Profiles FUNCTIONAL DOCUMENT. Morningstar Security Classifier. Financial Planning Application

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1 FUNCTIONS ADDRESSED IN THIS DOCUMENT: How are Morningstar rates of return (ROR) determined and applied in Profiles? What time periods are used by Morningstar to determine its asset classes? What assets are included in the database? How often is Morningstar data updated? Case Setup category Asset Allocation Settings screen Profiles has five different investor profiles to ensure that you are maximizing the rates of return for your clients portfolio while minimizing risk. Each of the five investor profiles comprises a unique mix of asset classes. Profiles uses Morningstar asset allocation to assist you in determining your clients investor profile and in recommending and designing your clients portfolios. The following investor profiles are available in Profiles : Conservative Moderate Conservative Moderate Moderate Aggressive Aggressive

2 Other sources on this topic: Asset Allocation Settings Reallocation Options and Output The data required to build these five investor profiles and the supporting asset classes is provided by Morningstar Associates, Inc. ( 2012 Morningstar Associated, Inc., all rights reserved. Morningstar Associates is a wholly owned subsidiary of Morningstar, Inc.) This feature is automatically included in Profiles and is referred to as Morningstar asset allocation. The asset classes can be viewed on the Case Setup category Asset Allocation Settings screen (as shown above). The provides you with access to a database of mutual funds, individual securities, and variable annuities to classify your clients current holdings into multiple asset classes, allowing you to perform portfolio analysis. Both these features automatically calculate the expected rates of return for your clients, which saves you time by reducing data entry. Your clients will feel confident knowing that you are using the data supplied by Morningstar, which was founded in 1977 and has been entrusted to create asset allocation models for many of the largest companies in the finance and investment industries. DID YOU KNOW? The Monte Carlo analysis performs a minimum of 500 projections using Morningstar s Capital Market Assumptions to determine each asset class s rate of return per year. As long as a holding has been classified (for example, 100% Large Cap Growth Stocks or Mixed), the holding will be subject to the varying return assumptions, regardless of the rate of return entered by the user. Holdings with asset allocations set to Unclassified will be excluded from the Monte Carlo analysis. How are Morningstar rates of return (ROR) determined and applied in Profiles? Within Profiles, Morningstar incorporates two types of analyses. For all individual asset class forecasts, Morningstar uses the building block approach to generate expected return estimates. For overall capital market assumptions for each individual asset class, Morningstar applies a returns-based style analysis. Building block approach The building block approach uses the current risk-free rate as a foundation, and then adds historical performance relationships to build expected return forecasts. This approach separates the expected ROR of each asset class into three components: the real risk-free rate, the expected inflation, and the risk premium. Real risk-free rate is the return that can be earned without incurring any default or inflation risk. Morningstar uses the long-term treasury yield curve rate as its measure of the risk-free rate. Expected inflation is the additional reward required to compensate investors for future price increases. Risk premium measures the additional reward demanded for accepting uncertainty associated with investing in a given asset class. For fixed income there are different components to build expected returns. They are the current risk-free rate, horizon premium, default premium, and mortgage pre-payment premium. All the underlying historical data used for calculations dates from back to 1970.

3 The chart to the right depicts the components of the basic equity and fixed income building blocks: Returns-based style analysis Morningstar Associates, Inc. provides a returns-based style analysis where asset allocations data is based on a fund s performance, not on the assets the fund actually holds. Morningstar asset allocation may show that a fund holds 10% long-term bonds when in reality that fund may have never owned a bond in its entire history and the fund manager may never intend to buy a bond in the future. However, if that fund s volatility, rate of return, and other factors used in Morningstar s formulas have shown the fund to behave as though it was invested in bonds, Morningstar will show that it holds bonds. In conclusion, when individual holdings are entered for a security, these holdings may have no effect on the Morningstar classification. DID YOU KNOW? You can view detailed descriptions of the asset classes in the Benchmark Descriptions output page (accessible from the Client Presentation dialog box, under Asset Allocation). What time periods are used by Morningstar to determine its asset classes? Morningstar determines the asset classes based on the historical returns of indexes for stocks going back to the 1930 s as well as fixed income dating from the 1970 s. Morningstar uses these indexes as a base, and then applies a proprietary formula (the building block approach described earlier) to determine the end result. What assets are included in the database? The database uses the asset classes shown in the figure on page one of this document to build portfolios, and it includes data on the following types of securities: Open-end mutual funds Variable annuity subaccounts Stocks listed on the NYSE, AMEX, and NASDAQ Exchange traded funds/index funds The database is used to classify the holdings for each account you enter in the Assets category. If you do not know the ticker symbol and/or the holding name for a specific security you want to enter, Profiles allows you to search for holdings for a specific account by following these steps: 1. Enter either the assumed ticker symbol or holding name in the Ticker Symbol or Holding Name fields (respectively) in a blank data-entry row on the applicable account entry screen. 2. Under Classify, click the button to open the Classify Holding screen. 3. To have a list of items from the database appear that match the data you entered, click Search. You can then browse the list for the specific holding.

4 Assets & Liabilities category Assets screen Edit button Qualified Account Entry screen Classify button Classify Holding screen 4. Once the holding has been found, click the button under Select. The data will appear under Selected Security on the Classify Holding screen. 5. Click OK to return to the applicable account entry screen. The holding now appears along with its ticker symbol, asset allocation classification, and rate of return. 6. In the Market Value field, enter a value. Assets & Liabilities category Assets screen Add button for Qualified Retirement Accounts

5 The database does not provide classification breakdowns for the following: Stocks and funds with less than 36 months of historical data Money market funds Sector funds Closed-end funds Unit investment trusts Municipal bond funds DID YOU KNOW? When a new asset class is added, previously created cases will be unaffected. You will simply gain the option of using the new asset class in all your cases old and new. How often is the Morningstar data updated? When using the, rates of return are determined by Morningstar s historical analysis of the applicable asset class s performance. The asset classes themselves are not updated very often since long-term assumptions are used. If there are drastic changes and, as a result, the long-term projection of the asset class is different, then the asset mix will change slightly. The ticker symbols within the are reviewed by Morningstar and adjusted, but again long-term projections apply so they will not change much, if at all. These changes are made quarterly (January, April, July, and October), and are included in a subsequent release or update of Profiles. RORs for the Morningstar asset allocation data are updated annually, in late March. These updates are included in a subsequent release or update Profiles.