Investment focus - July 2008
Morningstar Associates Europe — portfolio construction approach
The artful combination of asset allocation and fund selection forms the basis of Morningstar’s global equity portfolio within our Multi-manager portfolios for 5 for Life, Investment Control and Income for Life. Here Morningstar tells us how they built the global equity portfolio.
Morningstar Associates Europe Ltd (‘Morningstar’) has designed its strategic, long-term approach to portfolio construction based on our belief that it’s possible to enhance the risk-return profile of a portfolio through sophisticated asset allocation modelling, a rigorous fund research and selection methodology and finally, the efficient construction of the portfolio with funds that work well in combination. It’s possible to identify a desired asset allocation and simply pick strong performing funds. However, we believe that there’s an art to assessing how funds interact and affect the overall portfolio structure and risk exposures, whether this is at an asset class, regional, sector, or security level.
How we constructed the global equity portfolio
The construction of the global equity portfolio (which forms the basis of the Multi-manager portfolios for 5 for Life, Investment Control and Income for Life) began with Morningstar’s proprietary asset allocation methodology. This was followed by analysis of all the funds available to us (from AEGON Scottish Equitable International’s Create range) to identify the highest quality options. Finally, the underlying holdings of the funds were scrutinised as they were blended to achieve the desired asset allocation weights.
Asset allocation process
Asset allocation at Morningstar utilises the sophisticated Black-Litterman optimisation approach and is based on creating fundamental, practical, investible portfolios. There are three basic steps in the process:
- We begin with the global equity market based on free-float market capitalisation.
- The global model is tailored to local market (for example customised for UK investors) biases or preferences.
- This local market model is then adjusted, based on client specific constraints or stipulations.
Investors in each economy face their own reference portfolio, which is a function not only of the composition of the global market portfolio, but also the local consumption basket, local tax restrictions and cross-border trading frictions. Consequently, for the global equity portfolio we constructed a broadly diversified portfolio that emphasises the UK market for UK domiciled investors. Morningstar follows a similar process for balanced portfolios that incorporate fixed-interest assets.
As most investment managers are careful to caveat, past performance may not be replicated in the future. This also applies to asset allocation, especially during times of extreme market environments as we’re currently experiencing. However, through our process we’re able to develop a set of adjusted return estimates that can reflect current macroeconomic and market data. These implied risk and return estimates are used as inputs to generate the optimum set of portfolio weights for each asset class. This output is like an initial sketch and the next step is to add some colour and finer detail. In some cases, our ‘’colour palette’ is reduced due to a restricted universe of available funds. However, Morningstar always seeks to create the mix of colours (that is, funds) that produces the best finished canvas. The construction of the global equity portfolio was accomplished using the most appropriate funds available, to create the optimum asset allocation.
