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Portfolio > Mutual Funds > Equity Funds

Morningstar Launches a New Framework to Analyze Equity Funds

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Morningstar is revamping its framework to analyze equity funds and ETFs.

It is introducing the Morningstar Factor Profile, which will incorporate the two factors contained in the Morningstar Style Box — the size of a fund’s holdings in terms of market capitalization (small, mid and large) and style (value or growth) — and include five new additional factors: yield, momentum, quality, volatility and liquidity.

“While size and value/growth exposures can help explain the different between funds’ long-term returns, they don’t tell the full story,” writes Ben Johnson in his latest Fund Spy report. “The Morningstar Factor Profile is a new lens that complements the Morningstar Style Box, incorporating additional factors that further explain funds’ exposures to well-documented sources of long-term returns.”

The Factor Profile is based on the characteristics of the underlying stocks in a fund portfolio.  The profile displays the average ranking of a fund in each Morningstar category compared to its category average and its own historic ranking over the past five years, which lets investors  assess the stability of its factor exposures.

Its seven factors can explain why a particular equity fund or ETF performed “better, worse or just different than the market at large,” Johnson tells ThinkAdvisor.

Here are Morningstar’s descriptions of the five additional factors, which, according to Johnson, have been “well-documented and vetted in academic and implemented by investment practitioners”:

  • Momentum: the tendency for stocks that have recently performed well or poorly to continue to do so
  • Liquidity: Captures the extra returns investors receive as compensation for holding illiquid assets.
  • Quality: A measurement of the profitability and financial leverage of stocks. Higher quality stocks tend to outperform lower quality stocks.
  • Yield: The sum of trailing 12-month dividend and buyback yields, which can help explain stocks’ long-term returns.
  • Volatility: Although technically stocks with higher risk should earn higher expected returns, research has shown that less volatile stocks tend to outperform more volatile ones

The Factor Profile has multiple uses beyond understanding the different sources of returns for stocks and stock funds. They can be used to check whether a fund’s exposure aligns with the way a portfolio manager has described a fund’s investment approach. For example, does a low-volatile strategic beta fund truly focus on minimizing volatility or does a high-quality factor ETF actually have heavy exposure to stocks with strong balance sheets and consistent earnings within the sectors it invests in?

The Factor Profile can also be used to help compare similar funds. The bronze-rated iShares Russell 2000 ETF (IWM) and gold-rated iShares Corp S&P Small Cap ETF (IJR) are both categorized by Morningstar as small-blend funds and they appear “substantially similar,” writes Johnson. (The medal ratings refer to Morningstar analysts’ forward-looking ratings.)

But IJR has a high exposure to the quality factor, above the category average over the past five years, while IWM’s quality exposure is relatively low and below the category average. The differences reflect the differences in the methodologies of the underlying indexes for the two funds, according to Johnson.

IJR, based on the S&P Small Cap 600 index, has a quality basis that requires new index constituents to have positive earnings over the prior quarter and past year. IWM is based on the Russell 2000 Index which doesn’t have a similar filter. It tends toward smaller, unprofitable lower quality names, according to Johnson.

A total 13,267 mutual funds and 6,857 ETFs, both active and passive, will have Factor Profiles, according to a Morningstar spokeswoman who explained that it has 90% coverage of the underlying stocks in all those portfolios.

Factor Profiles will be available on Morningstar Direct and within the next day or so and on Morningstar Advisor Workstation and Morningstar Office, also used by advisors, by the end of December.

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