Understanding Morningstar's new Factor Profile

This month, Morningstar launched its Factor Profile framework for the Canadian market. For most investors, this can be thought of as an expansion of the renowned Morningstar Style Box™, first introduced in 1992 to help investors quickly understand an investment’s characteristics. As a quick reminder, the classic Morningstar Equity Style Box™ looks like this:

It has two dimensions: size and style. By looking at where the shaded area is located, an investor can quickly identify whether their investment is value or growth tilted, and the size of the companies owned in the fund. Today, the iconic Style Box remains prominent as a useful tool in Morningstar’s toolkit for equity fund analysis.

In the last decade, substantial research has been conducted to pinpoint other factors that drive investment returns. Appropriately, Morningstar has expanded the number of dimensions in our analysis to reflect now seven dimensions that the industry has widely accepted as driving factors of returns. This new tool is called the Morningstar Factor Profile and looks like this:

Like the Style Box, the Factor Profile is a holdings-based analysis, allowing investors to understand a fund’s exposures without relying on historical performance, which makes it particularly useful when looking at recently launched funds. To create each capsule, a standardized score from 0 to 100 is calculated to indicate the fund holdings rank relative to Morningstar’s global database of funds. Make no mistake, the ‘higher’ or ‘lower’ element of each factor is not the same as performance – past or future.

Like the Style Box, the factor profile is meant to provide clarity on what type of investment an investor has, not whether it will outperform or underperform a category or benchmark (for that, seek out Morningstar’s Quantitative Analyst Ratings for our forward-looking opinion).

The seven factors
Style: Like the Morningstar Style Box, the style capsule articulates whether the stocks in a fund are value tilted or growth tilted. Morningstar considers the earnings, book value, sales, cashflow-based valuation metrics, as well as the dividend yield when considering value. To quantify ‘growth’, we consider the growth rate of earnings, book value, sales, and cashflow. Funds ranked with a heavier growth tilt will appear near the top of the capsule.  

Yield: As many Canadians favor dividend investing, this capsule can provide a quick indication of whether a fund fits the objective. For this calculation, we use a combination of share buyback yield and dividend yield. Funds ranked near the top of the capsule will likely have a higher yield. 

Momentum: Particularly in cyclical markets like Canada, momentum of stock prices can often be a driver for return. Morningstar calculates this factor over a trailing 12-month timeframe. Funds ranked at the top of this capsule have more exposure to stocks showing positive momentum.

Quality: The term ‘quality’ can mean different things to different investors. Morningstar defines this in our methodology as a combination of profitability (measured by a stock’s trailing return on equity), and its financial leverage. Funds ranked near the top of the capsule hold companies of higher quality, in this context. 

Volatility: We measure this as the standard deviation of a stock’s 12-month daily returns. Funds appearing near the top of the capsule hold companies with higher volatility of returns.

Liquidity: Morningstar defines liquidity here as the average trading volume per month divided by the number of shares outstanding. Note that funds holding mostly Canadian stocks will typically rank near the bottom end of the capsule due to the nature of our equity markets relative to global markets, particularly in the US where trading volumes are substantially higher. 

Size: Consistent with the methodology used in the Style Box, funds holding larger companies will appear near the top of the capsule. 

Reading the Factor Profile: 
Each capsule shows the holdings’ relative rank for each factor in our global database of funds (dark blue dot) and compares it against the fund’s category average (black line, small dot). For reference, the fund’s historical range is also mapped as a bar (in light blue) so investors can understand the range of factor exposures over time. Let’s have a look at a couple of examples starting with the iShares Canadian Value ETF:

As evident in the name, this ETF certainly shows a value tilt relative to global funds, as well as relative to its own category average. The shaded area in the style capsule also shows that over the last five years, it has ranked consistently toward the value end of the spectrum. We can also see that the fund generally holds higher quality companies and the range of its quality rank has been near the top of the spectrum. Lastly, we notice that although the most recent holdings rank low in volatility, this has not always been the case as the range for this fund within the volatility capsule is quite large. 

This said, the factor exposure of a fund isn’t always immediately obvious in the name. Take for example the BMO Canadian Stock Selection series D fund: 

Investors can see that the holdings currently show a tilt toward growth and low volatility, although the range of these two factors has been wide over the last 5 years. The fund holds stocks that on average are slightly larger than the category average of Canadian Equity funds. 

Using the Factor Profile
The Morningstar Factor profile is meant to provide a more granular look through into the characteristics of an equity fund. It does not indicate an opinion on future performance but is quick and useful tool to show whether a fund is suited for your investment style. Moreover, it outlines the consistency of factor exposure over time which can be useful for due diligence of whether the fund manager is staying true to their stated investment objectives.