JPMorgan Small Cap Sustainable Ldrs R5 VSSCX

Reduced conviction in JPMorgan Small Cap Sustainable Leaders’ approach lowers its Process rating to Below Average from Average.

Formerly JPMorgan Small Cap Core, this strategy transitioned to a sustainability focus in July 2021. Previously, a model sifted through the Russell 2000 Index looking for stocks with the best combination of value and momentum characteristics. Now, lead manager Phil Hart and his team curate a list of small-cap companies that they consider leaders in their respective industries on environmental, social, and governancde stewardship. From there, the surviving names are still put into a quantitative model, though it now includes a third factor: quality.

These changes have resulted in a vastly different portfolio than its previous iteration. Now it's much more concentrated and tends to be lighter in energy stocks. Furthermore, adding the quality factor gave the portfolio a slight growth tilt compared with its previous value/blend profile.

The timing of these changes was poor. In the 28 months that the new sustainability focus has been in place, the institutional shares' 15.8% annualized loss through October 2023 ranked among the bottom 3% of all small-blend Morningstar Category peers and was 3.9 percentage points worse than the Russell 2000 Index. The strategy ran into major headwinds in 2022’s market pullback, as growth stocks plummeted and energy stocks were one of the few safe havens.

More concerning, though, was the strategy’s continued underperformance in 2023. While many similar ESG-focused funds have rallied under more favorable conditions, this strategy lost 10.2% through October, lagging the index by 5.7 percentage points, largely owing to poor stock selection. Furthermore, these poor returns and an abundance of outflows have led to the fund being a fraction of what it once was. After having more than $400 million in assets at the end of 2020, the fund stood with less than $40 million in October 2023.

Despite these concerns, the strategy still benefits from its veteran leaders and its adequate resources. Hart has led this strategy's fundamental team since 2010, while comanager Wonseok Choi leads the quant efforts. The overall team has also increased its interactions with J.P. Morgan’s broader resources, such as the global sustainable investing team. These resources should help, but the fund has plenty of ground to make up after a rough recent stretch.

Unlike its previous iteration, manager Phil Hart and his team play a key role in this strategy’s process, though the quant model designed to drive outperformance remains largely the same. The investment universe here was previously the small-cap-oriented Russell 2000 Index, but it now uses the small/mid-cap Russell 2500 Index and seeks “best in class” names from an ESG perspective. Hart and four analysts curate a working list of such companies, but it is skewed toward certain sectors like industrials and away from energy names because of ESG concerns.

From this universe, a quant model constructs a portfolio of stocks scoring the best on three factors: value, momentum, and quality. Comanager Wonseok Choi works with Hart to explore new automated techniques to extract value from data, such as using natural language processing to scan through earnings-call transcripts for clues regarding a company’s business momentum.

The model now builds a roughly 80- to 100-stock portfolio with few portfolio construction constraints. This is in stark contrast to the portfolio’s previous form and the other strategies that Phil Hart and crew run. A greater tolerance for risk has helped differentiate this portfolio, but the results have been poor. The strategy’s lack of energy has detracted, but its poor stock-picking across most sectors has been the main cause of the underperformance.

A mandate shift in July 2021 completely transformed this portfolio. It used to hold 400-500 stocks and track the sector composition of the Russell 2000 Index rather closely; with ESG now playing a role, the portfolio is much more concentrated and differentiated. As of September 2023, it held just 85 stocks, with notably fewer holdings in the energy and technology sectors. The percentage of assets invested in the top 10 holdings increased from about 8% at the start of 2021 to more than 24% by September 2023. Still, the portfolio is relatively diversified, as individual positions rarely exceed 3% of assets. Global consulting firm Huron Consulting Group HURN was the largest holding in September, at just 3.1% of assets.

As a result of its pivot, the strategy’s style profile also became more growth-oriented, though it remains in the blend section of the Morningstar Style Box. Historically, it hovered around the blend and value portions, but the addition of a quality factor and shift away from resource-related stocks was enough to alter the skew. The managers also scrapped a 1.5-percentage-point limit on the portfolio’s sector deviations from benchmark. As a result, the portfolio’s 0.5% energy stake as of September 2023 was 8.0 percentage points lighter than the index. The portfolio will also not own any companies involved in the production of alcohol, firearms, tobacco, gambling products, and thermal coal.

Phil Hart has led this strategy since November 2010 (when it was a broad small-cap equity strategy), but it is more of a group effort. Comanagers Akash Gupta and Robert Ippolito assist Hart on the fundamental side, covering stocks and vetting the quantitative model’s proposed trades. The trio also works closely with comanager Wonseok Choi, who leads the team’s quant efforts and oversees the development and analysis of the model that underpins the strategy’s process.

At the end of 2019, Hamilton Reiner took over as the head of J.P. Morgan’s structured equity department. He encouraged increased interactions between Hart’s team and the firm’s broader resources. An analyst from the firm’s equity data science division, who helped develop some of the factors used here, is now embedded with Hart and his team. The team also utilizes J.P. Morgan’s global sustainable investing team for assistance on specific ESG issues.

While the overall team has adequate resources, it has had to navigate a handful of departures in recent years, raising some uncertainty. Most notably, former comanager Lindsey Houghton left the firm after 15 years in September 2021. On the quant side, the group has lost several analysts, as well as former comanager Jonathan Tse, who took on a new role within the firm.

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.

From then through October 2023, the fund’s institutional share class lost 15.8% annualized, falling well behind the Russell 2000 Index’s 12.0% loss and its typical small-blend Morningstar Category peer’s 7.5% decline. Its performance over this 28-month stretch ranked in the bottom 3% among all category peers.

The timing of the mandate switch was unfortunate. The strategy’s severe energy underweighting in 2022 proved to be quite a headwind, as energy was the index’s best-performing GICS sector during the year. The losses continued into other sectors with some poor picks in materials and financials. Healthcare was one of the strategy's few bright spots, with solid picks in Sarepta Therapeutics SRPT and Halozyme Therapeutics HALO.

While the strategy’s shortcomings in 2022 were understandable given the market environment, its continued underperformance in 2023 is more concerning. While many ESG-focused peers kept in line with the index in 2023 through October, this strategy’s 10.2% loss was 5.7 percentage points behind the index. The portfolio’s lack of energy detracted again, though poor stock selection was the main culprit, particularly in consumer staples, financials, and healthcare.

Based on our assessment of the fund’s People, Process, and Parent Pillars in the context of these expenses, we don’t think this share class will be able to deliver positive alpha relative to the category benchmark index, explaining its Morningstar Medalist Rating of Neutral.