Construction Rules for Morningstar 529 College Savings Indexes

Transcription

1 Construction Rules for Morningstar 529 College Savings Indexes Morningstar Methodology Paper Version 1.2 April 28, 2015 For Financial Professionals Use Only 2015 Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. Reproduction or transcription by any means, in whole or in part, without the prior written consent of Morningstar, Inc., is prohibited.

2 Contents Introduction 3 Morningstar 529 College Savings Indexes Overview 4 Methodology 6 Construction Rules 8 Index Calculations 11 Data Correction and Precision 13 References Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 2

3 Introduction While there are a variety of ways to save for college, 529 plans are increasingly popular. These plans, named after Section 529 of the Internal Revenue Code, are tax-advantaged investment plans designed to encourage saving for college. Money from a 529 plan can be used for tuition, fees, books, supplies, and equipment required for study at any accredited college, university, or vocational school in the United States and at some foreign universities. The prime benefits of a 529 plan are that the principal grows tax-deferred and distributions for the beneficiary's college costs are tax-exempt. There are different investment approaches across 529 plan providers, with different levels of risk focus, active versus passive, etc. The large dispersion in equity allocations suggests there are a number of perspectives and methodologies when it comes to building the optimal glide path for a 529 plan. To help investors, Morningstar addresses these issues in the industry's first 529 index Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 3

4 529 College Savings Indexes Overview Morningstar 529 College Savings Indexes are designed to meet the benchmarking needs of investors attempting to fund a college education as defined under Section 529 of the Internal Revenue Code. The main component of these indexes is the construction of an optimal glide path, or adjustment in asset-class exposure over time, for a given risk tolerance and target graduation date. The glide path for each index series is developed using a simulation-based utility optimization process known as surplus optimization, where the expected risk factors associated with college inflation are considered when selecting the asset-class allocations. The Morningstar 529 College Savings Indexes are indexes of indexes, which may serve as useful proxies when benchmarking relative performance of 529 plans. Morningstar has combined the principles of Ibbotson s 6 asset-allocation methodology with a collection of Morningstar indexes to create the family of 529 indexes. The Morningstar 529 College Savings Index family consists of three risk tranches aggressive, moderate, and conservative to provide appropriate target date risk tracks. Each risk category contains a range of indexes corresponding to target graduation dates in three-year increments. Going forward, Morningstar will maintain a rolling set of indexes in each risk series. The industry approach to 529 funds is to allocate a majority of assets to equities early on, with the remainder in interest-bearing assets such as bonds and cash. The first step when creating a glide path for a 529 index is to define the capital market assumptions and the opportunity set. The next step is to determine the optimal subasset-class portfolios. Morningstar then determines the allocations by running what is known as a liability-relative optimization (also known as a surplus optimization). 4 To determine the optimal allocation, simulations are run to solve for the optimal glide path over each year of the remaining investing period for that child using a nonlinear optimization routine based on a constrained relative risk aversion (CRRA) utility function. Furthermore, the final glide path for each level of risk aversion is not based on the equity glide path for the newborn but rather the initial equity allocations for the different ages Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 4

5 Conceptually, liability-relative optimization is an extension of the traditional Markowitz asset-only approach to determining an optimal asset allocation in which the mean-variance optimizer is constrained to hold a short position in a particular asset class (or combination of asset classes) representing the future liability. Morningstar considers the increase in college funding costs (i.e., college inflation) as the liability for the purposes of this analysis. Tuition is an important variable when saving for college, since it's one of the primary costs. The cost of college has increased significantly over the past 40 years, with the average cost increasing 45% each five years in nominal terms. This rate of increase has been significantly faster than the rate of general inflation. Forecasting college inflation can be more difficult than forecasting the returns for more traditional asset classes, such as large-cap domestic equity or cash, because college costs tend to have more factors that can affect their future values, and costs will vary not only by college type (e.g., public or private) but also by region, state, or individual college. Morningstar assumes that college inflation will be general inflation plus the approximate long-term spread of college inflation over base inflation. Therefore, Morningstar assumes college costs are likely to increase 5.5% per year for our analysis. 1 The resulting Morningstar 529 College Savings Indexes deliver the features investors and fund manufacturers need when it comes to benchmarking and creating and managing an investment option respectively: Allocations grounded in capital markets assumptions and financial theory rigorously developed over several decades A family of asset-class-specific constituent indexes seamlessly engineered to provide stylepure exposure to respective asset classes in a low-cost, investable, and daily priceable manner A comprehensive set of asset classes that delivers exposure not only to global equities but also global fixed-income and inflation-protected assets A family of indexes for each risk tranche that covers the entire glide path from birth until a target graduation date An industry benchmark that may be used to compare the various 529 funds offered in the marketplace 2015 Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 5

6 Methodology The industry approach to 529 funds is to allocate a majority of assets to equities early on, with the remainder in interest-bearing assets such as bonds and cash. The percentage in equities is reduced over time and allocated to the other, usually safer, asset classes as the child approaches his or her target graduation date. This automatic adjustment in asset-class exposure is designed to reduce risk over time and is the central theme of a 529 fund. As mentioned previously, when creating a glide path, one must define the capital market assumptions and the opportunity set. Morningstar includes a robust opportunity set of 18 asset classes and uses Morningstar indexes as proxies for these asset classes, which are listed at the end of the Construction Rules section. Morningstar includes two "real return" asset classes in the opportunity set: Treasury Inflation-Protected Securities, or TIPS, and U.S. real estate investment trusts, or REITs, which are common in 529 products because of the inflation characteristics of the asset classes. Morningstar believes strongly in the benefits of diversification. All else equal, a larger opportunity set of investable asset classes should result in an efficient frontier with improved risk and return characteristics. The Morningstar family of individual asset-class indexes, which we use as building blocks for the 529 indexes, allows the construction of asset-allocation models that should produce long-term risk and return characteristics that represent best-in-class benchmarks. 3 After the opportunity set is selected, Morningstar determines the allocations by running what is known as a liability-relative optimization (also known as a surplus optimization). The historical approach to building portfolios has focused primarily on the risk and return characteristics of the assets. The historical "asset-only" approach ignores the fact that the portfolio exists to fund a future cash flow, the liability (future college expenses in this case) may have distinct risk characteristics that should be considered when building the portfolio. Proper asset allocation is of utmost importance when constructing the glide paths. Industry research and Morningstar s ongoing analysis of active and passive fund managers support the 2015 Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 6

7 belief that it will likely be asset allocation, not security selection, that drives a significant portion of a target-date portfolio's return over time; 529 funds behave similarly to target-date funds. 2 Morningstar s model assumes that the person saving for college is able to fully fund this goal, would start investing in the year the child is born (age 0), and would save a constant annual amount, increased by general inflation, until the child turns 18. Morningstar assumes that all savings take place at the end of the year, while all college costs are paid at the beginning of the year. The potential benefits of liability-relative optimization are a portfolio of assets with a value that should move in sync with the value of the liabilities because the portfolio of assets is determined in the presence of the liability. This leads to a portfolio whose health is steadier. This contrasts with the asset-only approach, which leads to a portfolio of assets with a value that might not always move in the same direction as the value of liabilities because the portfolio of assets is determined in isolation. This in turn leads to a portfolio whose health (and/or the cost associated with funding the portfolio) can vary significantly over time. Using these assumptions, Morningstar estimates the ratio of the account balance to the annual savings required to perfectly fund the college goal. Morningstar estimates this initial balance by solving for the initial cash flow (during the child's first year), which results in a $0 balance when the child is assumed to finish college. Morningstar assumes college begins soon after the child turns 18 and lasts for four years. To determine the optimal allocation, Morningstar runs simulations where we solve for the optimal glide path over each year of the remaining investing period for the child using a nonlinear optimization routine. The optimal glide path for each simulation is the one that maximizes the certainty equivalent utility for that set of runs. Each run consists of 100 different simulations. Morningstar uses the same returns for the glide-path optimization as was done for the surplus optimization to ensure consistency in assumptions. For optimization simulations, Morningstar focuses on minimizing the "tail risk" of a return distribution, focusing on mean-conditional value-at-risk, or M-CVaR. M-CVaR minimizes CVaR (conditional value at risk) for a given level of return and prefers assets with positive skewness, small kurtosis, and low variance. CVaR is closely related to VaR (value at risk) and is calculated by taking a probability-weighted average of the possible losses conditional on the loss being equal to or exceeding the specified VaR Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 7

8 Construction Rules The Morningstar 529 College Savings Index family consists of three groups of indexes aggressive, moderate, and conservative to provide appropriate target-date risk tracks based on an individual s risk preference and the target graduation date that the beneficiary of the 529 fund best aligns with. The following methodology holds for each risk tranche. The starting assumption is that the birth date of the child coincides with the date of the June reconstitution each year. As of 2013, for each risk track, Morningstar has the following target graduation date indexes: 2013, 2016, 2019, 2022, 2025, 2028, and The assumed ages of the children after their fictitious birthdays on the June 2013 reconstitution are: 18, 15, 12, 9, 6, 3, and birth, respectively. The Index Inception date is June 21, This corresponds to children that, on that day in 2002, had birthdays and became the following ages: 7, 4, 1, and less than 0 for the remainder. For ages equal to or less than 0, the age 0 allocation was held until the time came for each of the aforementioned children to become 1 year old. The allocation was then adjusted each year at the June reconstitution. It is important to note that while the naming convention uses threeyear increments, the asset allocation adjusts yearly at reconstitution so that the indexes move down a more continuous glide path toward the graduation target date. Every three years, a new index will be produced for each risk track. Levels will be calculated by holding the age 0 allocation from the June 2002 Index Inception Date until the time comes that the particular child is 1 year old (since it must continue to use the age 0 allocation for the first year). This is calculated by assuming that the target graduation date coincides with the child s 18th birthday. For example, in 2016, Morningstar will produce the 2034 target graduation date index for each risk track. While the index will be produced in 2016 for a newborn with a target graduation date of 2034, it will have been assumed to hold the age 0 allocations since June 2002 in order to be normalized with respect to previous portfolios. At each quarterly rebalancing, Morningstar will use the asset allocation from the June reconstitution. This is because the allocations the following year come from a recalibrated model, based on updated variables that are input into the optimization algorithms used to 2015 Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 8

9 calculate the glide path. Morningstar thus uses the current allocation throughout the year until the following reconstitution. Finally, once the index has reached maturity and uses the age 21 allocation, Morningstar continues to use the age 21 allocations for 10 years until the index is decommissioned. Inception Dates and Base Market Values The Index Inception Date of the Morningstar 529 College Savings Indexes are June 21, Daily price and total return series are available from this date forward. The index base market values at Index Inception are all 1,000. The Index Commencement Date (the date on which the index is launched with live end-of-day or real-time calculations) is January 2, Calculation and Dissemination of Index Values Index values are calculated end-of-day and disseminated by Morningstar. Index Value Currencies The closing values of all Morningstar 529 College Savings Indexes will be calculated in USD. Scheduled Reconstitution Date The Morningstar 529 College Savings Indexes are reconstituted i.e., the index membership is reset once annually. Adjustments are performed after the close of business on the third Friday of June and are effective on the following Monday. If Monday is a holiday, reconstitution occurs on the Tuesday immediately following. Scheduled Rebalancing Dates The Morningstar 529 College Savings Indexes are rebalanced i.e., the number of shares of each constituent security within the 529 index's underlying index is adjusted four times annually. Adjustments are performed after the close of business on the third Friday of March, June, September, and December. If Monday is a holiday, rebalancing occurs on the Tuesday immediately following. Index Constituents Morningstar indexes utilized in the 529 family are listed below. The rules governing security inclusion into the index, index reconstitution/rebalancing, security splits/dividends/contract expirations, and other index mechanics are detailed in the rulebooks that govern each index. These rulebooks are available on the Morningstar website at Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 9

10 Constituents: Morningstar Cash Index Morningstar Short Term Core Bond Index Morningstar Intermediate Term Core Bond Index Morningstar Long Term Core Bond Index Morningstar TIPS Index Morningstar Global ex-us Government Bond Index - Hedged Morningstar US Large Growth Index Morningstar US Large Core Index Morningstar US Large Value Index Morningstar US Mid Growth Index Morningstar US Mid Core Index Morningstar US Mid Value Index Morningstar US Small Growth Index Morningstar US Small Core Index Morningstar US Small Value Index Morningstar Developed Markets ex-us Index Morningstar Emerging Markets Index Morningstar US REIT Index 2015 Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 10

11 Index Calculations Basic Formula The 529 family of indexes are indexes of indexes. That is to say that the underlying constituents are themselves indexes. The index is calculated using the Laspeyres formula. n (p i(t)*s i(t)) i=1 Index(t)= *BaseIndexValue=(M(t)/B(t))*BaseIndexValue n C(t) p (0)*s (0) j=1 j j The above formulas can be simplified as: M(t) Index(t) D(t) Where: D(t) = divisor at time (t)=b(t)/base Index Value n = number of underlying constituent index in the Index p i (0) = closing price of constituent index i at the base date s i (0) = constructed shares of constituent index i at the base p i (t) = price of constituent index i at time (t) s i (t) = constructed shares of constituent index i at time (t) C(t) = adjustment factor for the base date market capitalization t = time the Index is calculated M(t) = market capitalization of the Index at time (t) B(t) = adjusted base date market capitalization of the Index at time (t) It is important to note that the shares (s i (t)) for the Index constituents are artificial constructs used for calculation purposes Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 11

12 Constructed Shares and Constituent Weighting The Index is rebalanced on a quarterly basis. A constituent index weighting IW i (q) in the Index is determined by the previously mentioned optimization routine. For specific allocations, please refer to Morningstar's 529 Index Methodology document. 1 The constructed shares (s i (t)) for each constituent in the Index calculation formula are determined as follows: Where: s(t)= i n j j i j=1 (s (t-1)p (t-1))*iw(q) p (t-1) n = number of constituent indexes in the Index (q) = quarter end time the Index weights are calculated (t) = time the Index is calculated p i (t) = price of constituent index i at time (t) IW i (q) = constituent weight in Index i at quarterly rebalancing time q s i (t-1) = constructed shares of Index i at time t minus 1 * * At time of Index Inception Date, the constructed shares are determined by an arbitrary portfolio value, $10 billion. i 2015 Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 12

13 Data Correction and Precision Intraday Index Data Corrections Commercially reasonable efforts are made to ensure the correctness of data used in real-time index calculations. If incorrect price or corporate action data affects index daily high or lows, it is corrected retroactively as soon as feasible. Index-Related Data and Divisor Corrections Incorrect pricing and corporate action data for individual issues in the database will be corrected upon detection. In addition, an incorrect divisor of an index, if discovered within five days of its occurrence, will always be fixed retroactively on the day it is discovered to prevent an error from being carried forward. Commercially reasonable efforts are made to correct an older error subject to its significance and feasibility. Computational and Reporting Precision All calculated and adjusted data are stored in real numbers. For reporting purposes, index values are rounded to two decimal places and divisors are rounded to appropriate decimal places. Undocumented Events Any matter arising from undocumented events will be resolved at the discretion of the Morningstar Index Committee. Morningstar Index Committee The Morningstar Index Committee oversees all of the Morningstar indexes. The committee seeks to create indexes of the highest quality that meet the recognized qualities of a good benchmark. All Morningstar indexes are constructed based on their respective published Construction Rules Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 13

14 References 1. David Blanchett. Morningstar 529 Index Methodology Morningstar white paper in progress. 2. Roger G. Ibbotson and Paul D. Kaplan. Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance? Financial Analysts Journal (2000): Thomas Idzorek. Lifetime Asset Allocations: Methodologies for Target Maturity Funds. Ibbotson Associates Research Paper (2009). 4. Thomas Idzorek and Jin Tao. The Impact of Liability-Relative Optimization and Non-Normal Returns on Asset Allocations. Morningstar white paper in progress. 5. James Xiong and Thomas Idzorek. The Impact of Skewness and Fat Tails on the Asset Allocation Decision. Financial Analysts Journal 67.2 (2011). 6. 'Ibbotson's' refers to Ibbotson Associates, Inc., a wholly-owned subsidiary of Morningstar, Inc Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 14

15 The following sections were modified: Between Version 1.1 and 1.2 Scheduled Reconstitution Date : The adjustment for reconstitution is made at the close of third Friday instead of the close of business day following third Friday Scheduled Rebalancing Date : The adjustment for rebalance is made at the close of third Friday instead of the close of business day following third Friday 2015 Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 15