to manage risk in global markets.

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 MSCI EAFE Index 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 MSCI EAFE Index. This structure, called a put spread, protects against index 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 index 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 MSCI EAFE Index, the index options remain a representative hedge.

The strategy’s equity portfolio should track the MSCI EAFE Index closely, as it constrains tracking error to 2% annually. Though it aims to outperform the index, individual stock exposure can only deviate within a 75-basis-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 MSCI EAFE Index, with a slight underweighting in materials and minimal overweighting in consumer staples stocks.

In late 2022, the managers switched to newly available quarterly options on the MSCI EAFE Index that start and end at the beginning of each calendar quarter, instead of those expiring on the third Friday of the last month in each quarter. They construct a zero-cost option overlay at the beginning of each calendar quarter and reset 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 MSCI EAFE Index, 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.

Piera Elisa Grassi, Winnie Cheung, and Nicholas Farserotu are also named portfolio managers on the strategy and are responsible for the equity portfolio implementation. Grassi also runs JPMorgan’s Global and International Research Enhanced Index strategies, where she directs JPMorgan's deep bench of 14 equity analysts, who average 19 years of industry experience.

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.

Before the third quarter of 2022, end-of-quarter expiration dates were not available for the MSCI EAFE Index option, and the fund used three-month options that expired on the third Friday of the last month in the quarter.

As such, its options expired right at the market bottom on March 20, 2020, when its short put option expired in-the-money. This caused the institutional share class to lose 13.4% during the first quarter of 2020. Meanwhile, the U.S.-based Hedged Equity fund was afforded a few more days of market recovery owing to its quarter-end expiry, and its short put option expired worthless, causing the sibling fund to lose only 4.9% during the quarter. Now that both funds are using options expiring on the last day of the quarter, the only deviations should be from differences in the performance of the underlying benchmarks themselves.

The options overlay is designed to protect capital when the MSCI EAFE Index drops between 5% and 20% in a given quarter. While investors are exposed to the first 5% of losses by the MSCI EAFE Index, it hasn’t stopped the strategy from achieving its goal of lower volatility relative to the index. From its 2019 inception through August 2023, its 10.48% annual standard deviation clocked in much lower than the MSCI EAFE Index's 18.2%.

This strategy shines during extreme drawdowns. It limited its maximum drawdown to 16.6% relative to the MSCI EAFE Index’s 27.3%, between September 2021 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 55% of the MSCI EAFE Index’s upside returns over the past five years while limiting downside capture to the same extent.

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 Silver.