What were the methodology design objectives?
How were the style methodology factors chosen?
Is the methodology subjectively determined?
What are the index eligibility requirements?
How does Morningstar assign stocks to the indexes?
How does Morningstar determine its cap cut-offs?
How frequently do you rebalance the indexes?
What data sources are used in the Morningstar indexes?
Why does Morningstar use free-float?
What are some examples of free-float adjustment?
What were the methodology design objectives?
To create robust asset allocation and measurement tools, Morningstar's research team designed the indexes to satisfy the following objectives:
Broadly represent the market without sacrificing investability
Consistently measure stocks' value and growth orientation in line with market practitioners and stock analysts
Maximize performance distinctions between growth and value—higher negative correlations between growth and value stocks
Classify each stock uniquely (i.e., each stock belongs to only one of the nine style indexes)
Minimize turnover
Utilize current best practices in index maintenance and construction methods (such as free-float weighting)
How were the style methodology factors chosen?
We chose the fundamental balance sheet and market factors that would best measure and describe the separate "value" and "growth" characteristics of common equities. To reflect the fact that fund managers look at both historical and projected measures of company characteristics, Morningstar assigned a 50% weighting to the forward-looking estimates. The 10-factor model's results were evaluated using different factor weightings to satisfy the index design criteria: a high negative correlation between the composite value and growth scores, accurate classifications, and good classification stability. The weightings selected produced superior results.
Is the methodology subjectively determined?
Morningstar's indexes are governed by transparent, objective rules for security selection, exclusion, rebalancing, and adjustments for corporate actions. Morningstar makes no subjective determinations related to index composition.
What are the index eligibility requirements?
To be eligible for Morningstar's indexes, a stock must be:
Listed on the NYSE, the AMEX, or Nasdaq
Domiciled in U.S. or its primary stock market activities are carried out in the U.S.
Have sufficient historical fundamental data available to classify its investment style
In the top 75% of companies in the investable universe based on its liquidity score
Stocks are excluded if they:
Have more than 10 non-trading days in the prior quarter
Are American Depository Receipts and American Depository Shares, fixed-dividend shares, convertible notes, warrants, rights, tracking stocks, limited partnerships and holding companies
How does Morningstar determine its cap cut-offs?
Morningstar uses a dynamic percentage-based approach to divide its U.S. Market Index into three cap indexes. By defining each as a percentage of the market cap of the investable universe, the definitions remain stable regardless of market movements.
Large Cap: Largest 70% of investable market cap
Mid Cap: Next 20% of investable market cap (70th to 90th percentile)
Small Cap: Next 7% of investable market cap (90th to 97th percentile)
How does Morningstar assign stocks to the indexes?
Within each capitalization class, index constituents are assigned to one of three style orientations—value, growth or core—based on the stock's overall style score. A stock's value orientation and growth orientation are measured separately using related but different variables.
Value Factors
Price/projected earnings (50.0%)
Price/book (12.5%)
Price/sales (12.5%)
Price/cash flow (12.5%)
Dividend yield (12.5%)
Growth Factors
Long-term projected earnings growth (50.0%)
Historical earnings growth (12.5%)
Sales growth (12.5%)
Cash flow growth (12.5%)
Book value growth (12.5%)
How frequently do you rebalance the indexes?
Morningstar rebalances constituent shares and weights of its indexes quarterly in March, June, September, and December (on the Monday following the 3rd Friday). Immediate rebalancing occurs if two constituents merge or a company's free-float changes by 10% or more. The indexes are reconstituted twice annually in June and December.
What data sources are used in the Morningstar indexes?
|
Data
|
Source |
|
Security Prices |
SIAC and Nasdaq data feed |
|
Corporate Actions
|
IDC, Dow Jones Newswire, and primary exchange and press announcements |
|
Fundamental Data |
Five years of restated financial data from Morningstar's internal databases • Earnings estimates are provided by IBES • Morningstar normalizes the data and generates the price ratios and growth rates • Morningstar uses restated financials data for calculating fundamental factors |
|
Float |
Proxy statements, 13-F, 10-K, and registration statements |
Why does Morningstar use free-float?
Full market capitalization represents the overall economic importance of a company. However, if corporate insiders hold a large portion of shares outstanding, then an investor seeking a proportional equity exposure may end up pursuing shares of the company that may not be available. For example, Wal-Mart has less than 60% of its shares available to the public for investing. If the full weight of the company is used in the index, the demand for Wal-Mart shares could outstrip the supply, causing price distortions. Therefore, using the free float instead of the full capitalization improves the investability of the index.
What are some examples of free-float adjustment?
As of June 26, 2002, the following examples of block ownership would require float adjustment:
Microsoft's Bill Gates privately owned more than 12% of the company's outstanding shares
Fiat had a 5.6% ownership in General Motors, which is a case of cross ownership and would require an adjustment to GM's shares to reflect true investability.
State Street Bank and Trust Co had a 9.3% stake in Morgan Stanley Dean Witter. Although State Street is an investment firm, this particular holding is a trust for a company-sponsored, equity-based compensation program (employee benefit plans). Morningstar's rules state that both employee benefit plans and trusts are considered block ownership.
See Also