Morningstar Factor Tilt Index Family ® Learn More For more information about all of Morningstar’s indexes, please visit: http://indexes.morningstar.com Contact Us indexes@morningstar.com U.S. 11 312 384-3735 Europe 11 44 20 3194 1082 Australia 1612 9276 4446 Japan 181 3 3239 7701 Asia 191 22 61217101 Research shows that over long periods of time, portfolios of small-company stocks, as measured by market capitalization, tend to outperform portfolios of largecompany stocks within the same equity markets. market-capitalization-weighted index. Likewise, stocks designated as “large” or “growth” stocks have underweighting compared to a standard marketcapitalization weighting. Similarly, research on global markets 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 unfavorable valuation ratios, even after controlling for beta. Methodology The Morningstar Factor Tilt Index Family is designed to take advantage of these market anomalies. The indexes in this family seek to capture both value and size premium to achieve what the efficient-markets camp refers to as systematic exposure to undiversifiable risk. The Morningstar Market Factor Tilt Index Family The Morningstar Factor Tilt Index Family is made up of three indexes: Morningstar® US Market Factor Tilt Index Morningstar® Developed Markets ex-US Factor Tilt Index and Morningstar® Emerging Markets Factor Tilt Index. These measure the perforMorningstar Developed & Emerging Markets Factor Tilt Indexindexes Construction Process mance of the U.S., Developed ex-U.S. and Emerging markets with increased exposure to small capitalization and value stocks. Stocks that are deemed to be smallcapitalization or small-value have an overweighting in the index compared to their weight in a corresponding The construction process for the indexes within the Morningstar Factor Tilt Index family follow a four-step process: Step 1: Define the Morningstar Investable Universe For the Morningstar US Market Factor Tilt Index, to qualify for inclusion in the investable universe, the investment must be classified as a U.S. security, trade on one of the three major U.S. exchanges (the NYSE, Nasdaq, or NYSE Amex) and must have sufficient liquidity. For the Morningstar Developed Markets ex-US Factor Tilt and Emerging Markets Factor Tilt Indexes, to qualify for inclusion in the Developed Markets ex-U.S. or Emerging Markets segments, a security must be classified as an eligible security type, have sufficient liquidity, and trade on an eligible global exchange. SM SM SM Step 2: Define the Morningstar Total Market Portfolio The largest 97% of liquid securities for each economic segment (U.S., Developed ex-U.S. and Emerging as defined by Morningstar) by market capitalization qualify for inclusion in the broad portfolio. ® Figure 1. Morningstar Factor Tilt Index Family Construction Process Morningstar® US Market Factor Tilt IndexSM Classify U.S. Market Assign Value Scores and Stock Style Define the Morningstar Investable Universe Apply Factor Tilt Classify Developed Markets ex-U.S. and Emerging Markets The largest 97% of liquid securities, by market cap for each economic segment. Group by Morningstar definitions of U.S. Market, Developed Markets ex-U.S., and Emerging Markets. Categorize by market cap: micro (U.S. only), small, mid, and large; and style: value, core, and growth. ©2012 Morningstar, Inc. All rights reserved. Morningstar and the Morningstar logo are either trademarks or service marks of Morningstar, Inc. Tilt portfolios toward small and micro market cap and value style. Morningstar® Developed Markets ex-US Factor Tilt IndexSM Morningstar® Emerging Markets Factor Tilt IndexSM Morningstar® Factor Tilt Index Family The portfolios are then broken down into three (or four for US Market Factor Tilt) cap indexes using the following guidelines: of settings to use for the tilting parameters, we first created 25 portfolios by using values of 0.1, 0.2, 0.3, 0.4, and 0.5 for each of two parameters. 3 The Large Cap Index is constructed by selecting the largest stocks that comprise 70% of market capitalization of the investable universe. 3 The Mid Cap Index represents the next largest stocks that comprise 20% of market capitalization of the investable universe. 3 The Small Cap Index represents the next largest stocks that comprise 7% of the market capitalization of the investable universe. 3 The Micro Cap Index is used for in the construction of the Morningstar US Market Factor Tilt Index only. The Micro Cap Index represents the next largest stocks that comprise 2.5% of the market capitalization of the investable universe. The Fama-French three factor (FF) model is then used to guide us toward one of these 25 portfolios to use. (See Fama and French 1993, 1995, and 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.) The size tilt factors, value tilt factors, and FF regression coefficients were set as follows: Step 3: Assign 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 an aggregate value score for each security by averaging the scores of the five prospective yields. These average scores are then used to assign the stocks within each size band to the size band’s value, core, and growth indexes. 3 Index constituents are assigned so that within each of the large-cap, mid-cap, small-cap and micro-cap (US Markets Factor Tilt Index only) size bands, the three indexes that reflect each of the three levels of value orientation account for roughly a third of the total float-adjusted market capitalization of the size band. Step 4: Apply Factor Tilt Morningstar developed a model that sets separate degrees of value tilting and size tilting, each on a scale from 0 (no tilt) to 1 (full tilt). To select which combination ©2012 Morningstar, Inc. All rights reserved. Morningstar and the Morningstar logo are either trademarks or service marks of Morningstar, Inc. Fama-French Coefficients Index Size Tilt Factor Tilt SME HMV History (Years) US Market Factor Tilt 0.4 0.1 0.18 0.23 14+ Developed ex-US & Emerging Markets Factor Tilt 0.2 0.1 0.14 0.21 11+ At each reconstitution, the Morningstar Index Committee reviews 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 constituent is only calculated at each rebalancing. Adjustment factors for each constituent are calculated at each reconstitution. Rebalancing and Reconstitution Morningstar Indexes in the Factor Tilt Index Family are 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.