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Morningstar U.S. Market Factor Tilt Index
SM
®
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Research shows that over long periods of time, portfolios of
small-company stocks, as measured by market capitalization,
tend to outperform portfolios of large-company stocks within
the same equity markets, even after controlling for beta.
corresponding market-capitalization-weighted index. Likewise, stocks designated as “large” or “growth” stocks
have underweighting compared to a standard market-capitalization weighting.
Similarly, research on the U.S. market reveals that in addition to a small-cap effect, there is also a value effect.
In other words, over long periods of time, portfolios of stocks
with relatively favorable valuation ratios (low price/book,
low price/earnings, high dividend yields, etc.) tend to outperform portfolios of stocks with relatively unfavor-able
valuation ratios, even after controlling for beta. Stocks with
favorable ratios became known as “value” stocks
and those with unfavorable ratios became known as
“growth” stocks.
Methodology
The Index construction follows a four-step process:
The Morningstar U.S. Market Factor Tilt Index is designed
to take advantage of these market anomalies—the
small-cap and value-oriented stocks tend to outperform over
the long term. The U.S. Market Factor Tilt Index seeks
to capture both value and size premium to achieve what the
efficient-markets camp refers to as systematic exposure
to undiversifiable risk.
The Morningstar U.S. Market Factor Tilt Index
The Morningstar U.S. Market Factor Tilt Index measures the
performance of U.S. equity markets with increased exposure
to small/micro-capitalization and value stocks. Stocks that
are deemed to be small-capitalization or small-value have an
overweighting in the index compared to their weight in a
Step 1: Defining Investable Universe. To qualify for inclusion
in the investable universe, a security must be U.S. domiciled,
trade on one of the three major exchanges (the NYSE, NASDAQ, or NYSE AMEX) and must not have 10 nontrading days
in the prior quarter.
Step 2: Defining Total U.S. Market Portfolio. The largest
99.50% of the liquid securities by market capitalization qualify for inclusion in the Total U.S. Market Portfolio. The Total
Market Portfolio is then broken down into four cap indexes
using the following guidelines:
3 The Large-Cap Index is constructed by selecting
the largest stocks that comprise 70% of the market
capitalization in the investable universe.
3 The Mid-Cap Index represents the next-largest stocks
that comprise 20% of the market capitalization in the
investable universe.
3 The Small-Cap Index represents the next-largest
stocks that comprise 7% of the market capitalization
in the investable universe.
Morningstar U.S. Market Factor Tilt Index Construction Process
Lrg
Morningstar
Investable Universe
Morningstar
Total U.S. Market Portfolio
Assign Value
Scores/Stock Style
Apply
Factor Tilt
Mid
Sml
Micro
Val
All U.S. domiciled companies listed
on NYSE, NASDAQ & NYSE AMEX
The largest 99.5% of liquid
securities, by market cap
Categorized by
market cap:
Micro, Small, Mid, Large
and Style:
Value, Core, Growth
©2011 Morningstar, Inc. All rights reserved. Morningstar and the Morningstar logo are either trademarks or service marks of Morningstar, Inc. 02-09-11
Tilt portfolios
toward Small/
Micro-Cap, Value
Cor
Gro
Morningstar ® U.S. Market Factor Tilt Index
SM
Growth of a $10,000 Investment (01 Jul 1997–31 Aug 2011)
28,000
24,000
Morningstar U.S. Factor Tilt Index
22,000
20,000
18,000
S&P 500
16,000
14,000
12,000
10,000
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Index Comparisons (01 Jul 1997–31 Aug 2011)
Annualized
Return
%
Standard
Deviation
%
Sharpe
Ratio
%
Max Draw
Morningstar U.S. Market Factor Tilt
5.31
17.86
0.22
-52.46
S&P 500
3.55
16.52
0.12
-50.95
Index
Data from July 01, 1997–September 30, 2011.
3 The Micro-Cap Index represents the next-largest stocks
that comprise 2.50% of the market capitalization in the
investable universe.
Step 3: Assigning Value Scores and Stock Style. A stock’s
value orientation reflects the price investors are willing
to pay for a share of some combination of the stock’s prospective earnings, dividends, sales, cash flow, and book
value. Value orientation is determined using the
following steps:
3 Calculate five prospective yields (earnings, dividend,
cash flow, revenue and book value) for each stock within
each of the cap indexes.
3 Compute a cumulative value score for each security relative
to other stocks in the cap band.
3 Index constituents are assigned so that within each of
the large-cap, mid-cap, small-cap and micro-cap size bands,
the three indexes that reflect each of the three levels of
value orientation account for roughly a third of the total floatadjusted of the size band.
©2011 Morningstar, Inc. All rights reserved. Morningstar and the Morningstar logo are either trademarks or service marks of Morningstar, Inc. 02-09-11
Step 4: Applying Factor Tilt. We developed a model that
allows us to set separately degrees of value tilting and size
tilting, each on a scale from 0 (no tilt) to 1 (full tilt). To select
which combination of settings for thee tilting parameters,
we first create 25 portfolios by using values of 0.1, 0.2, 0.3,
0.4, 0.5 for each of two parameters. We then used the threefactor Fama French (FF) model to guide us toward one of
these 25 portfolios to use. (See Fama and Franch 1993, 1995,
1996.) (The three factors of the FF model are the excess
return on the market portfolio; SMB, which is the difference
between the returns of a small-cap and a large-cap portfolio; and HML, which is the difference in returns between a
high book/market and low book/market portfolio.) Setting
the size tilt factor to 0.4 and value tilt factor to 0.1 results in
FF regression coefficients over the 14 plus year history of
SMB and HML of 0.18 and 0.23, respectively. Since these coefficients are close to our target sensitivities to the FF
factors, we selected this portfolio. At each reconstitution,
the Morningstar Index Committee will review the long-term
sensitivities of the candidate portfolios to value and size
factors, using at least in part the FF model to ensure the tilt
factors continue to be appropriate.
Constituent Weight Calculation
Each index constituent is weighted according to its modified
free float value, which is the product of free float shares, the
most recently traded price of the security and a weight adjustment factor. While the modified free float value is calculated continually for each index constituent, the free float
shares of each potential Total U.S. Market constituent is only
calculated at each rebalancing. Adjustment factors for each
constituent are calculated at each reconstitution.
Rebalancing and Reconstitution
The Morningstar U.S. Market Factor Tilt Index is rebalanced
—i.e. the security weights (the product of the number of free
float shares and the indicated dividend per share of each
constituent) are adjusted—four times annually. The index is
reconstituted—i.e., the index membership is reset—
twice annually.