Morningstar - Q4 2021 - 57

Strategies
Aligning Clients and Portfolios
How to use Morningstar's risk tools to
quantitatively build a suitable portfolio.
QUANT U
Paul D. Kaplan
Financial advisors around the world face
regulations to " know your client " and " know your
product. " In this issue of Quant U, I present a
quantitative framework in which, based on some
know-your-client and know-your-product
requirements, advisors can construct suitable
portfolios for their clients.
On the know-your-product side, this framework
includes the Morningstar Portfolio Risk
Score, which I discussed in the last issue of
Quant U ( " A Ruler for Risk, " Page 64, Q3 2021).
The portfolio risk score measures the risk
of a portfolio by first decomposing its risk into
systematic and unsystematic components,
benchmarking its systematic risk against a set
of target allocation indexes, and accounting for
unsystematic risk by applying leverage. The
result is expressed as the equity allocation of a
leveraged custom asset-allocation benchmark.
For a well-diversified portfolio, the portfolio
risk score usually falls between 0 and 100. For
concentrated portfolios, it can be considerably
greater than 100. (See the addendum.)
An additional score, the Alignment Score,
measures the combined effect of misfit
risk (relative to a set of target allocation indexes)
and unsystematic risk as a fraction of total
risk in units of the Morningstar Portfolio Risk Score.
The Alignment Score provides additional
information about a portfolio that can play an
important supporting role in fulfilling
know-your-product requirements. I discuss
Alignment Score and the role it can play in
portfolio construction below.
On the know-your-client side, the framework
includes the Morningstar Risk Profiler. The
profiler uses a set of questions to assess an
investor's risk profile, starting with a psychological
measure of risk tolerance. It then integrates
other investor factors such as investment
experience, financial knowledge, financial goals
(time horizon, required return, liquidity), and
the investor's capacity for loss. The result
of the risk profiler is a score between 0 and 100,
50 being the score of an average investor.
To connect the result of the Morningstar Risk
Profiler with the Morningstar Portfolio Risk
Score, the framework contains a third component,
the Risk-Comfort Range. This tool provides
ranges of Morningstar Portfolio Risk Score values
that are suitable for an investor with a given
risk profiler score.
EXHIBIT 1 shows the Risk-Comfort Range
graphically. For each possible risk profiler score,
there is a corresponding set of ranges. EXHIBIT 2
shows the ranges of Morningstar Portfolio
Risk Score values when the risk profiler score is 50.
For advisors who prefer to select prepackaged
portfolios, such as asset-allocation funds
or home office models, they should simply select
a portfolio with a portfolio risk score within
the comfort range of the client's risk profiler score.
EXHIBIT 1
The Risk-Comfort Range
Too Much Risk
Morningstar Risk Profiler Score
Morningstar Portfolio Risk Score
100
Marginal (High End)
Marginal (Low End)
Comfort Range
Too Little Risk
25
Morningstar Risk Profiler Score
Source: Morningstar.
Target Allocation Indices
Target Allocation Frontier
Eff. Frontier (AS Not Taken into Account)
Eff. Frontier (AS Taken into Account)
Expected Geometric Mean
6
50
75
100
gAsset-allocation preferences. Risk and
expected return are not the only considerations
morningstar.com/lp/magazine
57
25
50
75
gThe expected return of the portfolio. The purpose
of the portfolio is to generate returns to
fund an investor's financial goals. Hence, all other
things equal, higher expected returns are
preferred over lower expected returns. In the
framework I present here, I define expected return
to be the expected long-term compound
return. This is the expected geometric mean,
which I discuss below.
For advisors who prefer to assemble or construct
portfolios, they can build portfolios that have
a portfolio risk score within the client's comfort
range. But in addition to wanting to get the
level of risk right, investors and advisors may be
concerned about:
https://www.morningstar.com/authors/528/paul-kaplan https://www.nxtbook.com/nxtbooks/morningstar/magazine_2021q3/index.php#/p/64 http://www.morningstar.com/lp/magazine
Morningstar - Q4 2021

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