Morningstar Magazine - June/July 2018 - 62

Spotlight: Packaged Investing

Sizing Up Multi-Asset Portfolios
New tools provide a way to benchmark
asset-allocation portfolios.

TARGET RISK

Thomas M. Idzorek and Paul D. Kaplan

We in the investment industry evaluate just about
every product by comparing it to a benchmark.
Yet for asset allocation, regarded as one of
the most important parts of the investment process,
there are few agreed upon standards
for evaluation.
To evaluate managers operating within a specified
asset class, such as large cap or small cap,
most in the industry would agree that a marketcapitalization-weighted index can serve as a
reasonable benchmark. In the world of diversified
asset-allocation-oriented portfolios-those
that invest in a mix of equities, bonds, and other
types of investments-there is no such consensus.
Even within a given asset-allocation category,
portfolios can have significant differences
in weightings of equities and more granular asset
classes; some funds hold a lot of international
stocks, for example, and some do not.
At Morningstar, we have developed a set of tools
that form the Target Risk Ecosystem, which among
other things provides a way to benchmark
asset-allocation-oriented portfolios, monitor
the quality of portfolios across an entire network
of advisors, and pinpoint potential suitability
issues by comparing the risk level of a portfolio to
an investor's risk profile. In this article, we
explain how this system works and illustrate how
it applies to target-risk mutual funds.
The Target Risk Ecosystem

Morningstar's Target Risk Ecosystem is a set of
tools designed to provide a consistent lens across
diversified multi-asset-class funds and portfolios.

Morningstar June/July 2018

Its components are:
1 A family of five Morningstar Target Risk Indexes for

the U.S. market. Each target-risk index is an
asset-allocation model consisting of a wide range
of single-asset-class indexes. The target-risk
indexes represent Morningstar's best thinking in
asset allocation. The five asset-allocation indexes
are Conservative, Moderately Conservative,
Moderate, Moderately Aggressive, and Aggressive.
The equity content of the indexes is 20%,
40%, 60%, 80%, and 95%, respectively. EXHIB IT 1
shows a simplified version of the asset allocations
of the target-risk indexes. Morningstar is
also developing families of target-risk indexes
for Canada, the United Kingdom, Europe,
and Australia.

the index's equity percentage sits in the middle
of the equity range of the category.
4 A risk-scoring engine to analyze and compare

the asset allocation of a multi-asset-class
portfolio or fund to the asset allocations of the
target-risk indexes. The engine calculates
a risk score and a measure of how well aligned the
asset allocation in question is with the asset
allocation in the target-risk indexes.
The risk-scoring engine has several applications.
One is for a wealth-management firm to monitor
all of the portfolios created by its advisors to make
sure that 1) the portfolios' returns are driven by
asset-class exposure, 2) the risk levels of the
portfolios, as measured by their asset allocations,
are appropriate for investors based on the results of
their risk assessments, and 3) the portfolio asset
allocations are aligned with an independent asset
allocation, those of the target-risk indexes.
Another application of the risk-scoring engine is to
assess the asset allocations of target-risk funds.
This is the focus of this article.
The Risk-Scoring Engine

The risk-scoring engine takes the following steps
to assess the risk of a portfolio or a fund:

2 Risk-tolerance questionnaires that are designed

to assign investors to an appropriate level
of risk, whether for a single overall portfolio or for
multiple portfolios designed to meet a series
of specified goals. We align the output from
risk-tolerance questionnaires with the target-risk
indexes. So, for example, if an investor scores
"moderate" on a questionnaire, the Moderate
target-risk index corresponds to an appropriate
asset allocation for that investor.

1 Create a composite return history of 48 months,

if necessary.
2 Run a returns-based style analysis on the return

history to estimate the effective asset allocation.
3 Calculate the risk score and the misfit risk

by comparing the asset allocation to the asset
allocations of the target-risk indexes.
4 Assess the alignment of the asset allocation
relative to the target-risk indexes, based on the
risk score and misfit risk.

3 Five Morningstar fund categories for U.S. target-

risk funds that correspond to one of the
five target-risk indexes. The categories are defined
by an equity allocation range: 15% to 30%
(Conservative), 30% to 50% (Moderately
Conservative), 50% to 70% (Moderate), 70% to 85%
(Moderately Aggressive), and more than
85% (Aggressive). Morningstar uses a similar
category system for asset-allocation funds in the
United Kingdom and Australia and plans to
do the same in other fund markets. In most cases,

We will now describe what the risk-scoring engine
does in each of these steps.
Create a Composite Return History
For individual funds, there is no need to create
a composite history. The risk-scoring
engine just uses the past 48 months of total
returns. But for portfolios of multiple securities,
the risk-scoring engine calculates the
composite return for each of the past 48 months.

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