Morningstar Magazine - June/July 2018 - 66
Spotlight: Packaged Investing
EXHIBIT 3
2017. This gave us a sample of 511 funds. We
ran the returns-based style analysis on these funds
using the Morningstar indexes that represent
the asset classes listed in E X H I BI T 1 .
Of the 511 funds, 460, or about 90%, passed the
R-squared test. We calculated the risk score and
misfit risk as illustrated in E XH I BI T 2 for these
460 funds using a covariance matrix that
we estimated from monthly returns on the indexes
for the period from January 2007 to December
2017. We plot the results in E X H I BI T 3 , along with
the misfit budget line. Based on the misfit budget
line, we form the three zones of alignment.
Well Aligned We plot the risk scores and misfit risk of 460 U.S. target-risk mutual
funds. Most are aligned with their Morningstar Target Risk Index.
Misfit Budget
15-30% Equity
30-50% Equity
50-70% Equity
70-85% Equity
85%+ Equity
Misfit Risk
250bps
200
LOW ALIGNMENT
150
MEDIUM ALIGNMENT
When we average the risk scores for each targetrisk category, it confirms the above observation.
The average risk scores in each category
are close to the risk scores of the corresponding
Morningstar Target Risk Index. The table
also shows that about 85% of funds have High
or Medium alignment. Had these been advisorcreated portfolios rather than mutual funds,
quality control efforts might focus on the 51
portfolios that did not pass the R-squared test and
the 14.6% with Low Alignment.
The graph in E X H I B I T 3 shows that the risk scores
of the funds are generally consistent with
their category assignments, although there are
exceptions. It also shows that most funds are
reasonably well aligned to the target-risk indexes.
The table in E X H I B I T 3 confirms these observations.
It shows that the average risk scores across funds
in each category are generally close to the
risk scores of the corresponding target-risk index.
The one exception is the 15% to 30% equity
category, which has an average risk score of 1.4
rather than 1. As for alignment with the
target-risk indexes, about 85% of funds have
High or Medium alignment.
50
HIGH ALIGNMENT
0
Risk Score
1
2
3
66
Morningstar June/July 2018
4
0
5
6
Source: Morningstar.
Number of Funds
Category
Sample Pass R-Squared Test
Average
Risk Score (Risk
Score of Index)
Alignment (%)
High
Medium
Low
15% to 30% Equity
52
41
1.40 (1)
60.98
24.39
14.63
30% to 50% Equity
109
104
2.19 (2)
73.08
19.23
7.69
50% to 70% Equity
201
181
3.04 (3)
47.51
34.81
17.68
70% to 85% Equity
97
85
3.94 (4)
67.06
17.65
15.29
85%+ Equity
52
49
4.77 (5)
69.39
14.29
16.33
Overall
511
460
-
60.43
25.00
14.57
Source: Morningstar Direct, authors' calculations.
Data through December 2017.
Risk Ecosystem provides benchmarks for
target-risk funds. We think this approach will
prove useful in benchmarking the asset
allocations of multi-asset-class funds and other
multi-asset portfolios. K
A New Way to Monitor Multi-Asset Portfolios
The Target Risk Ecosystem provides a way to
benchmark asset-allocation-oriented
portfolios, monitor the quality of portfolios across
a network of advisors, and compare the
risk level of a portfolio to the desired risk level
based on the investor's risk profile. In this
article, we've demonstrated how the Target
100
Thomas M. Idzorek, CFA, is chief investment officer-
Retirement with Morningstar Investment Management.
Paul D. Kaplan, Ph.D., CFA, is director of research with
Morningstar Canada.
Both are members of the editorial board of
Morningstar magazine.
References
Idzorek, T.M. & Kaplan, P.D. 2017. "Morningstar Portfolio
Risk Scoring System." Morningstar research paper,
November. (Available from the authors on request.)
Kaplan, P.D. 2017. "A Primer on Factor Models and Portfolio
Optimization, Part III. Morningstar magazine, June/July,
pp. 70-73.
Sharpe, W.F. 1988. "Determining a Fund's Effective Asset
Mix." Investment Management Review, December, pp. 59-69.
Sharpe, W.F. 1992. "Asset Allocation: Management
Style and Performance Measurement." Journal of Portfolio
Management, Vol. 18, Issue 2, Winter, pp. 7-19.
Table of Contents for the Digital Edition of Morningstar Magazine - June/July 2018
Contents
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