Morningstar Magazine - October/November 2016 - 42

Spotlight: Risk 1.010 1.005 EXHIBIT 2 EXHIBIT 3 EXHIBIT 4 Premiums: Style Of the model's 11 style factors, volatility and liquidity saw the biggest impacts after the Brexit vote. Premiums: Sector Post-Brexit, financials turned negative; defensive telecom and basic materials broke upward. Premiums: Currency Most currency1.000 factors fell as the dollar strengthened. 0.995 The yen gained, but then pulled back. Economic Economic Moat Moat Ownership Ownership Risk Risk Size Size Fair Value Fair Value Valuation Uncertainty Valuation Uncertainty Financial Financial HealthHealth Value Value GrowthGrowth Liquidity Liquidity Volatility Volatility Momentum Momentum Ownership Popularity Ownership Popularity GrowthGrowth of $1 of $1 Basic Materials Basic Materials Communication Services Communication Services Consumer Cyclical Consumer Cyclical Consumer Defensive Consumer Defensive EnergyEnergy Financial Services Financial Services Healthcare Healthcare Industrials Industrials Real Estate Real Estate Technology Technology Utilities Utilities 05/24 Date AUD CAD 06/23 CHF EUR GBP JPY 07/23 0.990 NZD GrowthGrowth of $1 of $1 Growth of $1 1.015 1.015 1.15 1.15 1.050 1.010 1.010 1.10 1.10 1.005 1.005 1.05 1.05 1.025 1.000 05/24 05/24 Date Date 06/23 06/23 1.000 1.000 1.00 1.00 0.995 0.995 0.95 0.95 0.990 0.990 07/23 07/23 Source: Morningstar. Mathematically, factor premiums represent the AUD AUD CHF return CHFGBP GBPNZD market-level per one unit ofNZD exposure to that CADfactor; CADi.e. EUR EUR JPY JPY the gain/loss for investing in that Growth of24$1 of $1 , Dodge factor alone. To demonstrate, asGrowth of June & Cox International Stock had an exposure value 1.050 1.050 of 0.021 to the real estate sector, indicating an above-average investment in real estate-related 1.025 1.025 stocks. Real estate earned a 2.93% premium on June 24, meaning the fund earned a +0.061% (= 2.93% × 0.021) return on that day from its 1.000 1.000 real estate exposure. Given an exposure level, the higher the premium, the higher the return. 0.975 0.975 and 4 compound the individual premium series via growth of $1 charts. Each line is aligned to $1 at the end day on June 0.950 0.950 07/23 06/23 06/23of the07/23 05/24 05/24 23, the day of the Brexit vote (indicated in gray). Date Date We cover the period from one month before June 23 to one month after. EXHIBITS 2, 3, visualizes the premium series for the risk model's 11 style factors. Two factors stand out: volatility and liquidity. The volatility premium surges upward post-Brexit. Volatility exposure EXHIBIT 2 42 Morningstar October/November 2016 05/24 05/24 Date Date 06/23 06/23 0.90 0.9005/24 07/23 07/23 Date 0.975 06/23 07/23 0.950 Source: Morningstar. Source: Morningstar. is measured as the normalized range of trailing 12-month returns over the past year. Thus, the risk model finds that investors have earned a positive return premium in assets with high historical return volatility in the post-Brexit environment. subsequently recovering. Meanwhile, basic materials and communication services break upward, denoting the flight to defensive sectors. Liquidity, meanwhile, exhibits a persistent drawdown pattern throughout this time frame. Liquidity exposure is measured as the normalized logarithm of the average training volume divided by trailing 30-day shares outstanding. Therefore, we find that markets have granted a negative return premium toward highly liquid assets (alternatively, a positive premium for illiquid assets). In reality, we expect investors to receive additional compensation for holding illiquid assets through Brexit's uncertainty. E X H I B I T 3 visualizes the premium series for the risk model's 11 sector factors. It captures the sector rotation reaction to Brexit. We observe the premiums for financial services turning significantly negative after Brexit, but Why did consumer defensive and utilities, two other defensive sectors, not break upward? The methodology uses cross-sectional regressions to calculate factor premiums, such that each premium exists after controlling for the premiums to other factors. It may be that other characteristics of the consumer defensive and utility sectors captured the return premiums (such as ownership popularity) or that the premiums did not exist globally on average. E X H I B I T 4 displays the premium series for the risk models' seven currency factors. We first emphasize that these series do not mimic the price currency/U.S. dollar exchange rate. These premiums represent the return to stocks positively exposed to the price currency/U.S. dollar exchange rate: Positive exposure indicates a positive relationship between a stock's daily returns and the exchange-rate returns.

Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2016