Taking Notes

Interview with Paul Kaplan, Morningstar Director of Research

Taking Notes

Chicago-based Morningstar, Inc. has ventured into a crowded index industry with the debut of 16 proprietary equity benchmarks that correspond to the firm's heralded style boxes. Morningstar's director of research, Paul Kaplan, sat down with us to discuss what sets the new indexes apart. He is responsible for the quantitative methodologies behind Morningstar's fund analysis, stock analysis, advice, advisor tools, and other services.

Q: Why are overlapping indexes a negative thing?

A: It depends on what you're trying to achieve with the index. If the purpose of the index is to create a passive alternative to an active portfolio, then it makes sense to have overlaps and style indexes that are not completely pure. For example, we know that large-cap growth fund active managers sometimes buy mid-cap stocks, or they buy stocks that definitely are not growth stocks. So the passive alternative idea requires a benchmark that covers the same range as the active funds in whatever investment universe you're looking at.

But indexes can also be used to understand what's going on in the overall equity market, apart from what any particular active manager may be doing. Since we wanted to create a tool for understanding what bets active managers are actually taking, we didn't want overlapping indexes, but rather pure style indexes. So that's what we've created.

Q: In his article on index methodology, Vanguard index fund manager Gus Sauter basically says it's the managers themselves who decide what growth and value are.

A: I think Gus started from the efficient markets perspective. So a value stock is whatever a value manager buys, and a growth stock is whatever growth managers are buying. What we're saying is that there really is a playing field out there. When managers make decisions to focus on value or growth stocks, it's not because they're looking at the decisions of other managers. What we're trying to do is characterize the set of opportunities that are out there for active managers. It's just a different way of looking at indexes.

Q: Why is a "core" index or style box beneficial?

A: I think everyone in this business recognizes that not all stocks are clearly value or clearly growth. Some index providers take a stock and divide the market capitalization between the value and growth indexes. Again, that makes sense if you're creating a passive alternative to an active strategy. But if I want to understand what's going on in the market, then I need to put that stock in one sensible place. So when I see a manager buying a stock that falls into the middle range, then I can say that manager is making a 'core' bet. These middle stocks need their own distinct category.

Q: How do the Morningstar style indexes compare to others in terms of the number of style factors?

A: Right now we have ten style factors, which is a few more than most existing style indexes. The Dow Jones style indexes have six factors, for example. On the one extreme, the S&P/Barra style indexes only use one factor - price to book ratio. This is the general direction we've seen indexes going, with increasingly sophisticated models.

Q: Have existing indexes and index funds encouraged bad investor habits?

A: I wouldn't say the indexes encouraged bad behavior, but they haven't done anything to dissuade it. In a bull market, people put more money into equities. When the market goes down, people pull their money out. Of course, they do the same thing with respect to both active and passive funds. When people were throwing a lot of money into active funds in the 1990s, they were also putting a lot of money into the Vanguard S&P 500 index fund at the same time. The reverse happened when the market turned. The indexing industry hasn't done anything to rectify that.