Methodology Documents

Morningstar has conducted research on active and passive investment strategies and their associated vehicles since 1986.

This paper outlines the key assumptions and details behind our quantitative equity rating methodology.

We believe that a company's intrinsic worth results from the future cash flows it can generate. The Morningstar Rating for stocks identifies stocks trading at a discount or premium to their intrinsic worth--or fair value estimate, in Morningstar terminology.

This document describes the rationale for, and the formulas and procedures used in, calculating the Morningstar Rating for funds (commonly called the “star rating”). This methodology applies to funds receiving a star rating from Morningstar.

This paper outlines the key assumptions and details behind our quantitative equity rating methodology.

Morningstar developed the Morningstar Equity Comparables system to give investors and financial professionals an objective benchmark for comparing companies. Morningstar Equity Comparables is genuinely different to other industry classification schemes. We start from the bottom up with comparable companies, as opposed to the top down with sector definitions. For every pair of companies, we determine how similar they are–anywhere from closely comparable to distantly related based on automated analysis of the companies' own business description. We automatically analyse the text of the business description and work out whether companies are talking about similar things as they describe their businesses. Businesses described in similar terms are comparable.

The Black-Litterman model enables investors to combine their unique views regarding the performance of various assets with the market equilibrium in a manner that results in intuitive, diversified portfolios. This paper consolidates insights from the rel

During retirement, investors need to decide how to invest their savings among asset classes and possibly fixed payout annuities. The author explores retirement income solutions in a simple setting to illustrate the trade-offs that retired investors face

The Morningstar Tax Cost Ratio measures how much a fund’s annualized return is reduced by the taxes investors pay on distributions. In this paper we discuss how this is calculated.

Morningstar uses the historical monthly total returns for the appropriate time period (one-, three-, five-, 10-, 15-, and 20-year) to calculate the monthly standard deviation for stocks, open-end mutual funds, closed-end funds, exchange-traded funds, ind

Morningstar calculates potential capital gain exposure to give investors some idea of the potential tax consequences of their investment in a fund. PCGE estimates how much the fund’s assets have appreciated, and it measures the gains that have not yet be

Morningstar® Indexes were created to provide investors with accurate benchmarks for performance measurement, as well as offering discrete building blocks for portfolio construction. These indexes provide an accurate, comprehensive depiction of the perfor

This paper assesses the investment value of the CBOE S&P 500 BuyWrite (BXM) Index and its covered call investment strategy to an investor from the total portfolio perspective. Additionally, we compare standard investor portfolios to portfolios where BXM

The Sortino Ratio and the more recently developed Omega statistic are conceptually related “downside” risk-adjusted return measures, but appear distinct mathematically. We show that each of these measures is a special case of Kappa, a generalized risk-ad

The Morningstar Style Box™, sometimes referred to as the Equity Style Box, is a nine-square grid that classifies securities by size along the vertical axis and by value and growth characteristics along the horizontal axis.

Little academic research has been conducted that empirically and systematically compares the two most common approaches to assessing a mutual fund’s investment style, i.e., portfolio-based (fundamental) style analysis and returns-based style analysis. Ea

This paper examines the role that style (growth vs. value) plays in the risk and return characteristics of equities. Ibbotson Associates, with the help of the Center for Research in Security Prices (CRSP®), has created a set of style indices going back t

The Morningstar Rating™ for separate accounts is a quantitative assessment of past performance--both return and risk--as measured from 1 to 5 stars. The Morningstar Rating, often referred to as the "star rating," is a familiar tool that helps investors e

Morningstar calculates gross returns for funds as a simulation of the returns investors would have received had they not paid any expenses. Here are the formulas.

There are two main approaches to style analysis: holdings-based and returns-based. This study compares these methods by (1) developing a method to display the style plot points generated by the two methods, and (2) comparing the style plot points generat

This paper examines the constant and variable liquidity direct real estate price indexes of Fisher, Galtzaff, Geltner, and Haurin [2003] and use them in asset allocation exercises. Review of these indexes suggests they provide improved measures of direct

The Markowitz mean-variance model is widely accepted as the gold standard for asset allocation on the way to retirement. Unfortunately, this framework only considers the risk and return tradeoff in the financial market, neglecting the longevity risk peop

This article introduces the Morningstar U.S. Style Indexes as a new generation of equity indexes. It shows using several measures how the Morningstar indexes are more style pure than other style index families.

Traditionally, measuring industry risk has been a qualitative analysis and subject to the judgment of the appraiser. To address the problems inherent in this type of subjective approach, Ibbotson has developed industry risk premia for use in the buildup

This study estimates the forward-looking long-term equity risk premium by extrapolating the way it has participated in the real economy. The authors decomposed the 1926–2000 historical equity returns into supply factors—inflation, earnings, dividends, th

Data of domestic equity mutual funds indicates that winning funds, as defined by appropriate benchmarks, do repeat good performance, and that the strongest persistence is exhibited by funds with the highest returns over a stylized benchmark. This paper e

When designing investment portfolios within a long-term strategic asset allocation context, this paper maintains that direct energy investments (diversified portfolio of producing oil and gas properties) should be evaluated as a separate, distinct asset

In this paper, the authors collect individual stock prices for NYSE stocks over the period 1815 to 1925 and individual dividend data over the period 1825 to 1870. They use monthly price and dividend information on more than 600 individual securities over

Disagreement over the importance of asset allocation policy stems from asking different questions. We used balanced mutual fund and pension fund data to answer the three relevant questions. We found that about 90 percent of the variability in returns of

The curious title of this note refers to Lewis et al., "The Ibbostson-Sinquefield Simulation Made Easy," Journal of Business, 1980,. In that paper, the authors use a lognormal model of asset returns to proxy the Ibbotson-Sinquefield (1976) simulations, m

TIPS (Treasury Inflation-Protection Securities) possess unique characteristics that are not directly available through other investment vehicles. The authors demonstrate that TIPS offer potentially significant diversification benefits, establishing them

In this paper we describe a method for selecting portfolios of managers or mutual funds to implement a target asset allocation. Our goal is to maximize alpha for each level of tracking error. Furthermore, the routine is designed to meet manager imposed m

When small-cap stocks underperform large-cap stocks, does this mean there is no size premium? This paper examines data for small-cap stocks from 1977-96, against longer term findings.

In this article, its authors first present some support for the argument that the market is assigning a high degree of belief that the Euro will take hold in 1999. Then we consider the position of the long-term investor. In terms of historical performanc

This paper deals with a selection of investment judgment biases, and discusses errors of preference, which arise either from mistakes that people make in assigning values to future outcomes or from improper combinations of probabilities and values. In bo

This article explores one of the most important elements in any discount rate calculation—the equity risk premium. The assumptions that underlie the calculation of the equity risk premium have a material impact on the magnitude of the premium and, theref

This article briefly explains the inner workings of Harry Markowitz's pathbreaking algorithm for constructing the mean-variance efficient frontier.

The determination of the cost of equity portion of cost of capital can be controversial because cost of equity is not a readily observable concept. Cost of equity must be determined through the use of models. Referencing Ibbotson Associates’ data is one

Lummer and Siegel [Journal of Investing, Summer 1993] explored GSCI® collateralized futures as an asset that could be held along with stocks, bonds, and cash in a diversified portfolio. They found that a collateralized position in GSCI futures is both a

In this study, beta coefficients are estimated for 66 industries using both the pure-play approach and a full-information approach. The full-information approach incorporates industry-specific information contained in the betas of conglomerates into the

The authors adjust estimates of systematic risk, betas, for cross-autocorrelations in security returns. They show that substantial positive adjustments to beta are necessary for small firms. Traditional estimates of beta are unrelated to future returns o

This paper presents data on Latin American equity indices, Brady bonds, and currencies from the perspective of an unhedged U.S. investor. The purpose is to begin to quantify investment opportunities in Latin America and stimulate further study.

This paper explores the ability of CAPM and Fama-French to adequately reflect size in cost of equity on a stable basis across time. CAPM does not appear to accurately reflect size in cost of equity. In the most recent time period, CAPM actually predicts

This paper provides a quick summary of returns-based style analysis. It then addresses potential pitfalls one by one, with an eye to providing insights and methodologies for effective implementation and interpretation of the analysis.

This paper surveys the tools associated with asset allocation decisions.

This paper provides a quick summary of returns-based style analysis. It then addresses potential pitfalls one by one, with an eye to providing insights and methodologies for effective implementation and interpretation of the analysis.

Convertible bonds are an important asset class, but its risk and return performance and suitability as an asset class for different types of investors has received insufficient attention. We attempt to rectify this neglect by evaluating the unique charac

Investors regard asset characteristics as positive or negative costs, and investors evaluate expected returns net of these costs. The New Equilibrium Theory (NET) framework applies to all assets-including stocks and bonds, real estate, venture capital, d

An examination of the returns on equities, domestic bonds and crossborder bonds of the U.S. and 17 foreign countries over the 21-year period 1960-80 indicates that foreign stocks and bonds generally outperformed U.S. securities, although the U.S. was the

The authors present both annual index levels and total rates of return for common stocks, long-term government bonds, long-term corporate bonds, Treasury bills, and the Consumer Price Index over the period 1926-78. The authors also provide historical ret