From the March 2007 issue of Investment Advisor • Subscribe!

From Morningstar, Select Stock Baskets

Managed portfolios of stocks join mutual funds and ETFs

Advisors looking at separately managed accounts may want to examine a new offering from Morningstar Investment Services--Managed Portfolios Select Stock Baskets.

Available only through advisors, the portfolios consist of "baskets" of stocks based on the Morningstar indexes but individualized for an investor's goals and risk tolerances. "Let's give our clients a canvas to paint a picture of what they want their clients stock exposure to look like," says Morningstar Investment Services' President and CIO Art Lutschaunig.

As an example of how customization would work for these accounts, say an investor and her advisor decide that large-cap core and mid-cap value stocks are the way to go. The starting point for what would end up in this client's portfolio would be based on Morningstar's large-cap core and mid-cap value indexes, that are made up of, for this hypothetical example, 151 stocks. Investors can restrict certain types of companies (say tobacco, for example), so those stocks would be left out of the portfolio. If the client owns stocks in other accounts, they can be considered as well; in the Select Stocks Basket the allocation to those equities and sectors would be adjusted, so as not to inadvertently overweight them; and now out of the original 151 stocks in those two indexes, 93 stocks remain. Of that universe, those with the best Morningstar rating are selected for the portfolio. No more than 8% of any one stock could go into the portfolio. Advisors can specify how closely--or not--they want the portfolio to track the index.

The portfolios are actively managed; the stocks are all reevaluated daily and portfolio adjustments are made based on the analyst's ratings for those stocks. The analysts rate each company using a discounted cash flow model and other metrics that include price-to-fair-value; price-to-sell-target; and the economic "moat" surrounding a company--which, Lutschaunig explains, is the barrier to entry into a company's business as well as the company's level of market share. Analysts make an adjustment for each company's business risk, weighing its amount of debt, volatility of the business, steadiness of cash flows, and other factors. For companies that the analysts consider high-risk, the "discount-to-fair-value needs to be at least 15%," says Lutschaunig, while a company with very stable cash flows might need only a 10% discount. "It makes the research very valuation-sensitive; it tends to be a little bit more on the conservative side--it usually gives us very good entry points for purchasing."

Fees for the Select Stock Baskets are broken into two parts, an advisory fee for building and managing the portfolio, and an administrative fee. The advisory fee is 65 bps for the first $1 million, falls to 60 bps for the next million, and for assets beyond that, is 50 bps. The administrative fee is 8 bps for the first $1 million and 5 bps thereafter.

The minimum investment for the Select Stock Baskets is $500,000. Morningstar Investment Services offers two other types of customized accounts that have lower minimums, however: Morningstar Managed Portfolios using mutual funds, with a $50,000 minimum account size, and using ETFs with a $150,000 minimum account size.

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