How to Use Our New Factor Tool

Ben Johnson: Hi, I'm Ben Johnson, director of Global ETF Research with Morningstar.

In recent years an ever-broader swath of investors has been introduced to a new concept, the concept of investment factors, things like value, momentum, and low volatility. And too many of the uninitiated, this is effectively a new language, one which is very difficult for many to decipher. Morningstar has been working to develop the toolkit to help investors understand this new language and to put it to use when it comes to investing in funds and selecting amongst the very best of breed. Here to discuss a new tool, specifically the Morningstar Factor Profile, with me is Morningstar's Director of Quantitative Research, Tim Strauts.

Tim, thanks for being here.

Timothy Strauts: Yeah, thank you.

Johnson: So, Tim, let's start with the very most basic question, which is, what is the Morningstar Factor Profile?

Strauts: The Morningstar Factor Profile is a new visualization which allows an investor to look at an equity portfolio through the lens of seven investment factors that we think are standard throughout the industry today. And we think these factors are important drivers of risk and return.

We think that there's really two main use cases out of the gate, probably many more than that, but just initial two are to evaluate strategic-beta funds. Many products have come out in the last several years, for example, that maybe target momentum. And up to this point, you just had to follow the marketing literature to believe what they say is the amount of momentum exposure a fund is taking. But with Factor Profile, you'll actually be able to see the amount of momentum and actually make comparisons between funds.

The second area is that it can be a good way to analyze active manager investment process. When a portfolio manager discusses how they pick stocks, they often don't use the language of factors. But when you look at the data, you find that many managers are actually employing factor strategies even if they don't realize it themselves. So, you can use Factor Profile to even evaluate active managers.

Johnson: So, some of these metrics are already sort of evident--they're surfaced in things that are very familiar to investors today, notably the Morningstar Style Box, which allows investors to understand kind of on the value growth spectrum. The size spectrum is measured from large to small caps--where their managers stack up, where they tend to go fishing. How does the Factor Profile relate to the Morningstar Style Box?

Strauts: I really think Factor Profile builds on the Style Box. So we still have the two initial factors in the Style Box, the size and style factors, but we have added five additional factors. And those factors are yield, momentum, quality, volatility, and liquidity. And when choosing them, we kind of looked across the academic research that's out there, and obviously, there's hundreds, if not thousands of papers that talk about new investment factors. But the problem with most of that research is, is the back test always looks great. But then, once it's live and people are actually accessing it, the returns usually suffer. And so, we look for factors that had come out decades prior, that had held up to the scrutiny and still provide value to investors today.

Johnson: So, that's helpful context both on the relation to the Morningstar Style Box as well as kind of our rationale behind picking the factors that we've picked to include in the Factor Profile. What about factor definitions, which in academic research as far as practitioners are concerned, there are many different definitions of value, let's say. What are our definitions? Why did we arrive at the definitions that we arrived at?

Strauts: This is a hard problem, right? Because everyone has their own definition. So, we tried to look at the academic literature, what the industry was doing, and make Morningstar's best determination of what the industry standard definition was. In some cases, like momentum, it's pretty easy. Twelve-month minus the most recent one-month momentum is standard in the academic literature and generally accepted in the industry. Other factors like quality are a little more contentious. There's lots of different ways to measure quality. We tried to find a definition that was simple, easy to understand, but still measured what we wanted. And for quality, it's a measure of profitability and financial leverage.

Johnson: So, generally speaking, we're aiming to be noncontroversial to define these factors in a way that's readily intelligible to the end investor and hopefully, durable over time. Is that a fair characterization?

Strauts: Definitely. I mean, we definitely don't want to launch a factor in the Factor Profile that we're concerned would be at risk of not providing value in, say, five years from now.

Johnson: OK. That's helpful. So, you mentioned some of the use cases, specifically as it pertains to strategic-beta funds, which tend to have factors embedded in their DNA. What are some of the other ways that an investor might use this tool, use this visualization when it comes to doing due-diligence on funds they're either vetting or funds that they already own?

Strauts: Yeah, I think the easiest way is to look at an example. So, we do have an example here. And you'll see in the visual that we have the seven factors going across, with the style factor on the far left and the size factor on the far right, the two original Style Box factors, and then the five new factors in the middle. The blue dot shows you, based on the current portfolio, what the exposure to that factor is. And then, the black dot and line show you where the category average is. So, you can compare the blue dot to the black dot to see, Is this fund taking more or less exposure than the relevant peers?

So, for example, in the middle here, we have the quality factor. This fund takes very high-quality exposure, which is much higher than its average peer in the small-growth category, which is, kind of more middle of the range.

And then, finally, we have the five-year historic range. And the historic range, I think, is actually one of the most important aspects because it really tells you if the fund is attempting to target a certain factor. So, if you see a very tight range, it's likely that the manager is targeting that factor. Whereas if you see a very wide range, it might more just be random noise.

So, for example, the quality factor has a very tight range. You can barely even see the shading beneath the blue dot. The manager’s targeting very high-quality stocks consistently. But then move over to the left and look at momentum. Momentum tends to head--it's above-average momentum today, but it's gone from very high to very low across the whole spectrum. So, this manager is really not focusing on momentum when they're choosing stocks. It just happens to be that they have high- or low-momentum stocks based on the day or week or the month.

So, looking at this fund, you can see the seven factors for this small-growth fund. And it's clearly small-growth based on the style and size, but it's really--its defining characteristic is a very high-quality exposure, which is something new you would not have known before we had the Factor Profile.

Johnson: So, it's almost a way at the margin to validate an investment manager's stated process, be they a flesh-and-blood human being actively managing a portfolio, or a strategic-beta index underpinning a factor-oriented fund?

Strauts: Yeah, and I would mention is that this hypothetical fund, which we're not going to mention, is actually covered by a Morningstar analyst and our Morningstar analyst actually picked out this quality exposure in their report. But as you know, not every fund is covered by an analyst and so Factor Profile can fill in the gaps whenever an analyst isn't there.

Johnson: That's great. And Tim, the final question I have for you is, where will investors be able to find the Morningstar Factor Profile?

Strauts: We have a very broad launch across all of our software platforms, specifically Direct, Office, Advisor Workstation, and our Morningstar.com website. If you want to find the Factor Profile, you need to go to a quote page. So, type in the ticker of your favorite fund, equity fund, and go to the portfolio section of the quote page and you should see the Factor Profile next to the Style Box.

Johnson: Well, Tim, thanks for joining me to discuss this exciting development, the Morningstar Factor Profile.

Strauts: Thanks for having me.

Johnson: For Morningstar, I'm Ben Johnson.