Morningstar Hits Big Board With Style

July 04, 2004

The long-awaited iShares based on the Morningstar style box metholdology debuted with a Big Board bell ringing.

The long-awaited Morningstar ETFs, listed on the New York Stock Exchange began trading on Friday.  The iShares Morningstar funds cover the U.S. style and size spectrum that is represented by Morningstar's ubiquitous style boxes.

In the opening day of trading, according to NYSE data, the range of trading volume varied from zero to 300 shares for the three small-cap funds, in the range of 10,000 for each of the three mid-cap funds, and a notable 200,000 up to nearly 500,000 for the large-cap funds.  The following are the 9 new ETFs that were launched. 

  • iShares Morningstar Large Value Index Fund (ticker: JKF)
  • iShares Morningstar Large Growth Index Fund (ticker: JKE)
  • iShares Morningstar Large Core Index Fund (ticker: JKD)
  • iShares Morningstar Mid Value Index Fund (ticker: JKI)
  • iShares Morningstar Mid Growth Index Fund (ticker: JKH)
  • iShares Morningstar Mid Core Index Fund (ticker: JKG)
  • iShares Morningstar Small Value Index Fund  (ticker: JKL)
  • iShares Morningstar Small Growth Index Fund (ticker: JKK)
  • iShares Morningstar Small Core Index Fund (ticker: JKJ)

With expense ratios ranging from 0.20%-0.30%, the funds are designed to track each of Morningstar's nine style boxes, which are based on a framework that moves from value to growth across and large to small down the style box framework.  For a graphical illustration, here is how the various style box indexes faired in the 2nd quarter through June 28, 2004:


The Morningstar U.S. Market Index covers approximately 97% of the capitalization of the U.S. stock market.

Reaching out to advisors and individual investors

With its highly recognizable brand name, databases, and vaunted style boxes, Morningstar seems like a natural index provider.

"Many advisors follow Morningstar's research and determine a target asset allocation for their clients based on the Morningstar Style Box," said Lee Kranefuss, CEO of BGI's intermediary business.

"Our style box methodology is a very popular way of looking at the stock universe with financial advisors and individual investors - now they will have actual investments based on the style boxes," said Joe Mansueto, founder, chairman, and CEO of Morningtar.

So far institutional investors and sophisticated traders have been the primary users of ETFs, but Vanguard, BGI, and others have eyed the financial advisor and retail investor market.

"The opportunity to bring the iShares brand together with the Morningstar brand we think will appeal to our existing clients, as well as to a wider range of investors who may not have looked at us or ETFs before," said J. Parsons, head of sales for BGI's Intermediary Business.

A question of style

In the indexing industry, the trend is toward higher complexity when it comes to structuring style index methodology.

"We believe the Morningstar indexes offer a higher level of style purity, partly because we use a 10-factor style methodology," said Mansueto. The ten factors are:

Value Factors
• Price/projected earnings
• Price/book
• Price/sales
• Price/cash flow
• Dividend yield

Growth Factors
• Long-term projected earnings growth
• Historical earnings growth
• Sales growth
• Cash flow growth
• Book value growth

"Unlike some indexes, a stock cannot be in multiple indexes," said Mansueto. "We also have a 'core' category for stocks that are not strong value or growth. In some existing indexes for example, stocks may end up in the growth camp simply because they're not value, or vice versa."

With back histories to 1992, the Morningstar Indexes Web site has more information on the index methodology, returns, and constituents.

"There are no gaps or overlaps in our indexes, so they work nicely as portfolio building blocks," said Mansueto.

Outsider moves inside

The move to partner with a fund provider could be a bold step, because Morningstar is known for its unique and independent fund commentary and ratings. (Index providers normally receive a licensing fee that is a small percentage - usually a few basis points - of the ETF's assets.) Morningstar has been active recently in partnering with several other financial services firms.

Mansueto said there is a wall between the index business and Morningstar's fund analysts.

"Our index business is separate from the analyst group," said Mansueto. "We don't rate ETFs currently, but it's possible we may do so in the future. However, our ratings are purely quantitative and transparent - there are no subjective elements."

Morningstar experienced at least one false start before lining up BGI as the ETF manager.

The launch is remarkable in that it marks the transition from Morningstar rating funds, to Morningstar now actually having funds that track indexes of their own.  It will be interesting to see if Morningstar is able to leverage its intermediary relationships, together with BGI and the NYSE's marketing muscle to bring significant assets to these ETFs.  Morningstar has some serious catching up to do, as there are already at least two other ETFs, and in some cases 3 or 4, in every asset class that the Morningstar indexes cover, although the argument could made that the core funds in small- mid- and large-cap make up a new asset class altogether. 

The launch is also significant as a landmark for the NYSE, which is with every passing quarter becoming a more serious player in the ETF market.  Now with numerous primary listings, including two based on it's own indexes, as well as scores of unlisted trading privileges ETFs that trade on the Big Board, the NYSE has made it clear that it intends to say in the ETF business.  The Morningstar listings give the NYSE a broader range of primary offerings now, with complete offerings now covering asset classes across the U.S. market. 

In 2002 Morningstar, long known for independent investment research, released a family of indexes based on its popular style-box categories.  By coming to the market relatively late, Morningstar was able to design an index family that incorporates the current best practices in index construction. 

Morningstar's indexes are free-float, rather than market-capitalization, weighted - which means that a company's weight in an index is based on shares only available for purchase on the open market, and excludes shares held by company insiders and governments, for example. 

Morningstar's index family consists of 16 U.S. equity indexes that track the U.S. market by capitalization and investment style using a comprehensive and non-overlapping approach based on the methodology for the Morningstar style box. The investment style of each individual security is determined by a comprehensive 10-factor methodology that separately measures both the value and growth characteristics of each security, using historical and forward-looking elements.

One of the defining characteristics of the indexes is the treatment of the 'core' style for the stocks for which neither growth nor value characteristics dominate. Such stocks merit their own category, allowing them to be treated as a distinct group. Further, it permits value and growth indexes that reflect the accepted definitions of these different approaches to security evaluation and selection. The 16 indexes in Morningstar Index family serve as building blocks of a diversified portfolio-thus offering a flexible basis for portfolio construction.

It was a long road to market, but Morningstar, iShares and the NYSE finally got a chance to celebrate their new collaboratiion with a bell-ringing on the floor of the NYSE. 


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