|An Introduction to the Morningstar Indexes
By Sanjay Arya
Not all indexes are created equal. As discussed in Chapters 5 – 8 of the book, even seemingly interchangeable benchmarks like domestic large-cap value indexes can differ significantly. We created the Morningstar style indexes as pure distillations of style, not as recreations of active managers' behavior. We know that active managers may deviate from their mandate when their chosen style goes out of favor. Why try to replicate such imperfections in an index when the opportunity to create a more disciplined alternative exists?
By eliminating core stocks and eliminating holdings overlap, we end up with very distinct style characteristics in our value and growth indexes. Not only does our value index have lower price ratios for forward earnings and cash flow and a higher yield than the overall market, but also our index is substantially more value-oriented than conventional value indexes. Our value index sports a price to forward earnings ratio that is more than 10% lower than that of a conventional value index and produces a dividend yield that is 50% higher. In short, with our index, value really means value.
Similarly, our growth index holds stocks whose revenues and cash flow are growing much faster than those of the broad market or conventional growth indexes. Moreover, the market's earnings expectations for the stocks in our large-growth index are more than 25% greater than for those of standard growth indexes. Simply put, investors seeking growth stocks will find them in a purer fashion in our index than in most alternatives.
Style-pure indexes allow investors to more easily reposition a portfolio. It would take a much smaller sampling of our growth index than of a more conventional one to bring a value-heavy portfolio to style neutrality. By doing the basic blocking and tackling of portfolio construction more efficiently, our indexes allow a higher percentage of client assets to be placed in alpha generating active managers, giving investors the best of both worlds—the ability to deploy disciplined passive strategies, while still allowing for active management.
The 16 indexes in Morningstar Index family serve as a complete non-overlapping system with each index representing a unique opportunity set within a discrete style or capitalization orientation. Investment products based on these indexes form “building blocks” that investors can use easily to construct portfolios without any unintended overlaps or gaps. Stocks in Morningstar's “investable universe” are assigned mutually exclusively—each stock is assigned to only one style index, and exhaustively—all stocks in the investable universe are included.
As investors grow more modular in their portfolio construction, index-oriented investment options can play a powerful role in building or adjusting a client's market posture. Rather than seeking to imitate active management, we've sought to create something new, a highly disciplined, style-pure set of tools to allow for more efficient portfolio construction. By complementing, rather than seeking to displace, active management, we set the stage for better integration of passive and active strategies.
To help investors understand the trends in the market, we created a visual tool called the Morningstar Market Barometer that allows instant analysis of performance trends. Using each of the nine boxes of the Morningstar Style Box to represent the performance of corresponding Morningstar Indexes, we offer an intuitive way to look at the market behavior. By rendering each index in shades of red and green according to performance, investors can quickly gauge where the headwinds and tailwinds in the market lie. Construction Methodology
The Morningstar Indexes track 97% of the U.S. equity market by capitalization and investment style and are governed by transparent, objective rules for security selection, exclusion, rebalancing, and adjustment for corporate actions. To be eligible for inclusion, a stock must be liquid, listed on the NYSE, the AMEX, or Nasdaq, domiciled in U.S. or its primary operations are carried out in the U.S., and have sufficient historical fundamental data available to classify its investment style.
Index constituents are weighted according to their free float value and then divided into three cap indexes by a dynamic percentage based approach. Each cap index is defined as a percentage of the market cap of eligible securities. The Large Cap Index is defined as stocks that form the largest 70% of investable market cap. The Mid Cap Index is defined as the next 20% of investable market cap (70th to 90th percentile). The Small Cap Index is defined as the next 7% (90th to 97th percentile) Cap.
Within each capitalization class, index constituents are assigned to one of three-style indexes-value, growth or core-based on the stock's overall style score. The style score is determined by measuring a stock's value orientation and growth orientation separately using forward looking and historical factors.
The value factors are as follows:
- Price/projected earnings
- Price/cash flow
- Dividend yield
The growth factors are as follows:
- Long-term projected earnings growth
- Historical earnings growth
- Sales growth
- Cash flow growth
- Book value growth
The Morningstar Indexes utilize buffering to reduce stock turnover, meaning stocks are reclassified in terms of style or capitalization only if they move sufficiently beyond the break point between styles or capitalization.
For more information on the indexes, visit: http://indexes.morningstar.com/ or the index research section of IndexUniverse.com.