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Investment Trust Insider: JPM Europe - activists build big positions on broad discount

Investment Trust Insider: JPM Europe - activists build big positions on broad discount

By and large, income funds have been outperforming equivalent growth funds over the past year or so. One anomaly I spotted recently is JP Morgan European, where the growth pool has been beating the income pool.

JP Morgan European is an unusual fund in that it has two discrete pools of investments represented by different share classes. It is not a split capital fund but rather an umbrella structure, sharing overheads. The growth pool is benchmarked against the FTSE Europe ex UK Index but the income pool is benchmarked against MSCI Europe. Shareholders can convert between the two pools semi-annually (in March and September).

Arbitrageurs up stakes

Back in 2006 the fund was known as JP Morgan Continental European. It was a decent size, with more than £600 million of assets. Between 2002 and 2005, it had traded on a discount of more than 15% and a number of arbitrageurs, notably Carrousel, built up substantial holdings. After consulting shareholders, the board decided to adopt the new structure. It also made a commitment to keep the discount at 5% (prior to this it had been targeting 10%).

Since the reconstruction, it has bought in vast numbers of shares; the growth pool has ended up being almost exactly three times the size of the income pool (with a market cap of £156 million versus £52 million). Faced with the alarming shrinkage in the size of the fund, the board decided to relax the discount target and now professes to aim to keep it around 10%.

Currently, helped by the conversion option, the two pools trade on similar discounts, but they exceed the board’s 10% target. They are around 11%, and the discounts have exceeded the 10% target for much of the past three years. Unsurprisingly, this has attracted the attention of value investors and now, led by 1607 Capital Partners, these dominate the register.

The growth pool is managed by Stephen Macklow-Smith, who managed the old fund, and the income pool is managed by Alexander Fitzalan-Howard, who has been involved with the management of the fund since the start of 2000. JP Morgan has a fairly prescriptive approach to running money, based on investing in a blend of the best value and growth shares as identified by its stock-picking system. The approach did not fare well in the credit crunch and hit the fund hard.

Over 2012, both pools’ performance has been OK, with the growth pool a little ahead of its benchmark, helped by the uplift from share buy-backs at a discount. However, over the year to end March 2012 both pools underperformed and longer term, the numbers aren’t great.

The 10-year performance record is only a little behind its benchmark but is dwarfed by most of the other competing funds. To be fair to the JP Morgan fund managers, they have been up against some impressive competition. Over the past decade the growth pool / JP Morgan Continental European has returned 121% versus 132% for the FTSE Europe ex UK but the top performing fund, and still my favourite in the sector, Jupiter European Opportunities, is up 370% over the same period.

The board were concerned by the performance during the credit crunch but decided to give the investment process the benefit of the doubt. In June this year, though, they instigated an external review of the investment process and we will probably get to hear the conclusion of that when the final results are announced later this month.

There are a few odd things going on. The ‘growth’ pool has ended up having the third-highest dividend yield in the whole sector (4.2%) behind European Assets (6%) and the income pool (5%). European Assets derives its yield from its structure rather than its portfolio, so it is likely that the growth pool’s portfolio has the second highest yield in the sector. I am also uncomfortable with the vast number of holdings in the income pool – its portfolio covers five pages of the annual report.

The charging structure is unusual too. For the income pool, the base fee is 0.75% of gross assets with a performance fee of 15% of the outperformance of its benchmark plus 0.5%, but for the growth pool the base fee is 0.45% and this is increased to 0.6% if the net asset value (NAV) exceeds the benchmark by 0.5% over the accounting year. This doubles up on its performance fee – 20% of outperformance of the benchmark plus 0.5% – it is a good job the overall fee is capped.

Given the state of the share register, sooner or later the board will have to contemplate a more decisive return of capital, perhaps in the form of a tender close to net asset value. The board may also be considering a beauty parade for the management contract – I can see why the managers might think that is harsh as their performance relative to the benchmark isn’t that awful. I would at least think about changing the fee structure. A base fee on market cap, to encourage JP Morgan to narrow the discount, and a performance fee relative to the NAV performance of the peer group might do the trick.

James Carthew is a director of Sapient Research 

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