The Jupiter Europa SICAV seeks to generate alpha from bottom up stock-picking in the long portfolio and limit drawdowns through the use of dynamic option strategies.
As a result, the fund tends to participate in equity market rallies while minimising the impact of corrections in equity markets. We measure our success in this regard using upside and downside capture ratios which show what proportion of a rally or correction has been captured by the fund. As equity markets tend to go up more often than they fall, even a small positive spread between an upside and downside capture ratio can lead to strong returns for investors.
In the past, the fund has achieved attractive capture ratios both on the upside and the downside.
This has been achieved by maintaining a portfolio of long positions in medium-sized companies which we believe have strong fundamentals and are attractively priced. Some of these stocks also have unrecognised strategic value which may require a merger or acquisition to unlock significant additional upside. Generally, we aim to hold 100% of the netasset value of the fund in the long portfolio and we generally expect this portfolio to outperform the broad equity index. This portfolio would then drive the upside capture ratio.
At the same time, we also need to mitigate against unexpected and often violent corrections in equity markets to minimise the downside capture ratio. We seek to do this in a number of ways. We hold single-stock short positions in companies that we believe are overvalued. Historically, this has represented about 10% of the net-asset value of the fund, although over the last year we have gradually increased the size of this portfolio to around 20% of net-asset value. Over time, we expect this to improve the downside capture ratio of the fund.
We also hold a portfolio of put options which allows us to rapidly shrink the net equity exposure of the fund in falling markets. We dynamically trade this options book in response to perceived market risk and the price we are willing to pay to mitigate this risk. Generally speaking, the size of the put options book varies between 30% and 60% of net asset value. A successful implementation of this options portfolio should provide significant downside mitigation in a falling equity market while not disturbing the fund’s ability to participate in market rallies.
In the past, we have tended to hold put options over the EuroStoxx 50, a market-cap weighted index of the largest 50 companies in Europe. As such, this structure provides a good hedge against broad market corrections in which large companies fall by similar amounts to mid- and small-cap companies.
However, some corrections, such as the correction in the fourth quarter of 2018, are uneven, in that small- and mid-cap stocks can fall much faster and further than their larger cap counterparts. In these situations, Jupiter Europa faces a particular challenge because the losses in the long portfolio of medium-sized companies are greater than the gains on the index option book. This can create higher downside capture ratios. And that is exactly what happened to the fund in the fourth quarter of last year when the fund’s NAV fell 9.3% while the EuroStoxx index fell 11.4%. (Source FE)
We are generally happy to be exposed to this factor risk (i.e. that mid-and small-cap stocks will generally outperform large caps). All equity long/ short funds employ some level of exposure to one factor or another and, over time, we have shown that we can add value from investing in midcap stocks. We also note that corrections in which markets are driven lower by small- and mid-cap stocks are not common but will happen from time to time. The last time we saw such a correction was in 2007-08 at the onset of the Global Financial Crisis.
The experience of late 2018 has helped us to improve how we manage downside risk in the fund. In addition to index put options, we now have the ability to hold put options over bespoke ‘baskets’ of mid-cap stocks which can defend the fund against the type of correction that was seen in the final quarter on 2018. Stocks that offset the risks of the long portfolio are selected by our fund management team for inclusion in a ‘basket’ which is established by an investment bank and sold to the fund in the form of a put option.
So, today, as well as holding some index put options, the fund also holds approximately 21.6% of its net asset value in these bespoke put options (Source: Jupiter as at end May 2019). And we dynamically adjust the level of index and basket mitigation based on our assessment of the likelihood and, just as importantly, the type of correction that might be expected.
This enhancement to our portfolio management tools, together with the increase in size of the single stock short portfolio, has in our view created a more resilient fund which should help to minimise the downside capture ratios going forward. We are confident that the fund is more robust to equity market corrections than before whilst continuing to offer the prospect of participating in equity market rallies. We have learned, restructured and evolved from the challenging times late last year. We believe we are better fund managers as a result of the experience and that Jupiter Europa is a more resilient fund than before. We look forward to working with investors in the future.