Methodology Documents

The Morningstar Ownership ZoneSM complements the style box to provide an additional layer of detail about an equity portfolio’s investment style.

Financial planners and advisors increasingly recognize that human capital must be taken into account when building optimal portfolios for individual investors. But human capital is not simply another pre-endowed asset class; it contains a unique mortality risk in the form of the loss of future income and wages in the event of the wage earner's death. Life insurance hedges this mortality risk, so human capital affects both optimal asset allocation and demand for life insurance. Yet, historically, asset allocation and life insurance decisions have been analyzed separately. This article develops a unified framework based on human capital that enables individual investors to make these decisions jointly.

The Morningstar Rating™ for load-waived versions of the class A shares of mutual funds and other load-waived statistics better reflect the investor experience for those individuals who do not pay the fund's front-end sales load, such as retirement-plan participants.

This study measures historical equity returns over 42 years on the Japanese market by a supply-side approach using accounting data for 24 industries. It also demonstrates a method of constructing expected returns for the future. Equity return is generated from two fundamental sources: growth of shareholders’ equity and dividend payments.

A number of risk-adjusted performance measures have been developed to address the shortcomings of the information ratio when active-return strategies are non-normal. These include the Sortino ratio, Omega, and the Stutzer index. The various risk-adjusted performance measures differ in theoretical motivation and mathematical form and can result in different rankings for non-normal distributions. However, they are more closely related to each other than is apparent. In this paper we unify all of these measures into a single family and expand on it.

The Black-Litterman model enables investors to combine their unique views regarding the performance of various assets with the market equilibrium in a manner that results in intuitive, diversified portfolios. This paper consolidates insights from the relatively few works on the model and provides step-by-step instructions that enable the reader to implement this complex model. A new method for controlling the tilts and the final portfolio weights caused by views is introduced.

During retirement, investors need to decide how to invest their savings among asset classes and possibly fixed payout annuities. The author explores retirement income solutions in a simple setting to illustrate the trade-offs that retired investors face regarding how much income they can generate, how much short-term risk they are exposed to, how large an estate they can expect to leave, and how likely they are not to run out of assets before dying (the “success” probability).

Morningstar uses the historical monthly total returns for the appropriate time period (one-, three-, five-, 10-, 15-, and 20-year) to calculate the monthly standard deviation for stocks, open-end mutual funds, closed-end funds, exchange-traded funds, indexes, separate accounts, variable annuity underlying funds, and variable annuity sub-accounts.

The Morningstar Tax Cost Ratio measures how much a fund’s annualized return is reduced by the taxes investors pay on distributions. In this paper we discuss how this is calculated.

Morningstar calculates potential capital gain exposure to give investors some idea of the potential tax consequences of their investment in a fund. PCGE estimates how much the fund’s assets have appreciated, and it measures the gains that have not yet been distributed to shareholders or taxed.

Morningstar® Indexes were created to provide investors with accurate benchmarks for performance measurement, as well as offering discrete building blocks for portfolio construction. These indexes provide an accurate, comprehensive depiction of the performance and fundamental characteristics of U.S. equity markets.

This paper assesses the investment value of the CBOE S&P 500 BuyWrite (BXM) Index and its covered call investment strategy to an investor from the total portfolio perspective. Additionally, we compare standard investor portfolios to portfolios where BXM has been substituted for large cap assets and find significant risk-adjusted performance improvement.

The Sortino Ratio and the more recently developed Omega statistic are conceptually related “downside” risk-adjusted return measures, but appear distinct mathematically. We show that each of these measures is a special case of Kappa, a generalized risk-adjusted performance measure. A single parameter of Kappa determines whether the Sortino Ratio, Omega, or another risk-adjusted return measure is generated.

The Morningstar Style Box™, sometimes referred to as the Equity Style Box, is a nine-square grid that classifies securities by size along the vertical axis and by value and growth characteristics along the horizontal axis.

Little academic research has been conducted that empirically and systematically compares the two most common approaches to assessing a mutual fund’s investment style, i.e., portfolio-based (fundamental) style analysis and returns-based style analysis. Each method has its proponents and detractors, yet fundamental questions about the accuracy of each approach remain open. This paper clarifies the debate over style analysis and completes the literature with an empirical analysis of the accuracy of the two methods, with respect to an actual set of open-end mutual funds.

This paper examines the role that style (growth vs. value) plays in the risk and return characteristics of equities. Ibbotson Associates, with the help of the Center for Research in Security Prices (CRSP®), has created a set of style indices going back to 1969 that are both comprehensive and mutually exclusive. This paper discusses the construction methodology of these indices, presents an analysis of the results, and provides samples of raw data.

The Morningstar Rating™ for separate accounts is a quantitative assessment of past performance--both return and risk--as measured from 1 to 5 stars. The Morningstar Rating, often referred to as the "star rating," is a familiar tool that helps investors evaluate the risk-adjusted returns of separate account composites.

There are two main approaches to style analysis: holdings-based and returns-based. This study compares these methods by (1) developing a method to display the style plot points generated by the two methods, and (2) comparing the style plot points generated by the two methods over a large set of U.S. equity funds. We highlight where the results are similar and where they significantly differ. Where there are significant differences, we explore some of the possible reasons. Users of style analysis should find this study helpful in determining which, if either, method is appropriate for their applications.

This paper examines the constant and variable liquidity direct real estate price indexes of Fisher, Galtzaff, Geltner, and Haurin [2003] and use them in asset allocation exercises. Review of these indexes suggests they provide improved measures of direct real estate performance that do much to remedy problems resulting from the appraisal-induced smoothing of the NCREIF property index.

The Markowitz mean-variance model is widely accepted as the gold standard for asset allocation on the way to retirement. Unfortunately, this framework only considers the risk and return tradeoff in the financial market, neglecting the longevity risk people face during retirement. To fill this gap, our paper revisits the importance of longevity insurance (while discussing the problems with fixed payout annuities) and then addresses the proper asset allocation between conventional financial assets and variable payout annuity products.

This article introduces the Morningstar U.S. Style Indexes as a new generation of equity indexes. It shows using several measures how the Morningstar indexes are more style pure than other style index families.

Traditionally, measuring industry risk has been a qualitative analysis and subject to the judgment of the appraiser. To address the problems inherent in this type of subjective approach, Ibbotson has developed industry risk premia for use in the buildup model using a method that is more quantitative and objective in nature. This paper explores its calculation and methodology.

This study estimates the forward-looking long-term equity risk premium by extrapolating the way it has participated in the real economy. The authors decomposed the 1926–2000 historical equity returns into supply factors—inflation, earnings, dividends, the P/E, the dividend-payout ratio, book value, return on equity, and GDP per capita.

Data of domestic equity mutual funds indicates that winning funds, as defined by appropriate benchmarks, do repeat good performance, and that the strongest persistence is exhibited by funds with the highest returns over a stylized benchmark. This paper examines the relevance of this trend.

When designing investment portfolios within a long-term strategic asset allocation context, this paper maintains that direct energy investments (diversified portfolio of producing oil and gas properties) should be evaluated as a separate, distinct asset class. The authors demonstrate that direct energy investments offer potentially significant diversification benefits and relatively low correlation with other traditional asset classes, establishing them as a viable asset class to be considered when constructing a long-term asset allocation policy.

In this paper, the authors collect individual stock prices for NYSE stocks over the period 1815 to 1925 and individual dividend data over the period 1825 to 1870. They use monthly price and dividend information on more than 600 individual securities over the period to estimate a stock price index and total return series that extends virtually to the beginning of the New York Stock Exchange. This data is used to estimate the power of past returns and dividend yields to forecast future long-horizon returns.

The curious title of this note refers to Lewis et al., "The Ibbostson-Sinquefield Simulation Made Easy," Journal of Business, 1980,. In that paper, the authors use a lognormal model of asset returns to proxy the Ibbotson-Sinquefield (1976) simulations, making the Ibbotson-Sinquefield forecasts easy to do. Unfortunately, their paper is not easy to read. This is a condensation of its basic ideas.

Disagreement over the importance of asset allocation policy stems from asking different questions. We used balanced mutual fund and pension fund data to answer the three relevant questions. We found that about 90 percent of the variability in returns of a typical fund across time is explained by policy, about 40 percent of the variation of returns among funds is explained by policy, and on average about 100 percent of the return level is explained by the policy return level.

TIPS (Treasury Inflation-Protection Securities) possess unique characteristics that are not directly available through other investment vehicles. The authors demonstrate that TIPS offer potentially significant diversification benefits, establishing them as a viable asset class to be considered when constructing a long-term asset allocation policy.

In this paper we describe a method for selecting portfolios of managers or mutual funds to implement a target asset allocation. Our goal is to maximize alpha for each level of tracking error. Furthermore, the routine is designed to meet manager imposed minimum investment requirements by utilizing discrete optimization techniques. A step-by-step example illustrates the practical use of the methods we have developed.

When small-cap stocks underperform large-cap stocks, does this mean there is no size premium? This paper examines data for small-cap stocks from 1977-96, against longer term findings.

In this article, its authors first present some support for the argument that the market is assigning a high degree of belief that the Euro will take hold in 1999. Then we consider the position of the long-term investor. In terms of historical performance and optimal asset allocation, what are the implications of the disappearance of eleven currencies and the appearance of a new one?

This paper deals with a selection of investment judgment biases, and discusses errors of preference, which arise either from mistakes that people make in assigning values to future outcomes or from improper combinations of probabilities and values. In both cases, each bias is introduced with a question that illustrates the bias and conclude with recommendations for financial advisors to help mitigate the harmful effects of these biases. The article concludes with a checklist that advisors can use to measure their effectiveness at dealing with these biases.

This article briefly explains the inner workings of Harry Markowitz's pathbreaking algorithm for constructing the mean-variance efficient frontier.

This article explores one of the most important elements in any discount rate calculation—the equity risk premium. The assumptions that underlie the calculation of the equity risk premium have a material impact on the magnitude of the premium and, therefore, the ultimate discount rate. This article explores some of the more common equity risk premium methodologies currently in use by business valuation professionals. This paper attempts to address how the equity risk premium is calculated under each methodology and the assumptions that underlie each approach.

Lummer and Siegel [Journal of Investing, Summer 1993] explored GSCI® collateralized futures as an asset that could be held along with stocks, bonds, and cash in a diversified portfolio. They found that a collateralized position in GSCI futures is both a good diversifier for stocks and bonds, and an effective hedge against inflation. In this updated version, we extend the data period to the end of February 1997 and use the official time series of the GSCI Total Return Index as computed by Goldman Sachs. We find that the main conclusions of the original study continue to hold.

The determination of the cost of equity portion of cost of capital can be controversial because cost of equity is not a readily observable concept. Cost of equity must be determined through the use of models. Referencing Ibbotson Associates’ data is one commonly used methodology in determining a privately held company’s cost of capital. This paper details the particulars of that data set.

In this study, beta coefficients are estimated for 66 industries using both the pure-play approach and a full-information approach. The full-information approach incorporates industry-specific information contained in the betas of conglomerates into the beta estimation process. Full-information beta estimates and their corresponding standard errors are substantially smaller than their pure-play counterparts.

The authors adjust estimates of systematic risk, betas, for cross-autocorrelations in security returns. They show that substantial positive adjustments to beta are necessary for small firms. Traditional estimates of beta are unrelated to future returns over the 1931 through 1994 time period, whereas adjusted estimates are positively correlated with future returns. In addition, adjusted beta estimates partially account for the size effect in common stock returns.

This paper explores the ability of CAPM and Fama-French to adequately reflect size in cost of equity on a stable basis across time. CAPM does not appear to accurately reflect size in cost of equity. In the most recent time period, CAPM actually predicts a positive relationship between size and return. Fama-French appears to reflect size in cost of equity both in the most recent time period and historically.

This paper presents data on Latin American equity indices, Brady bonds, and currencies from the perspective of an unhedged U.S. investor. The purpose is to begin to quantify investment opportunities in Latin America and stimulate further study.

This paper provides a quick summary of returns-based style analysis. It then addresses potential pitfalls one by one, with an eye to providing insights and methodologies for effective implementation and interpretation of the analysis.

This paper provides a quick summary of returns-based style analysis. It then addresses potential pitfalls one by one, with an eye to providing insights and methodologies for effective implementation and interpretation of the analysis.

This paper surveys the tools associated with asset allocation decisions.

Convertible bonds are an important asset class, but its risk and return performance and suitability as an asset class for different types of investors has received insufficient attention. We attempt to rectify this neglect by evaluating the unique characteristics of convertibles and documenting the convertible bond market in terms of its historical return performance. We find that convertibles allow the investor to experience the benefits from both a fixed-income and equity investment, have favorable features for issuers who are consequently motivated to price the bonds attractively, and are ideally suited for an investment in firms whose future risk is difficult to assess.

Investors regard asset characteristics as positive or negative costs, and investors evaluate expected returns net of these costs. The New Equilibrium Theory (NET) framework applies to all assets-including stocks and bonds, real estate, venture capital, durables and intangibles such as human capital-and incorporates all asset characteristics.

An examination of the returns on equities, domestic bonds and crossborder bonds of the U.S. and 17 foreign countries over the 21-year period 1960-80 indicates that foreign stocks and bonds generally outperformed U.S. securities, although the U.S. was the outstanding performer in some periods. International investors may expect gains from diversification. In addition, any imperfections in international capital markets may allow them additional profit opportunities. The data presented here suggest that the economic relationships often posited between international stock and bond expected returns, inflation and ex- change rates hold only imperfectly. Deviations from the international parity theorems occur often, especially over short periods of time.

The authors present both annual index levels and total rates of return for common stocks, long-term government bonds, long-term corporate bonds, Treasury bills, and the Consumer Price Index over the period 1926-78. The authors also provide historical return figures for four component series - the riskless rate of interest, the equity risk premium, the bond default premium and the maturity premium between the return on long-term governments and Treasury bills. Taken together, the five basic asset series and the four component series provide the investor with the necessary historical background for making judgments about future tradeoffs between risk and reward