The magazine of independent research for the world’s financial professionals Q2 2024

Bring It On
Financial advisors look for ways to incorporate artificial intelligence into their practices.
Also in this issue

gValue Investing Evolves gA Muni Fund’s Spool of Risk gAnd the latest investing trends from around the world...
 Q2 2024

4 Contributors
5 Letter From the Editor

Dispatches
6
Letter From the Board
Today’s Concentration Is Unusual

Phillips Curve

8 The Adult Thing to Do

Ivory Towers
9 Undeservedly Popular

Advisor Insights

11 Oops! You Goofed! Now What?

Sustainability Matters

12 ‘Greedy Occupations’ Drive C-Suite Pay Gap

Global Briefs

14 Americas
18 Greater Europe
19 Asia

Spotlight

Advisors Need to Embrace AI—

23

but Carefully
Like computers before it, artificial intelligence
will transform your practice.
27 Decoding AI Uses
31 Advisors Await SEC Rule for AI
34 Are There Any Undervalued Opportunities Left in AI?

1
 Q2 2024

Strategies Research

38 Tugging on a Thread
41 ARK Tops List for Value Destruction

How-to

42 Is Your Active Manager Worth It?

Best Ideas

45 Manager: Patience Required
46 Passive: Global Bond Exposure With a Razor-Thin Fee
47 Equity: A Strong Core

Investors

Morningstar Conversation
48 Value Investing in the Age of Intangibles

Undiscovered Manager

54 A Healthy Blend

Sector Rap

57 Changing Playbook

User Profile

60 Navigating Newfound Financial Success

Data Dashboard
62 Morningstar Global Market Barometer
64 Morningstar Global Valuation Lens
68 Morningstar US Fund Flows
69 Morningstar Medalists

70 Crossword Puzzle

72 Ten Questions

2
 e
rat Ag
g
de

res
Mo

siv
e
e
Ag rat

68
g de
res

Mo
siv
e

e
rvativ

Very A
68 68

nse

g
Avoid Weapons

g
Co
0 100

res
siv
e

e
rvativ
Very

Advisor Workstation
Avoids military, small arms, and controversial
A

Client Name > {Investment Plan Name}

nse
weapons industries. Edit Build Report
g

Avoid Weapons
gre

o
100 0

C
ssi

Plan Summary
Risk Score 68
v

e
Advisor Workstation
Avoids military, small arms, and controversial Risk Level Aggressive
Edit Build Report
weapons industries.Client Name > {Investment Plan Name}
Current Portfolio Proposed Portfolio
Plan Summary
68 Risk Score
Portfolio Risk vs Target Portfolio Risk vs Target

Aggressive era
te Ag
gre era
te Ag
gre
Risk Level
od od
ssi

ssi
M

M
ve

ve
Current Portfolio Proposed Portfolio
Risk Score Risk Score
+
100 Risk Level
Portfolio Risk vs Target 38 Risk Level
Portfolio Risk vs Target
rvative

rvative
Very

Very
Risk Comfort Range Risk Comfort Range
nse

nse
Agg

Agg
te Ag te Ag
Co

Co

era g era gre

res

res
100re
od od
s

s
0 ive 0 ive

ssi

ssi
M

M
ve

ve
Risk Score Risk Score

Deviation From Target % Deviation From Target %

100+ Risk Level
38 Risk Level
rvative

rvative
Very

Very
Risk Comfort Range Risk Comfort Range
Current Target Proposed Target
nse

nse
Agg

Agg
% % % %
Co

Co
res

res
s

s
0 ive 0 100 ive
U.S. Stocks U.S. Stocks
Non-U.S. Stocks Non-U.S. Stocks
Deviation From Target % Deviation From Target %
Bonds Bonds
Current Target Proposed Target
Cash Cash
% % % %
Other Other
U.S. Stocks U.S. Stocks
Non-U.S. Stocks Non-U.S. Stocks
Bonds Bonds
Cash Cash
Other Other

Give your clients a holistic personalized investment plan.

ment plan.We empower financial advisors withGive
the toolsyour clients
they need to truly a holistic personalized investme
Advisor Workstation
personalize their client portfolios - all in one place. Create tailored Explore the Investment Planning
portfolios based on clients’ values, goals and risk comfort with the Experience today.
kstation We empower financial advisors with the tools they need to truly Advisor Workstat
Investment Planning experience. www.morningstar.com/try/ipx
nvestment Planning personalize their client portfolios - all in one place. Create tailored Explore the Invest
oday. portfolios based on clients’ values, goals and risk comfort with the Experience today.
With a holistic investment planning strategy, advisors can hold
gstar.com/try/ipx Investment Planning experience. www.morningstar.
productive conversations with clients, take the bias out of planning
to help identify goals, maintain regulatory compliance and profile
With a holistic investment planning strategy, advisors can hold
risk with our most academically validated risk tool.
productive conversations with clients, take the bias out of planning
to help identify goals, maintain regulatory compliance and profile
risk with our most academically validated risk tool.
Contributors
For this issue’s Spotlight, Morningstar editorial
director of financial advice Sheryl Rowling
ventures into artificial intelligence. In “Advisors
Need to Embrace AI—but Carefully” (Page 23),
Sheryl Rowling Rowling explores how financial advisors can use
this emerging technology. “AI isn’t changing
much yet, especially in our industry, because there
isn’t anything designed specifically for advisors
that’s also being widely used,” Rowling says.
And there’s good reason to approach with caution,
as regulation governing advisor use is still in
the works. (For Morningstar’s take, see “Advisors
Await SEC Rule for AI,” Page 31.)
That said, advisors can’t afford to ignore AI,
and it isn’t too soon to dip your toes in the water,
even if just for fun. “When you have a need
in daily life, instead of going to Google, go to an AI
chatbot,” Rowling suggests. She favors Google
Gemini and has used it for things like planning an
upcoming family vacation to New Orleans
and searching for a gift for “a friend turning 50
who likes baseball and going to the beach.”
Rowling, a CPA/personal financial specialist with
30 years of experience, is a columnist on
Morningstar.com and a regular contributor to
the magazine’s Advisor Insights column.
(This issue, she tackles what to do when you
make a mistake, Page 11.) She founded Total
Rebalance Expert, an automated portfolio
rebalancing tool for financial advisors, in 2008,
after she couldn’t find a comparable product
for her former independent advisory firm, Rowling
& Associates. Morningstar acquired Total
Rebalance Expert in 2015.
Ewelina Karpowiak is the founder of Klawe
Rzeczy, a design studio based in Lodz, Poland, that
specializes in editorial illustrations and digital
collages. For this issue’s cover, Karpowiak says,
Ewelina Karpowiak “I tried to show in a literal but slightly exaggerated
way the complexity and multilayered nature of
the issues that AI can solve. The collage technique
was perfect for this project.” Karpowiak’s
work has been published by Forbes, The Economist,
and Harvard Business Review, among others.
She also creates posters, book covers, and graphic
designs for new media and advertisements.
4 Morningstar Q2 2024
Morningstar Magazine
Volume 16, Issue 2
Editor-in-Chief Jerry Kerns
Managing Editor Laura Lallos
Editorial Board Bryan Armour, Hortense Bioy, Wing Chan, Adam Fleck,
Charles Gross, Michael Holt, Thomas M. Idzorek, Dan Kemp,
Alec Lucas, Alex Morozov, Marta Norton, Don Phillips, Jeffrey Ptak, Katie
Rushkewicz Reichert, Daniel Rohr, Janet Yang Rohr, Jeffrey Stafford,
Timothy Strauts, Lorraine Tan
Contributors Bidappa A R, Amy C. Arnott, Christine Benz, Hortense Bioy,
David Carey, Drew Carter, Jackie Cook, Ivanna Hampton, Eric Jacobson,
Ben Johnson, Jaime M. Katz, Charles Keenan, Danielle Labotka, Samantha
Lamas, Leslie Norton, Andy Pettit, John Rekenthaler, Sheryl Rowling,
Eric Schultz, David Sekera, Jasmin Sethi, Jack Shannon, Chris Tate,
Tony Thomas, Tony Thorn, Lan Anh Tran, Julie Willoughby, Karen Zaya
Art Director Alex Skoirchet
Designer Paul Zdon
Illustrator Ewelina Karpowiak
Photographers Matthew Gilson, Sheryl Lanzel, David Lees,
Matthew Lomanno
Copy Editor Mike Eiler
Proofreader Mary Kate Chambers
Publisher Sheila Berleman
Director of Advertising Sales Stuart Roge
Regional Sales Directors Dan Atkinson, Emily Martin, Lisa Turner
Morningstar, Inc.
CEO Kunal Kapoor
Managing Director, Design David Williams
Editor-in-Chief Adley Bowden
How to Reach Morningstar Magazine
Subscriber Services magazine_operations@morningstar.com
Editorial and Letters to the Editor magazine_editor@morningstar.com
Advertising Opportunities magazine_adrates@morningstar.com
Reprints and Licensing reprints@morningstar.com
How to Reach Morningstar
Customer Service +1 312 384-4000
Advisor Product Sales +1 877 586-5405
Morningstar is a Pending Periodical (ISSN 2993-6918),
Copyright ©2024 by Morningstar, Inc.
Morningstar is published Quarterly by Morningstar, Inc., 22 W. Washington,
6th Floor, Chicago, IL 60602-1605. Application to Mail at Periodicals
Postage is pending at Chicago, IL and at additional mailing offices.
All departments located at Morningstar, Inc., 22 W. Washington, 6th Floor,
Chicago, IL 60602-1605. Call 312-384-4000 to subscribe.
POSTMASTER: Send address changes to Magazine Publisher, Morningstar,
Inc., 22 W. Washington, 6th Floor, Chicago, IL 60602-1605.
The information contained herein: (1) is intended solely for informational
purposes; (2) is proprietary to Morningstar and/or its content providers;
(3) may not be copied or distributed; (4) is not warranted to be accurate,
complete, or timely; and (5) does not constitute investment advice
of any kind. Neither Morningstar nor its content providers are responsible
for any damages or losses arising from any use of this information. Past
performance is no guarantee of future results. Indexes are not available for
direct investment. Investment research is produced by subsidiaries
of Morningstar, Inc. including, but not limited to, Morningstar Research
Services LLC, registered with and governed by the U.S. Securities
and Exchange Commission. Morningstar Investment Management LLC
is a registered investment adviser. “Morningstar” and the Morningstar logo
are registered marks of Morningstar, Inc.
Morningstar licenses its indexes to certain providers for use in
exchange-traded funds and exchange-traded notes. These ETFs and ETNs
are not sponsored, endorsed, issued, nor sold by Morningstar.
Morningstar does not make any representation regarding the advisability
of investing in ETFs and ETNs that are based on Morningstar indexes.
E03112499
Letter From the Editor
The AI Odyssey Arrives
It seems that with every great leap in technology
comes the fear that machines will replace
us (at best) or will lead to our destruction (at
worst). For baby boomers, the machine takeover
Jerry Kerns is epitomized by HAL, the computer antagonist
in “2001: A Space Odyssey” that refuses the
commands of a stranded astronaut to “open the
pod bay doors.” HAL’s response, “I’m sorry,
Dave. I’m afraid I can’t do that,” still sends chills.
There are countless other examples for every
generation to latch on to, all with the same
message: Beware of new technology. It’s hard not
to feel threatened by something that has the
capability of transforming our world, whether we
want it to or not. Often our minds race to the
worst possible scenarios, and we dread outcomes
before they have come close to realization,
forgetting the immense number of positive
developments innovations produce.
Remember when the great fear was that robo-
advisors were going to replace human advisors?
It didn’t turn out that way. In a discussion with
Morningstar’s Julie Willoughby and Ben Johnson,
Andrew Brzezinski, Fidelity’s head of data
strategy, says that the robos were “naive” about
people’s complex financial situations (“Decoding
AI Uses,” Page 27). “That human element …
just couldn’t be replaced by technology,” he says.
Still, robo-advice has an important role to
play—even if it isn’t putting advisors out of work.
We believe the same will hold true for artificial
intelligence. As Sheryl Rowling argues in
our lead Spotlight article, “Advisors Need to
Embrace AI—but Carefully,” Page 23, AI
will be transformative in ways we don’t yet fully
understand. Advisors need to be cautious
in these early stages, but everyone should view
it as a way to better serve clients. “AI will
supplement advisors, making them more efficient,”
tech expert Joel Bruckenstein tells Rowling.
“By streamlining back-office tasks, advisors will
have more client-facing time.”
Even if you’re still wary, it’s hard to resist the
optimism of Fidelity’s Brzezinski as he details how
Fidelity is evaluating AI and its potential.
But he also discusses the guardrails Fidelity is
putting in place. Advisors would be wise to follow
suit. In fact, until clear regulations are put
in place (“Advisors Await SEC Rule for AI,” Page
31), advisors should err on the side of extreme
caution—being as transparent as possible and
documenting uses of AI in their practice.
Besides AI, a second theme emerges in this issue
and serves as a preview to the Spotlight topic
of our next issue: active investing. At the end of
2023, index funds had more assets than active
funds for the first time. It seemed inevitable but
still was a noteworthy moment. This issue’s
Morningstar Conversation (“Value Investing in the
Age of Intangibles,” Page 48), moderated by
Morningstar manager research’s Tony Thomas,
features two great active managers: Bill Nygren of
Harris Associates and David Hoeft of Dodge &
Cox. Both are very candid about the state of active
investing but argue that truly active managers
still have an opportunity to shine. “Too many
active managers clung to the old business model
of providing basically a closet index fund,”
Nygren says. He suggests that investors should
pay attention to active share and the fee they’re
being charged relative to active share. In
our Strategies section, analyst Tony Thorn shows
exactly how to do that using Morningstar Direct
(“Is Your Active Manager Worth It?” Page 42).
Finally, in May, Morningstar turns 40. We wanted
to do something fun to mark the occasion,
so we created a Morningstar-themed crossword
puzzle. Get out your pencils (or pens if you’re
feeling confident) and head over to “The Sun Is but
a Morningstar” on Page 70. Good luck!
morningstar.com/products/magazine 5
 Dispatches
Today’s Concentration
Is Unusual
Market’s favorites
warrant caution.
Phillips Curve LETTER FROM THE BOARD
8 The Adult Thing to Do Marta Norton
Ivory Towers
9 Undeservedly Popular With the market’s largest companies on
everyone’s minds, I’ve stumbled across a few
Advisor Insights articles suggesting that market concentration
11 Oops! You Goofed! Now What? is nothing new. Does the historical data
bear that out? Let’s take a look.
Sustainability Matters
‘Greedy Occupations’ Drive C-Suite
12 Like most things, it depends on how you look
Pay Gap at it. Certainly, market concentration—as
measured by the percentage of index market cap
Global Briefs held in the 10 largest companies—has varied
14 Americas over time. At the start of our time series in
18 Greater Europe E X H I BI T 1 —in the early 1970s—that percentage
19 Asia was falling from highs near 30%. And while
we didn’t quite return to those levels in 2000,
we weren’t far off.
However, the concentration among today’s
top 10 outstrips both periods, topping
32% after climbing steeply over the past six years.
In other words, for the first time in modern
US history, 32 cents of every dollar that
goes into an S&P 500 index tracker heads to
the top 10 companies.
It’s Not All Smoke and Mirrors
Give them credit; they deserve it. When we
investigate the underlying fundamentals
of the 10 largest US companies, it’s clear they
have simply outdelivered the broader
global equity market.
Before we dig into the numbers, a quick reminder:
While stock prices bounce around daily, what
drives companies’ returns over longer periods
is their fundamentals: their current distributions
to shareholders (total yield, or dividends plus
6 Morningstar Q2 2024
buybacks), earnings and expected growth (their
potential future distributions), and, at least
in the intermediate term, their change in
valuation, or the price investors are willing to
pay for them.
We’ve decomposed the returns for the current
top 10 companies over the past six years, as their
market cap has steadily climbed ( EXHIBIT 2 ).
Over that period, the behemoths returned 21.7%
annualized, while the US market broadly returned
11.5%, and stocks outside the US generated
3.6%. While all return drivers contributed to the
total return for the Big 10, the lion’s share—
13.4%—came from the change in sales, or
revenue. Contrast that with the broader US market
or stocks outside the US. While total yield has
contributed more return for those markets, their
change in sales was far more modest.
Woulda, Coulda, Shoulda: What to Do Now?
Investing is a prospective game. We can’t
capture—or relive—the returns that have already
occurred. So, here’s the question for today’s
investors: Will we see the same dominant returns
for today’s top 10 companies that we have over
the past six years?
First, some historical context. As we can conclude
from EXHIB IT 1 , dominance has not tended to
persist indefinitely.
But we’ve seen other sources of variability as well.
For example, the drivers of equity returns have
not been consistent, even for the market’s largest
and arguably most competitive companies.
To demonstrate, we constructed an index of the
market’s top 10 companies in the S&P 500,
rebalanced monthly, and decomposed returns over
rolling five-year periods from 1997 through
January of this year.
This period captures a range of market
environments and a changing mix of dominant
companies. And the primary drivers of return?
Ever-changing. Depending on the environment and
the company makeup, we find margins, sales,
valuation, and—in the recovery from the
global financial crisis—total yield driving the lion’s
share of the top 10’s gains.
 EXHIBIT 1

So, if history is any guide, at some point the Market Concentration on the Rise The 10 largest companies continue to dominate
earnings outperformance of the top 10 companies the S&P 500 index.
should fade to more normal levels, with market
concentration diluting as a result.
40%
02/2024 32.53 Top 10 Holdings
But perhaps, given the magnitude of the artificial as a % of S&P 500
intelligence revolution, it’s hard to believe that 30 Market Cap
we’ll see the same mean reversion we’ve 38.55
observed historically. So, let’s envision a world in
20
which the top 10 companies keep delivering
and ask ourselves how probable that is.
10
For this exercise, we compared analyst earnings HISTORICAL ANALYST CONSENSUS CASE
0
estimates for today’s top 10 companies 12/1973 12/1993 12/2013 12/2028
relative to the S&P 500 over the next five years. Sources: FactSet, Morningstar Investment Management. Data as of Feb. 26, 2024.
We then calculated returns, holding yield and
valuations constant (an attempt at conservatism,
since investors would likely bid the top EXHIBIT 2
10 higher if they demonstrated such persistent
There’s a Reason for Their Dominance Strong fundamentals drove the performance
outperformance), and calculated market
concentration at the end of 2028. of the behemoths.

Return Decomposition, 2018 through January 2024

The results are shown on the right-hand side of Other
USD Total P/E Margins Sales
EX H I B I T 1 . Should analysts prove accurate in Return (%) ≈ Yield (%) + (%) + (%) + (%) + (%)
their estimates, the top 10 companies will account
Largest 10 US Stocks 21.69 2.46 1.92 3.89 13.43 –0.01
for nearly 40% of the US equity market at
the end of 2028. And their aggregate earnings Morningstar US Target Market Exposure Index 11.46 3.59 1.07 2.47 4.26 0.07
would be larger than the present-day earnings Morningstar Global Markets ex-US Index 3.56 3.21 –2.53 3.09 1.56 –1.77
of all public companies in Europe. Possible? Sources: FactSet, Morningstar Investment Management. Data as of Jan. 31, 2024.
Sure. Probable? No.

Remember the Range of Outcomes

Valuation isn’t a timing indicator, except at the
extremes. As we start to forecast improbable
outcomes as the base-case expectation, I’d argue
we are getting closer to those extremes.
And don’t forget, there’s a cost to being wrong
on these extremes. Consider what we’ve
seen after previous periods of extreme market
concentration. From December 1972 through
September 1973, the Ibbotson Associates
Large Cap Stock Index lost 43%. In the wake of
the internet bubble—an arguably equally
transformative technology to AI—that same
large-cap index was down 45%.
The Path Forward
Growing concern about market concentration and
valuation risk doesn’t mean avoiding these
top companies altogether. Timing is tricky, and
the potential is there—however remote—that
these companies continue to defy all expectations
and ride AI to the moon.
But risk-management strategies can help. For the
active subset, I’d argue that individual stock
selection is critical. That’s because, despite the
monolithic perception of these top names,
valuations vary by company. Our investment team
thinks that the more tech-heavy names that are
closer to the AI narrative have benefited from more
enthusiasm about their future earnings, but others,
including those in the communication-services
sector, have far more approachable valuations.
(See also “Are There Any Undervalued Opportunities
Left in AI?” on Page 34.) Thus, sorting among
the subset allows investors to have some exposure
to the market’s dominant firms without taking
on the same amount of sentiment risk.
For passive investors, index selection can help.
A simple suggestion that’s made the rounds:
Switching index construction from a market-cap
weight to an equal-cap weight will reduce
market concentration risk without sitting out the
biggest names altogether. I shouldn’t hide the
ball here: Moving from a market-cap weight to an
equal weight amounts to a roughly 25% reduction
in the largest names. A significant switch.
For those leery of that kind of change in one fell
swoop, introducing the equal-weighted index
for new contributions and leaving the market-cap
index intact for already invested dollars could
help investors avoid exacerbating market
concentration risk. K
Marta Norton, CFA, is chief investment officer at
Morningstar Investment Management.

morningstar.com/products/magazine 7
 Dispatches
The Adult Thing to Do
Sustainable investing
is about accepting
responsibility.
PHILLIPS CURVE
Don Phillips
Investing, to me, has always been an act of
personal responsibility. When my father introduced
me to mutual funds, he explained that our
family set aside the immediate pleasure of buying
some things today to provide greater security
and opportunity in the future.
This model of responsible adult behavior stuck
with me through the years. It seemed only
right that if one was fortunate enough to be in the
position to save for the future, one shouldn’t
transfer the responsibility for their later care to
others or the government. A mature adult
recognizes life’s inherent risks and takes steps
to ameliorate them. There can be no guarantee
that one’s savings will be sufficient to meet
all future needs—we need and have social
safety nets—but there is nobility in shouldering
some of that responsibility, in pulling one’s
own weight rather than simply depending on
a helping hand from others.
My father’s lesson resonated with the fables
I already knew as a child. The industrious ant
storing away food for the winter was the behavior
to emulate, not that of the grasshopper idling
away the summer months. As I grew, tales
of Ben Franklin’s personal and financial discipline,
Ralph Waldo Emerson’s self-reliance, and
William James’ pragmatism strengthened my
conviction that investing was admirable.
James’ exhortation not to take “moral holidays”—
not to turn our back on our shared human
obligation to strive for better futures—particularly
hit home. He advocated rolling up our sleeves
and working to improve things rather than
8 Morningstar Q2 2024
ignoring problems and simply hoping that
we will be magically saved from their
consequences. These lessons furthered my
admiration for investors and told me that assuming
responsibility for the future was embedded
in the American character.
Now, investors are responding to a different
call for responsible action. The dangers
and looming costs of discrimination and
environmental damage have become increasingly
clear. Not surprisingly, the investment community
has stepped up to address these growing
environmental, social, and governance concerns.
After all, investors have already disciplined
themselves to temper their desire for immediate
comfort or ease with a concern for long-term
consequences. That is precisely the mindset
needed to deal with challenges like protecting the
planet or ensuring the humane treatment
of others. Sustainable investing requires shunning
the grasshopper’s lethargy and adopting the
ant’s commitment to preparation.
Not everyone shares this work ethic, however.
There has been a violent backlash among
some American politicians who claim
that ESG issues can and should be decoupled
from investment thinking. They assert
that higher returns can be won by ignoring
“woke” concerns.
If one only considers short-term results, they
might be right. If a company exploits its workers,
if it systematically underpays women or uses
sweatshops to supply parts, its immediate
profits may be higher than if it didn’t. Similarly,
if a company pushes the cleanup costs of its
environmental damage onto local communities
or to future taxpayers, its next-quarter
margins may improve.
But these companies are taking on ESG risks that
they will have to reckon with over the longer
term. Inefficiencies between current prices and
ultimate costs exist in many industries. What
matters is how one deals with them. A responsible
community of adults would try to balance
and correct such mispricing rather than rush
to exploit it.
Sadly, many US politicians—to the horror
of much of the rest of the world—advocate the
exploitation route. Many of the same politicians
who rail against the welfare state because
they oppose its mismatch of payments and
benefits have no objection to transferring the
costs of pollution from this generation to the
next or the toll of discrimination from shareholders
to employees and customers. Some extremist
legislators recently even proposed to make
it a felony to consider ESG issues when investing
taxpayer monies. Yet how can anyone possibly
make an informed investment decision
without considering all its potential costs, both
current and future?
Long-term consequences are often ignored in
politics, where winning the next election
can take precedence over governing for posterity.
Many of today’s leaders offer us William
James’ moral holidays rather than call on us for
sacrifice, as Jack Kennedy once did. As a result,
a responsible movement like ESG can be
derailed when politics clouds the debate. We must
not think in terms of red or blue ideologies but
of mature versus childish responses.
Americans were gifted a heritage of personal
responsibility by our forefathers. We owe it to our
heirs to embrace the teachings of Franklin
and Emerson, to accept the burden of personal
responsibility. It is time to grow up. K
Don Phillips is a managing director at Morningstar. He is
a member of the editorial board of Morningstar magazine.
The views expressed here are not necessarily those
of Morningstar.
Undeservedly Popular
Covered-call stock
funds’ high
distributions don’t tell
the whole story.
IVORY TOWERS
John Rekenthaler
Covered-call stock funds have become bestsellers.
While almost all other actively managed
equity categories recorded net outflows last year,
derivative-income funds (to use Morningstar’s
terminology) attracted $22 billion. Over the
past three years, these funds have seen $65 billion
in net inflows, and through every month of
that period, their net sales have been positive.
The reason for their appeal is obvious: They make
high ongoing distributions. The largest such
fund, JPMorgan Equity Premium Income ETF JEPI,
boasts an official SEC yield of 7.04%. Similarly,
BlackRock High Equity Income BMCIX registers
6.65%, and Invesco Income Advantage U.S. SCIUX
pays 5.77%.
Income that far surpasses that of Treasuries,
coupled with the stock market’s capital gain
potential? Sign me up!
It’s Complicated
Regrettably, the matter is not that simple. The
difficulty begins with their names. I have described
these as covered-call funds because that is
their most common designation. However, since
most covered-call funds are not so labeled—
and several do not even invest in that fashion—
that term is flawed. Therefore, I will now
adopt Morningstar’s phrasing and call them
derivative-income funds.
Historically, as implied by the covered-call
description, derivative-income funds have invested
in an equity portfolio, then sold call options
on those positions. Doing so generated cash
for shareholders. Of course, those transactions did
not acquire something for nothing. The
trades gave as well as received. If equities were
to rally, the funds would concede potential
capital appreciation, as the owners of those call
options could purchase their stocks at below-
market prices.
These days, rather than trading options directly,
some derivative-income funds achieve the
same result indirectly by owning equity-linked
notes, or ELNs. In effect, these notes deliver
the combined performance of two distinct
investments: the underlying stock and the sale
of its call option.
This divergence mucks up the fund’s reported
yields. Although the investment techniques
of (1) selling covered calls and (2) buying ELNs
perform similarly—the marketplace is too
efficient for them to greatly diverge—they are
taxed differently. By IRS regulations, the proceeds
from selling options are classified as capital
gains (usually short term), while ELN returns are
nonqualified income.
Thus, the SEC yield calculations for derivative-
income funds are misleading. The three
previously referenced funds have high official
yields because they hold ELNs. In contrast,
rival offerings that sell call options rather than
purchase ELNs have paltry SEC yields because
their payments consist mostly of capital
gains, which are omitted from those computations.
For example, Global X S&P 500 Covered Call ETF
XYLD has an SEC yield of 0.95%, while First
Trust BuyWrite Income ETF FTHI registers 1.14%.
Conflicting names, conflicting tactics, conflicting
yields. What’s an investor to do?
The Correct Yardstick: Total Returns
The answer is easy: Ignore the funds’ payouts.
I realize that sounds silly, as distributions,
either in the form of income or capital gains, are
why derivative-income funds exist. But those
payments are deceptive because they represent
the benefit from the derivative trade but not
its cost. Effectively, derivative-income funds swap
tomorrow for today. Perhaps those exchanges
will prove worthwhile. One cannot know, however,
by assessing only half the deal.
Happily, the statistic of total return measures
the entire package. It accounts not only for
the money that derivative-income funds receive
for surrendering potential capital growth
but also for the extent to which that growth is
forfeited. If the latter exceeds the former,
derivative-income funds are merely a parlor trick.
Investors who seek upfront cash would be
better off purchasing a conventional fund and
then periodically selling its shares. In that
fashion, they could duplicate the derivative-income
funds’ ongoing payouts while achieving a
higher future return.
The logical rivals to derivative-income funds are
dividend-stock funds and equity-income
funds. Wait, you say, two of the derivative-income
funds mentioned earlier have equity income
right in the name. How can such funds be rivals
to themselves? The answer: There are two
flavors of equity-income funds. The traditional
variety invests in stocks without using derivatives.
However, some newer “equity-income” funds
do incorporate such investments and, thus, land
in the derivative-income category.
Sigh. These funds are so messy! Nevertheless,
let’s see the results. EXHIB IT 1 shows the average
five-year total returns for all derivative-income
funds that hold large-blend US stocks (few have
10-year records) compared with those for the
dividend-stock and traditional equity-income funds
managed by the three largest discount brokers,
Vanguard, Fidelity, and Charles Schwab SCHW.
Count me unimpressed. I’m not sure what went
on with Schwab Dividend Equity SWDSX, but
Vanguard’s and Fidelity’s pedestrian competitors
thumped most derivative-income funds.
(In fact, Vanguard’s dividend funds outgained all
of them.) The natural counterargument is that
derivative-income funds are safer than stock
market indexes. Fair enough, but so are dividend-
stock or old-school equity-income funds.
Consequently, the risk-adjusted outcomes for
derivative-income funds are similarly disappointing,
as shown in EXHIB IT 2 .
morningstar.com/products/magazine 9
 Dispatches

Supporters of derivative-income funds can claim, which concerns not only derivative-income In contrast, if stocks are languishing, derivative-
offer two additional defenses. One, the category’s funds but also other high-distributing strategies, income funds may well receive something for
largest fund, JEPI, has recorded a higher cannot be so easily dismissed. Because nothing. After all, they are paid to surrender their
Sharpe ratio since its May 2020 inception than derivative-income funds concede capital growth, upside. If there is no upside, then derivative-
the above rivals. True, but because that their worst relative performance occurs during income funds enjoy a free investment lunch. They
outperformance occurred solely during the fund’s bull markets. eat the money they collected from selling call
first 18 months, with nearly all the fund’s options (or the interest paid by their equity-linked
assets arriving afterward, the achievement was In theory, that is correct. As with other stock notes) while ceding nothing in return.
largely theoretical. funds, the highest relative gains for derivative-
income funds come when stock prices That argument makes sense. However, it
The Bull-Market Rebuttal increase. But because derivative-income funds assumes a streamlined model, where equities
The other rebuttal is that derivative-income funds sign away some of their potential capital in unison either rise, stagnate, or fall. In
perform best in choppy markets rather than growth, they will likely trail traditional equity funds practice, though, fund portfolios usually do all
ones boasting a double-digit annualized gain. This during such times. three. That is, even if the overall stock
market is moping, many derivative-income
fund positions will be increasing—and
EXHIBIT 1
thus potentially called away. Similarly, during
bull markets, some of the funds’ holdings
Derivative-Income Funds Lag Traditional Rivals
will trail the averages, thereby preventing the
call option from being exercised.
Annualized 5-Year Total Returns
5-Year Return %
Further muddying the waters is that, for
Vanguard Dividend Appreciation ETF 13.84
derivative-income funds, the pattern of stock
Vanguard Dividend Growth 13.50 market returns is as important as the
Fidelity Equity-Income 12.27 level. The more volatile security prices are, the
5-Year Return %
more valuable call (or put) options become.
Vanguard Equity-Income 11.85
Because derivative-income funds sell options,
Vanguard
Fidelity Dividend
Equity Appreciation
Dividend Income ETF 11.83 13.84
that bromide works in reverse for them.
Vanguard DividendFunds
Derivative-Income Growth 10.19 13.50 They struggle when market volatility increases
Fidelity and profit when it subsides.
SchwabEquity-Income
Dividend Equity 8.94 12.27
Vanguard Equity-Income 0 3 6 9 11.85 12 15 Case Study Number One: the Mid-1980s
Source: Morningstar Direct. Data from Jan. 1, 2019, through Dec. 31, 2023.
Fidelity Equity Dividend Income 11.83 An example of the former occurred during the
Derivative-Income Funds 10.19 mid-1980s. At that time, funds that wrote
Sharpe Ratio
covered calls did so mostly with bonds, as opposed
Vanguard
Schwab DividendEquity
EXHIBIT 2 Dividend Growth 8.94 0.77
to equities. But the same principles applied.
… EvenDividend
Vanguard on a Risk-Adjusted
Appreciation ETF Basis
0 3 6 9 0.76 12 15 If bond prices moved sharply in one direction
Fidelity Equity-Income 0.66 and then the other, those funds could become
Annualized 5-Year Sharpe Ratios two-time losers. They would suffer once
Vanguard Equity-Income Sharpe Ratio 0.63 when rising bond prices forced them to surrender
Vanguard DividendFunds
Derivative-Income Growth 0.60 0.77 their winners and then again when they
Vanguard Dividend Appreciation 0.76 held their entire portfolio through the bond
Fidelity Equity Dividend Income ETF 0.59
market’s decline.
Fidelity Equity-Income
Schwab Dividend Equity 0.45 0.66
Vanguard Equity-Income 0 0.2 0.4 0.63
0.6 0.8 1.0 That is exactly what happened. From 1986 through
Derivative-Income Funds 0.60 1987, 10-year Treasury yields went nowhere.
They exited the 24-month period at virtually the
Fidelity Equity Dividend Income 0.59
same amount at which they had entered it.
Schwab Dividend Equity 0.45 Unfortunately for those option-selling bond funds,
0 0.2 0.4 0.6 0.8 1.0 those endpoints were deceiving. Treasury
Source: Morningstar Direct. Data from Jan. 1, 2019, through Dec. 31, 2023. bonds initially rallied for 14 months, during which

10 Morningstar Q2 2024
the funds’ holdings were called away. Bond prices
then sank over the next eight months. Although
the funds’ losses were cushioned by their
call-option proceeds, their net asset values
nevertheless dropped significantly.
That episode scotched the future of covered-call
bond funds (which were officially named
“government-plus bond funds” and unofficially
dubbed by their disappointed shareholders
“government-minus funds”). They disappeared from
the earth—or at least the US fund market—
for several decades.
Case Study Number Two: the Pandemic
In 2020, history repeated itself. This time,
the surge in volatility affected stocks rather than
bonds, and the fall preceded the rise, but the
investment logic was identical. When covid-19
sent US equities to a 34% monthly loss,
the revenue that derivative-income funds had
received from selling call options proved
scant consolation. Then, when stocks’ fortunes
abruptly reversed, derivative-income funds
missed much of the rally, as their stocks were
called away. Whipsawed!
For the year, the S&P 500 index gained 18.4%,
while the four derivative-income funds that are
explicitly managed to the S&P 500 lost an average
of 0.11%. Ouch!
Nor were the performances of those funds
consistent. Unknowingly, their shareholders had
participated in something of an investment
lottery, as the calendar-year returns on those
funds ranged from positive 7.30% to negative
3.66%. The upshot: There is no such thing
as a predictable derivative-income fund. Not only
do they perform differently from the overall
marketplace, but even funds that track the same
benchmark can diverge widely. Derivative-income
investors fly blind.
Conclusion
I don’t understand why investors have become
so fond of derivative-income funds. Yes, of
course, I realize that people like high distributions.
What I don’t understand is why. Clearly, these
funds do not receive something for nothing. They
pay a price for those income/capital gains
payouts—a price that can be readily measured
with their total returns, which have been
unspectacular. After all, we have been here before.
At least in kind, the 2020 results for these
funds resemble the 1986–87 period for disgraced
covered-call bond funds.
None of which is to say that derivative-income
funds cannot perform well. They can, under certain
conditions. If those conditions persist long
enough, such funds could indeed justify their
purchases. But why invest on faith, especially
when the returns on such funds vary so
greatly and when there is insufficient evidence
to distinguish the category’s future winners
from its losers? To that rhetorical question, I have
no answer. K
John Rekenthaler is a vice president at Morningstar
Research Services LLC. He is quick to point out that the
views expressed in Ivory Towers are his own.
Oops! You Goofed!
Now What?
Four steps to help
you recover.
ADVISOR INSIGHTS
Sheryl Rowling
It’s inevitable. You made a mistake. Whether
it’s a trading error, a bust on a tax return,
or a missed opportunity, it’s bound to happen.
You’re human. The key to keeping the
client is all in how you handle it. I recommend
a four-step process:
“slip through the cracks?” Was a number
1 Buy time.
2 Apologize.
3 Make it right.
4 Make sure you don’t do it again.
morningstar.com/products/magazine
Step 1: Buy Time
If you found the mistake, take time to figure out
what happened and quantify the cost (or gain)
to the client. If the client found the mistake,
let them air their grievances and get it out. Don’t
try to defend yourself or interrupt. When
they are done, acknowledge what was said and
commit to calling them back. Set a time
and keep it. The goal of buying time is to give them
an opportunity to cool down while you gather
all the facts.
Step 2: Apologize
It doesn’t matter how it happened. It doesn’t
even matter who was at fault. You need
to apologize. It will immediately put your client
at ease. By accepting responsibility, you
take the antagonism off the table and create
an opening for agreement.
Step 3: Make It Right
Here comes the big swallow. If you did something
that left your client out of pocket, you need
to pay the price to make them whole. If you’re
lucky, it won’t be a lot of money. If it is a lot, you
might need to call your insurance company.
(On a side note, you should always carry errors
and omissions insurance. As my attorney friend
once said to me, “I like my clients. If I make a
mistake that costs them money, I want them made
whole. But I don’t want to go out of business
paying for it!”)
What if an employee blew it? Unfortunately, that’s
part of the cost of doing business. It doesn’t
matter if you made the mistake personally or your
employee did it, you are still responsible.
(Another side note. Should you punish your
employee? If it was an honest mistake, no.
Only employees that aren’t working never make
a mistake!)
Step 4: Make Sure You Don’t Do It Again
How did the mistake happen? Did something
transposed? Did a note in the file get overlooked?
No matter what happened, a mistake is a
result of a workflow failure. Maybe you need to
add a review step or add a box to a checklist.
11
 Dispatches
Play detective by working the mistake backward
and solving for what would have prevented
it. Clients can accept rare mistakes but not
repeated ones.
The Bottom Line
Mistakes happen. How you handle them can
make the difference between keeping or losing
a client. What if a client is still mad after you
apologize and make it right? Give it time. Often,
they will cool off and all will be fine. If not?
Let them go. You can’t promise to be perfect. You
can only promise to do your best. K
Sheryl Rowling, CPA, is an editorial director at Morningstar.
The views expressed here are not necessarily those
of Morningstar.
‘Greedy Occupations’
Drive C-Suite Pay Gap
Women lack
representation in
the highest-paying
jobs and industries.
SUSTAINABILITY MATTERS
Jackie Cook
As more women graduated from US colleges
in the 1970s, they began to close the pay
gap. From the mid-1980s on, women graduates
have outnumbered men. But sometime in
the 1990s, the gap in earnings between male and
female college graduates stopped narrowing.
Today, the gap in annual earnings isn’t noticeably
different from what it was in 1995.
This is one of the labor market puzzles that Claudia
Goldin illuminated in her Nobel Memorial Prize in
12 Morningstar Q2 2024
Economic Sciences acceptance speech last fall.
Goldin, an economic historian and labor
economist, was celebrated for her groundbreaking
work into why gender-based pay differentials
persist—worldwide and in the US—
despite major labor market shifts over the
last 120 years.
Where the Pay Gap Is Greatest
Goldin found that the gap is greatest in the
business sector among senior executives, finance
professionals, and banking. She coined
the term greedy occupations to describe job
roles that demand more face time, client
contact, and networking. These occupations
have less flexibility, less predictability, and
longer hours.
My own sleuthing, using Morningstar’s Executive
Insight dataset with pay data on C-suite
executives, underscores Goldin’s findings. At the
very top of the US’ largest corporations, men
continue to be paid more than women. Roles held
by named executive officers, or NEOs, whose
annual compensation is reported in company proxy
statements, are perhaps the “greediest” jobs,
as Goldin defines the term.
According to last year’s corporate pay disclosures,
women holding the senior-most executive roles
in the largest companies in the US earned
around 85 cents for every dollar earned by men in
these roles. This ratio has ranged between
75% and 88% over the past 10 years.
The 1963 Equal Pay Act made sex-based wage
discrimination illegal. Men and women
performing substantially the same jobs in the
same place of work must be paid equally.
Our data shows that women are indeed paid at
least as well for the same work, looking at
specific titles typically held by the highest-paid
executives at S&P 500 companies. At the
very top, female CEOs outearned their male
counterparts across the S&P 500 in 2022 by an
average of $2 million! And female CFOs
were paid $1 million more, on average. Note
that because the number of women in
some senior executive categories is very low,
one lucrative signing bonus can skew the
year’s average. Overall, though, there does not
appear to be a bias against women in pay
outcomes across the largest NEO role categories.
What Explains the Pay Gap?
But there is a gendered division of labor at the top
( EXHIB IT 1 ). The NEO pay differential arises
because women are underrepresented
in the highest-paying corporate executive titles.
Women held the majority, or 64%, of chief
human resources officer titles, but this role was
the lowest paid among the NEOs of S&P 500
companies in 2022. Women held almost
40% of chief legal officer roles, the second-lowest
paid of the major senior executive titles.
Meanwhile, women held only 8% of S&P 500
CEO positions, the highest-paid role. In fact,
women are least-represented in all three of the
highest-paid C-suite titles.
Grouping S&P 500 companies into broad industry
categories, I compared NEO pay across
categories with at least 20 companies. The three
groups with the highest average NEO pay are
also the industry groups with the lowest
representation of women in these roles. Tech
companies, financial firms, and companies in the
hospitality and entertainment grouping were
least likely to have at least one female NEO
in 2022. Yet, NEOs in these groups were paid more
than $9 million, on average, in 2022. By contrast,
86% and 74% of utilities and industrial companies,
respectively, had at least one female NEO.
Yet average NEO pay across these groups was
well below $6 million.
Women are scarcer in large companies and at
higher levels of the corporate hierarchy.
Combining Morningstar’s NEO Executive Insight
data with Sustainalytics’ impact metrics on
women’s workplace and senior management
representation for 2,200 US companies,
I was able to compare the gender gap at three
levels within the corporate hierarchy and
across company size ( EXHIB IT 2 ). This analysis
shows that women become progressively scarcer
in companies with higher market capitalizations.
While their representation in senior
management increases slightly with company
size, women’s participation in senior management
and C-suite roles, as a percentage of total
positions, remains far below their participation
 EXHIBIT 1

in the general workforce, even at the largest, Women Are Underrepresented at the Top of the C-Suite
most visible companies.

$20M 80%
Across the S&P 500’s annual NEO cohort
data, the representation of women has increased $20M 80% 16.7
8 percentage points over the last 10 years to 64
15 60
16.5% in 2022 from 8.4% in 2013. This is 16.7

by Women
going in the right direction, but it’s a rate of 64
15 60
change that, projected linearly, only delivers

Women
10 40 39

Pay Pay
gender parity well after 2060. Among CEOs, gender

TitlesbyHeld
parity lies even further out. Even the youngest 8.2

C-SuiteC-Suite
10 40 7.0 39
among today’s working women will likely 6.0

Titles Held
5 20 8.2 5.4
have a more difficult time reaching the C-suite Average 7.0 17 4.6 4.2
16

C-SuiteC-Suite
13 13 6.0
and the top of the corporation than their 50 8 200 5.4
17 4.6 4.2
Average

male peers of the same age. 16

CEO CTO13 COO13 CFO Business Chief CHRO
0 0 Named8Executive Officer Title Head Legal
According to pay disclosures in companies’ CEO Business Chief
Source: Morningstar’s Executive Insight data, 2022. CTO COO CFO CHRO
2023 proxies, $21.5 billion was awarded to the Named Executive Officer Title Head Legal
roughly 2,400 top-paid workers at S&P 500
companies in 2022. Of this amount, $18.5 billion
went to men and $3 billion, or 14%, went EXHIBIT 2

to women. This persistent gender representation The Bigger the Company, the Lower the Percentage of Women Workers
50% 49
gap translates into an unadjusted gender
Avg % of Women
pay gap across society. Pew Research Center 44 43
50% 49 in the Workforce
analysis shows that, across the US workforce, 40 39 Avg % of Women
women earned 82% of what men earned, 44 43 in
Avgthe%Workforce
of Women in
40 39
per hour, in 2022. 30 Senior Management
Avg % of Women in
30 21 23
What Needs to Change? 20 19 Senior Management
Avg % of
18
Understanding the labor market forces 14 15 15 23 16 Women NEOs
20 21 Avg % of
contributing to the gender pay gap can help to 18 10 19
inform effective public policies and corporate 14 15 15 16 Women NEOs
0
practices. Goldin finds that, for highly 10 Less Than $1B $1B to $5B $5B to $10B More Than $10B
qualified workers, female earnings plummet 0 Market Capitalization
more noticeably with the birth of the first Source: Less Than $1B $1B to $5B $5B to $10B More Than $10B
child, and women’s earnings relative to men’s Market Capitalization
decrease across their lives. She concludes Source: Morningstar’s Executive Insight data; Sustainalytics’ impact metrics data. Data representing 2,200 US companies in 2022.

that structural aspects of the labor market are

affected by the distribution of household
responsibilities. When faced with the difficulties
of balancing demanding jobs and childcare,
couples often make career trade-offs that
thwart efforts to close the gender gap in high-
paying business contexts. Social policies that
support parents can help. But no one policy
or intervention is going to erase the multifaceted
gender gap.
pay-transparency measures. In 2023, several gender pay gap. Perhaps a fundamental approach
shareholder resolutions asked companies to report to addressing the gender pay gap in workplaces
median adjusted and unadjusted gender and society is to stem the inexorable rise in senior
and racial pay gaps. These were supported by 38% executive and CEO pay. K
of shareholders, on average. At Nike NKE
and Oracle ORCL, these two resolutions earned Jackie Cook is director, stewardship, product strategy and
development, at Morningstar Sustainalytics.
majority support in the second half of 2023.

Still, progress is being made, however modest. The gender imbalance at the top of the corporation
Focusing on pay itself, shareholders suggests that compensation structure and
have thrown their weight behind greater the compensation-setting process are driving the

morningstar.com/products/magazine 13
 Dispatches
Global Briefs
TRENDS
Can a 60/40 Portfolio Maintain Its Risk-Adjusted Edge?
Portfolio diversification didn’t boost returns during
2023’s generally bullish market. A plain-vanilla
60/40 portfolio of US stocks and high-quality
bonds gained about 18% for the year, while
diversifying into other asset classes generally led
to lower returns.
A basic 60/40 portfolio has been tough to beat
over longer periods, too. We tested the
value of diversification over rolling 10-year periods
starting in 1976. A broadly diversified portfolio
improved risk-adjusted returns—as measured by
the Sharpe ratio—versus an all-stock portfolio
during most rolling 10-year periods between May
1993 and December 2016. However, it posted
weaker risk-adjusted returns over most periods
since then.
Rolling 10-Year Sharpe Ratios Relative to a Stocks-Only Benchmark
0.75
0.50
0.25
Net Effect on Risk-Adjusted Returns
–0.25
–0.50
12/1985 12/1990 12/1995
Source: Morningstar Direct. Data as of Dec. 31, 2023. Note: The IA SBBI US Large Stock and IA SBBI US Intermediate Term Government indexes (which both have longer performance histories) are the baseline for the 60/40 Portfolio.
The Diversified Portfolio includes a 20% weighting in larger-cap domestic stocks; 10% each in developed- and emerging-markets stocks, Treasuries, core bonds, global bonds, and high-yield bonds; and 5% each in small-cap stocks,
commodities, gold, and REITs. Both portfolios assume annual rebalancing.
14
The basic 60/40 portfolio, on the other hand, fared
better than the stocks-only benchmark about
87% of the time going back to 1976. It also
came out ahead of the more broadly diversified
portfolio in every rolling 10-year period since
the period starting in late 2004.
But diversification strategies that have worked
in the past may not work in the future. That
is particularly true now that the landscape has
shifted for both interest rates and inflation.
In a period of ongoing interest-rate increases and/
or above-average inflation, Treasuries and
other high-quality bonds would likely be less
reliable diversifiers, although they still have merit
as core portfolio holdings. Meanwhile, over
the past 20 years, correlations versus an all-stock
12/2000 12/2005
benchmark have edged up for several asset
classes, including corporate bonds, global bonds,
high yield, municipal bonds, and REITs, and
many of these categories have posted losses in
periods of equity market stress. In such periods,
gold, commodities, and some alternative
investment strategies have been more compelling
from a diversification standpoint.
In their recent “2024 Diversification Landscape,”
Morningstar’s Amy C. Arnott, Christine
Benz, and Karen Zaya took a deep dive into how
correlations have changed and what those
changes mean for investors and financial advisors
trying to build well-diversified portfolios.
Some of these trends are highlighted on Pages 16,
19, and 21 in this section of the magazine.
Differences
in Sharpe Ratio
60/40 Portfolio
vs. Stocks Only
Diversified Portfolio
vs. Stocks Only
12/2010 12/2015 12/2023
 EXHIBIT 1

Waiting for Small Caps Small Caps Have Traded at a Big Discount in Recent Years

30
AMERICAS Morningstar US

Price/Earnings Ratio (Trailing 12 Months)

United States Large-Mid Cap Index
23.40

20 Large-Cap Long-Term Avg

Now could be a good time to consider US small 19.20
caps. Contrary to a broad academic consensus that
small-cap stocks tend to outperform large caps, Small-Cap Long-Term Avg
small caps have trailed for an extended period, 17.20
10
which suggests they could rebound. Valuations are
Morningstar US
compelling, too. In terms of price/earnings, Small Extended Index
small-cap valuations are low relative to their own 15.17
0
history and large caps ( E XH IB IT 1 ). Morningstar
12/2008 12/2013 12/2018 12/2023
equity analysts’ stock-by-stock reviews of small caps’
Source: Morningstar Direct. Data as of Dec. 31, 2023.
price/fair value estimates also suggest they’re
cheaper than large caps. Finally, small caps are a
fruitful hunting ground for active managers, who EXHIBIT 2
should benefit by avoiding a rising number of
Maintaining a High-Quality Small-Cap Portfolio Requires Active Sector Shifts
low-quality companies in the small-cap universe.

To test the effect of quality on performance, 20

o Energy
we bucketed active funds’ holdings and stocks in
8.08
the Russell 2000 Index into quintiles based on
10 a Technology
quality, which we defined as an equally weighted
mix of trailing 12-month return on equity and debt/ 6.55
capital ratios. We found that index performance 0 y Financial Services
Active Weight %

closely followed quality. In the 15 years through –7.38

2023, the highest-quality quintile beat the –10 d Healthcare
lower-quality ones. Although there were brief –7.57
–20
periods when low quality outperformed, most
recently in the 2020–21 rally after covid vaccines 03/2009 03/2013 03/2018 12/2023
Source: Morningstar Direct. Data as of Dec. 31, 2023. Data relative to the iShares Russell 2000 ETF.
were released, we learned that it pays to avoid
low-quality businesses over the long term.

However, when we ran the same analysis for

active small-cap funds’ holdings, performance
did not correlate as neatly with quality levels as it
did with the Russell 2000 Index. For example,
bucket 4 (the second lowest in quality) posted the
best results over the same 15-year period,
while bucket 1 (the highest quality) finished last.
Additionally, the spread between first and fifth
quintiles’ returns was more compressed than that
of the index. This was likely due to active
managers’ limited exposure to the index’s highest
quality—and highest-returning—bucket 1 stocks.
So why didn’t active managers simply load up on
high-quality stocks? Quality, it turns out, is a
moving target, making it difficult for active
managers to consistently invest in a portfolio
of the highest-quality stocks. In fact, managers
seeking to do this needed to be adept in
their portfolio positioning and make big, potentially
career-risking sector bets. EX HI BI T 2 shows
the largest active underweights or overweights—
and rapid shifts between them—required to
maintain exposure to the highest-quality stocks.
Another reason managers struggle to own quality
is that index composition could also push
them into lower-quality areas of the market. One
such example is biotech, which in the small-cap
universe often consists of nascent businesses
with little to no earnings. They can often be highly
indebted and reliant on the commercial success
of a single drug, so they struggle with our
definition of quality. That said, the industry is hard
to ignore—particularly for growth managers,
given its prominence in the Morningstar US Small
Growth Index, where it peaked near 12% in
mid-2021 before falling to roughly 9% by year-end
2023. The median growth manager owned a
lot, though remained slightly underweight versus
the index. Despite having its moments, biotech
was a net drag on the Morningstar US Small Cap
Healthcare Target Market Exposure Index in

morningstar.com/products/magazine 15
 Dispatches
WKHɖɚ\HDUSHULRGWKURXJKɗɕɗɘ:LWKRXWELRWHFK
VWRFNVWKHLQGH[ZRXOGKDYHJDLQHGURXJKO\ɗɚ
PRUHWKDQLWGLG
2QWKHRWKHUVLGHRIWKH0RUQLQJVWDU6W\OH%R[
YDOXHPDQDJHUVIDFHGDVLPLODUGLOHPPD
ZLWKUHJLRQDOEDQNV7KHEDQNLQJEXVLQHVVPRGHO
LVLQKHUHQWO\OHYHUDJHGDQGUHJLRQDOEDQNV
KDYHPRUHJHRJUDSKLFDOO\FRQFHQWUDWHGGHSRVLW
EDVHVDQGOHVVGLYHUVLīHGEXVLQHVVHVFRPSDUHG
ZLWKODUJHUEDQNV9DOXHPDQDJHUVWHQGHG
WRHPEUDFHUHJLRQDOEDQNVDVWKHLUZHLJKWLQWKH
Morningstar US6PDOO9DOXH,QGH[LQFUHDVHG
WRURXJKO\ɗɕE\ODWHɗɕɗɗ7KH\VKRXOGKDYH
TRENDS
'LYHUVLīFDWLRQ,QVLJKWUS Treasuries Provide
/RQJ7HUP5HVLOLHQFH
5HFHQF\ELDVPLJKWFDXVHDQLQYHVWRUWREDON
DWWKHXVHIXOQHVVRIUS7UHDVXULHVLQDSRUWIROLR
DVFRUUHODWLRQVZLWKUSVWRFNVKDYHVSLNHG
VLQFHɗɕɗɖ%XWRYHUWKHORQJWHUP7UHDVXULHVDQG
RWKHUKLJKTXDOLW\JRYHUQPHQWEDFNHGIDUH
VXFKDVDJHQF\PRUWJDJHVUHPDLQVRPHRIWKH
PRVWFRPSHOOLQJGLYHUVLīHUVIRUDSRUWIROLR:KHQ
LQWHUHVWUDWHVDUHVWDEOHRUIDOOLQJWKHVH
RĭHULQJVSURYLGHDPRGHVWEXWUHOLDEOHUHWXUQWKDW
EDODQFHVWKHYRODWLOHVZLQJVLQKHUHQWLQVWRFNV
5LVNLHUDOORFDWLRQVVXFKDVKLJK\LHOGDQG
Taxable Bonds: Rolling Three-Year Correlations vs. Morningstar US Market Index
ɖɕ
ɕɚ
ɕ Yr Treasury Bond
ɘ<HDU&RUUHODWLRQ
śɕɚ
śɖɕ
ɖɗɗɕɕɗ ɖɗɗɕɕɞ
6RXUFH0RUQLQJVWDU'LUHFW'DWDDVRI'HFɘɖɗɕɗɘ
ɖɛ
DYRLGHGWKHP)URPɗɕɕɞ to ɗɕɗɘWKH0RUQLQJVWDU
US)LQDQFLDO6HUYLFHV,QGH[ZRXOGKDYHQHDUO\
GRXEOHGLWVFXPXODWLYHJDLQZLWKRXWUHJLRQDOEDQNV
'HVSLWHWKHVHLVVXHVDFWLYHPDQDJHUVKDGD
EHWWHUFKDQFHRIRXWSHUIRUPLQJLQVPDOOFDSVWKDQ
WKH\GLGKLJKHUXSWKHPDUNHWFDSVSHFWUXP
$FWLYHIXQGVLQWKHVPDOOEOHQG0RUQLQJVWDU
&DWHJRU\EHDWWKH5XVVHOOɗɕɕɕ,QGH[LQURXJKO\
ɛɞRIWKHUROOLQJWKUHH\HDUSHULRGVIURP
ɗɕɕɞWKURXJK\HDUHQGɗɕɗɘ,QFRQWUDVWDFWLYH
ODUJHJURZWKFDWHJRU\IXQGVRXWSHUIRUPHG
WKH5XVVHOOɖɕɕɕ*URZWK,QGH[MXVWɘɘRIWKH
WLPHGXULQJWKHVDPHSHULRG
HPHUJLQJPDUNHWVGHEWRQWKHRWKHUKDQGDUH
SRRUGLYHUVLīHUVUHODWLYHWRHTXLW\6ZLIWO\ULVLQJ
LQWHUHVWUDWHVPD\SODFHUS Treasuries at a
VWUXFWXUDOGLVDGYDQWDJHEXWWKHUHFDOLEUDWLRQ
SHULRGLVW\SLFDOO\UHODWLYHO\VKRUWDQGIROORZLQJ
WKDWUHVHWLVZKHQWKHVHDOORFDWLRQVSURYLGH
ORZDQGDWWLPHVQHJDWLYHFRUUHODWLRQVWR
HTXLWLHV$SRUWIROLRFRQVWUXFWHGIRUORQJWHUP
UHVLOLHQFHZLOOEHZHOOVHUYHGE\DKLJKTXDOLW\
JRYHUQPHQWERQGDOORFDWLRQLQSDUWLFXODU
RQHZLWKUS7UHDVXULHVDQGDJHQF\PRUWJDJHV
Morningstar US
Core Bond
ɕɛɞ
0RUQLQJVWDU86ɖɕ
ɕɛɖ
Morningstar US
Cash T-bill
śɕɕɖ
ɖɗɗɕɖɛ ɖɗɗɕɗɘ
4XDOLW\SOD\VDELJUROHLQVPDOOFDSVWRFN
SHUIRUPDQFH\HWDFWLYHIXQGSRUWIROLRVŒDJJUHJDWH
TXDOLW\H[SRVXUHKDVQŒWEHHQGUDVWLFDOO\GLĭHUHQW
IURPWKHLUEHQFKPDUNVŒ6RLQYHVWRUVVKRXOG
SUHVVVHOISURIHVVHGKLJKTXDOLW\PDQDJHUVIRUWKHLU
GHīQLWLRQRITXDOLW\DQGKRZWKH\GLĭHUHQWLDWH
WKHPVHOYHVIURPWKHLUSHHUVDQGLQGH[HV
6LPLODUO\LQGH[FRQVWUXFWLRQPHDQVWKDWORZTXDOLW\
DUHDVOLNHELRWHFKQRORJ\DQGUHJLRQDOEDQNV
FDQEHKDUGIRUPDQDJHUVWRLJQRUHVRH[SHUWLVH
LQWKHVHDUHDVLVSDUDPRXQWDVWKH\FDQKDYHD
ELJLQĬXHQFHŜIRUEHWWHURUZRUVHŜRQSHUIRUPDQFH
0DQDJHUVZKRPDNHELJEHWVIRURUDJDLQVWVXFK
ORZTXDOLW\DUHDVVKRXOGEHDEOHWRGLĭHUHQWLDWH
WKHPVHOYHVZLWKDQDO\WLFDORUUHVRXUFHHGJHV
)LQDOO\DOWKRXJKLWFDQEHKDUGIRUPDQDJHUVWR
PDLQWDLQFRQWLQXDOH[SRVXUHWRWKHKLJKHVWTXDOLW\
VWRFNVVHFWRUZHLJKWVFDQRĭHULQVLJKWLQWR
KRZZHOOWKH\ŒYHEHHQDEOHWRLGHQWLI\WKHVHKLJKHU
TXDOLW\VWRFNVEHIRUHWKHPDUNHWUHZDUGVWKHP
(ULF6FKXOW]'UHZ&DUWHUDQG&KULV7DWH&)$DUHPDQDJHU
UHVHDUFKDQDO\VWVDW0RUQLQJVWDU5HVHDUFK6HUYLFHV//&
7KH7HPSWDWLRQRI
7UHQG\,QYHVWPHQWV
1HZLQYHVWLQJWUHQGVFDQEHH[FLWLQJEXWWKH\ŒUH
QRWDOZD\VDJRRGīWIRULQYHVWRUVŒSRUWIROLRV
RUWKHLUORQJWHUPJRDOV%XWEHFDXVHEHKDYLRUDO
ELDVHVRIWHQLQĬXHQFHWKHGHVLUHWRRZQWKHP
WKH\FDQEHKDUGWRUHVLVW7RKHOSDGYLVRUV
EHWWHUFRDFKWKHLUFOLHQWVZKRDUHFRQVLGHULQJ
MXPSLQJRQWKHEDQGZDJRQRIDWUHQGZHVRXJKW
WRXQGHUVWDQGKRZLQYHVWRUVWKLQNDERXWWKHP
2XUUHVHDUFKVXJJHVWVWKDWLQYHVWRUVODFN
IDPLOLDULW\ZLWKWUHQG\SURGXFWVDUHRYHUFRQīGHQW
DQGWHQGWRZDUGVKRUWWHUPWKLQNLQJ$GYLVRUV
KDYHDNH\UROHLQKHOSLQJLQYHVWRUVRYHUFRPH
WKHVHFKDOOHQJHV
What Is Trendy?
:HFRQVXOWHGLQGXVWU\H[SHUWVDQGREVHUYHG
PHGLDPHQWLRQVWRLGHQWLI\QLQHDVVHWFODVVHVWKDW
ZHWKLQNKDYHEHFRPHUHFHQWLQYHVWPHQW

trends: business development companies,
commodities, cryptocurrency, private credit, private
equity, REITs, semiliquid interval funds, separately
managed accounts via direct indexing, and
structured products. We surveyed 948 US investors
not yet in retirement about these trending
asset classes via the online Prolific platform.1
We first queried them about how knowledgeable
they thought they were about each of the
nine asset classes. For each asset class that
investors indicated they at least had encountered
in passing, we asked them whether they owned
the asset and whether they were planning
on increasing, decreasing, or keeping the same
amount of their holdings in the asset. For those
who said they planned to change their holdings,
we asked them to explain why. Investors’
rationale for why they wanted to change their
holdings was coded using a scheme of common
investing motivations, including accessibility,
confidence, curiosity, customization, diversification,
liquidity, macroeconomics, returns, social, taxes,
transparency, timing, and volatility.
Two human raters then independently coded
a subset of 20% of the responses to establish
inter-rater reliability. Next, the two raters resolved
any codes where they disagreed to create a
“gold standard.” From there, we developed a series
of prompts for each code and input them into
the ChatGPT 3.5 Turbo artificial intelligence
platform, which coded the rest of the responses.
To ensure the validity of the AI’s codes, the
prompts were tested against the gold standard
to establish reliability before coding the rest
of the data. The AI then coded the remaining data,
using majority rules over three trials.
Knowledge and Ownership of Assets
In our sample, more than half of participants had
never heard of business development companies,
direct indexing, semiliquid interval funds,
or structured products. Participants had higher
levels of knowledge of commodities, REITs,
private credit, private equity, and cryptocurrency.
1 Investors were defined as individuals who reported that they owned at least one of the following items: employee-provided retirement account, individual retirement account, mutual funds,
stocks, exchange-traded funds, money market funds, brokerage account, health savings account, annuities, or cryptocurrency. On average, investors were 39 years old and reported having
$212,346 (median: $50,000) in assets and an annual salary of $112,402 (median: $90,000). The data was collected in December 2022.
EXHIBIT 1
Cryptocurrency stood out: Almost 80% of Frequency of Reported Motivations for
participants said they had at least recognition- Changing Investment
level knowledge of crypto. This is a concern
because investors could mistake such knowledge
Category Count
for a deeper understanding of the asset
class. Commodities, cryptocurrency, private equity, Returns 114
and REITs had the highest ownership levels. Confidence 101
The chances of owning an asset class increased
Macro 76
with stated knowledge, increased for those
who have an advisor, and decreased with financial Timing 63
literacy. This final finding is concerning Diversify 39
because it suggests that those with a lower
Volatility 35
understanding of financial matters are more
likely to be drawn to trendier assets. Furthermore, Payouts 21
even though these individuals have lower Customizable 13
financial literacy, they reported higher rates
Social 13
of stated knowledge, suggesting some level of
overconfidence bias. Curiosity 11
Government 11
The Changing Appetites for Trending Assets
Overall, we found that investors don’t have Liquidity 9
a desire to change their investments in these Accessibility 7
trending assets. The most common response Taxes 3
across each asset class indicated that investors
who did not already own the asset were Transparency 2
not planning to buy it. The second most common 0 60 120
Source: Morningstar.
response pattern indicated that investors
who already owned an asset were not planning
to increase or decrease their holdings—which
suggests that after entrance into ownership, importance of advisor guidance, which often
these assets have some stickiness. entails the behavioral coaching investors
need to put on blinders to the news and focus
The most common reasons investors gave for on their long-term financial plans.
wanting to change their holdings were
returns, confidence, macroeconomics, and timing It’s clear that many investors are interested in
( E XH IBI T 1 ). A general picture emerges: Investors’ trends. Advisors can play a key role in educating
trade decisions often seem to be prompted their clients. To guide these conversations,
by short-term thinking that is overly focused on advisors should focus on making sure the clients
the present market performance. fully understand the asset, uncovering the
client’s motivations for pursuing these assets,
The Importance of Advisors as Behavioral Coaches and ensuring that the asset can work within the
In general, the explanations investors gave for client’s financial goals.
their desire to change their investments did
not differ based on their background. But investors Danielle Labotka is a behavioral scientist at Morningstar.
who worked with an advisor were less likely Samantha Lamas is a senior behavioral researcher
to cite macroeconomic events. This points to the at Morningstar.
morningstar.com/products/magazine 17
 Dispatches

Putting a Label means that only a segment of funds that use

on Sustainable
Investments
GREATER EUROPE
United Kingdom
The United Kingdom’s Financial Conduct
Authority unveiled its long-awaited Sustainability
Disclosure Requirements and investment
labels guidelines for investment products in
November. The rules will initially apply
to sustainable funds domiciled in the UK and may
be expanded later to pension products,
portfolio management, and insurance-based
investment products. The SDR policy statement
includes a substantial package of measures
aimed at improving the trust in, and transparency
of, sustainable-investment products and
at minimizing greenwashing.
These measures include four consumer-focused
sustainability labels that asset managers
will be allowed to use beginning July 31:
Sustainability Focus, Sustainability Improvers,
Sustainability Impact, and Sustainability
Mixed Goals.
The four labels are only for products seeking
positive sustainability outcomes, which
EXHIBIT 1
Expected Representation of
Labeled Funds
Focus
Mixed Goals 11%
Improvers
12%
Impact
46%
31%
Source: Morningstar Research. Forecast for end of 2024.
environmental, social, and governance
factors in their investment strategies can qualify.
Funds that just employ exclusions, negative
screening, ESG integration, or basic ESG tilts
alone will not qualify for a label.
We estimate that about 300 UK-domiciled
open- and closed-end funds will opt for a label
by year-end. Labeled funds may represent
8% of funds domiciled in the UK, amounting
to around GBP 110 billion.
To assess the size and makeup of this future
market, we first searched the Morningstar
fund database for funds in the scope of the
regulation with sustainable and sustainability in
their names, or related terms such as ESG,
responsible, ethical, climate, and impact. We
identified 410 such UK-domiciled funds.
We then interviewed 15 asset managers marketing
funds in the UK. Based on these conversations
and our knowledge of the strategies and the firms,
we estimated which funds would opt for a label
and which label they would use.
We predict that Focus will be the dominant
label, representing almost half of labeled products
( E XH IB IT 1 ). It appears that asset managers
have the best understanding of the Focus label
and the type of strategy that will qualify for
it. Managers we spoke with drew a parallel with
the European Union’s Sustainable Finance
Disclosure Regulation. Many were confident
that strategies meeting the criteria for Article 9,
portfolios with high sustainable investments
as defined under SFDR, as well as thematic
strategies would meet the requirements for the
Focus label.
100% 46
Focus
The Mixed Goals label was not among those
originally proposed in 2022; its addition Mixed Goals
75 that the regulator would like to see
is evidence
Improvers
as many labeled products as possible. Several
managers acknowledged the attractivenessImpact
of the50 Mixed Goals label31 because of the
flexibility it offers. It should allow them to
slice portfolios and create as many allocations
25
to sustainability objectives
12 as they see
fit as long as 70% of the overall assets are
0 11
aligned with the criteria of at least two of the
other three labels.
When the FCA first unveiled its proposed
labels, the Improvers label was commended
because it reflects the current state of
the world: Few companies are sustainable, but
many more are transitioning to be sustainable
one day. But according to our preliminary
analysis, managers may prefer to hold a
mix of assets that have different sustainability
strategies, including an Improvers sleeve.
We expect only a small number of funds to
use the Impact label because of the FCA’s strict
criteria. Managers will have to demonstrate a
theory of change at both the investor level
(through engagement, for instance) and asset
level. Strategies for which it will be easier
to show evidence of impact are those focused
on bonds (green and social bonds, for example)
as well as those investing in private assets,
including direct property and infrastructure,
which are more suited to a closed-end investment
trust format.
Asset managers need to decide whether to
opt for a label before the rule comes into force
on Dec. 2. Reasons for using labels include
investor demand, competitive pressure, and the
benefit of clarity. But some managers will
consider the requirements too constraining. Others
will wait and see how the market of labeled
products develops.
Hortense Bioy, CFA, is director, sustainability research,
global manager research, at Morningstar EMEA.
Andy Pettit is director, policy research, at Morningstar UK.
Biddappa A R is a senior quantitative analyst at
Morningstar UK.

18 Morningstar Q2 2024
Too Risky to Own,
Too Big to Ignore
ASIA
China
Some emerging-markets investors aren’t
comfortable having large stakes in China, given its
murky property market, challenging demographics,
and penchant for intervening in the affairs
of its largest public companies. China’s economy
and stock market have fallen off their peak
but still pose a conundrum for these investors. In
2010, China leapfrogged India, Japan, and
Germany to become the world’s second-largest
economy. Over the next 10 years, its weighting in
the MSCI Emerging Markets Index rose from
17.4% to an all-time high of 42.8% in October 2020.
Slowing economic growth and a retreating
stock market reduced that stake to 26.1% by the
end of 2023, but China remained the index’s
largest single country.
To accommodate wary emerging-markets investors,
fund companies have launched 16 emerging-
markets funds that exclude China since
2021, bringing the total to 21. Compared with their
typical diversified emerging-markets Morningstar
Category peer, these portfolios tend to have
larger stakes in other developing countries such
as India and Taiwan. But these aren’t exactly free
from China-related risks. India, a democracy,
and China, a communist country, are rivals, and
the Chinese government and military openly plot
and maneuver to make Taiwan part of the
mainland again. Emerging-markets ex-China funds
also tend to have more exposure to Brazil and
Mexico, which have their own economic, social,
and political downsides.
Some of the emerging-markets ex-China funds’
most popular holders include Taiwan
Semiconductor Manufacturing TSM, Bank Central
Asia BBCA, and Samsung Electronics SMSD.
Taiwan Semiconductor is also a top holding among
diversified emerging-markets funds, which
also own big Chinese companies such as Tencent
TCEHY, Alibaba BABA, and Meituan MPNGY.
Emerging-markets ex-China funds tend to own
TRENDS
Diversification Insight: Equity Factors Show
an Upward Trend in Correlations
Theoretically, each equity factor should have
its own set of performance characteristics
and succeed or fail in different types of market
environments. Indeed, there have been
some sharp divergences in performance based
on equity factors in recent years. In 2023,
for example, the MSCI USA Quality Index gained
36.3% while the MSCI High Dividend Yield
Index gained just 6.8%. During the 2022 bear
market, two equity factors emerged mostly
unscathed: yield and value.
Over the past three years, however, factor
correlations have landed in a fairly narrow range.
Factor Indexes: Rolling Three-Year Correlations vs. Morningstar US Market Index
1.0
0.9
0.8
0.7
3-Year Correlation
0.6
0.5
12/2002 12/2009
Source: Morningstar Direct. Data as of Dec. 31, 2023.
fewer consumer cyclical companies because
they don’t own these Chinese giants ( EX HI BI T 1 ).
They tend to have more money in technology,
financial services, and basic materials firms.
Indeed, the typical emerging-markets ex-China
fund has close to half its assets in technology and
financial stocks, which courts sector risk.
The quality factor has shown the highest
correlation with the broader equity market,
followed by minimum volatility. Correlations for
the small-cap, momentum, yield, and value
factors have been a bit lower. Across factors, the
lowest correlation has been between small-cap
stocks and minimum volatility. Now that
factors are so widely studied and embraced by
asset managers, one possible cause for this
convergence could be that so many investors are
following the same factors that their performance
has become less and less discrete. This
general upward trend in correlations has reduced
the diversification value of equity factors.
Quality
0.97
Minimum Volatility
0.90
Small Cap
0.89
Momentum
0.86
High Dividend Yield
0.86
Value
0.85
12/2016 12/2023
The timing of the funds’ launches has made them
look good. In 2023, Chinese equities were
among the globe’s worst-performing stocks. The
average emerging-markets ex-China fund gained
21.8% in 2023, which was far more than the
typical diversified emerging-markets category
peer’s 12% gain. Moreover, all 15 of the funds with
morningstar.com/products/magazine 19
 Dispatches
EXHIBIT 1
Funds That Pass on China Have More in Technology and Less in Consumer Cyclicals
Emerging Markets Ex-China Funds
r Basic Materials
i Communication Services
t Consumer Cyclical
s Consumer Defensive
d Healthcare
p Industrials
€ Real Estate
a Technology
o Energy
y Financial Services
f Utilities
0%
Sector Allocation
Source: Morningstar. Data as of Dec. 31, 2023.
full-year 2023 returns ranked in the top quintile
among category peers.
In 2023, emerging-markets ex-China funds took
in $5.6 billion. IShares MSCI Emerging Markets ex
China ETF EMXC was by far the most popular
choice, taking in $4.8 billion, more than 80% of
total flows.
It’s not clear whether these funds are just another
flash in the pan. If history is any guide, there could
be a shakeout. Japan has long posed a similar
problem for the MSCI EAFE Index and funds that
use it as a benchmark; it makes up nearly one
fourth of the benchmark and has taken up more in
the past. Since the first launch of an Asia ex-
Japan fund in 1977, asset managers have launched
114 such funds in the US. As of December 2023,
just 25 remained. In fact, nearly half the Asia
ex-Japan funds didn’t make it to their fifth birthday.
Emerging-markets ex-China funds help solve some
problems but create others. On one hand, they
allow investors to minimize or eliminate China risk,
but they increase exposure to other risky
developing markets. Investors in these funds must
evaluate on their own how much, if any, China
20 Morningstar Q2 2024
Diversified Emerging Markets Category
5 10 15 20 25
exposure they want, which can complicate their
portfolio management and leave a wider
margin for error. Investors should approach these
funds with a healthy dose of skepticism.
David Carey is a manager research analyst at Morningstar
Research Services LLC.
Why Japanese Stocks
Still Have Room to Run
ASIA
Japan
Investing in Japanese stocks had long been
considered dead money. Then the Nikkei 225
rallied 28% in 2023. In February, it surged
past 40,000, finally beating its previous all-time
high set in December 1989. Does this surprising
rally have room to run, or will this turn out
to be yet another false dawn for a market that
has frustrated investors for decades?
“Japan is progressing,” says John Vail, chief
global strategist at Nikko Asset Management.
“The buybacks are coming in hot and heavy,
companies have pricing power, profit margins
are still hitting new highs, and valuations
are reasonable.”
Alicia Ogawa, founder of Ogawa Japan Advisory,
says: “The upshot is that Japanese companies are
being held more accountable for financial
performance. In a nutshell, there’s a sudden lurch
to capitalism.”
These are some of the conditions that support
a continued run for Japanese stocks:
Economic Growth
For all the challenges of its aging population,
Japan’s economy continues to tick along.
Nikko Asset Management believes Japan’s
economy will expand 1.1% this year. Revenue is
growing, too. According to Yardeni Research,
analysts on average see revenue growth
of 2.2% in 2024, and 2.1% in 2025. One reason
is rising prices. Headline inflation hit 3.3%
in Japan in October, a sea change. The hope is
that deflation is in the rearview mirror.
Earnings Growth
Pretax profit margin surged to a record high of
just under 7% versus under 1% in December 1989,
when the Nikkei reached 38,916. Analysts
on average see earnings growth of 11.5% for 2024,
and 7.2% for 2025, according to Yardeni.
For the five years, they expect earnings growth
to clock in at 10.3%.
Cheap Stocks
Even after its 2023 run, Japan traded at only
14.4 times forward earnings versus 16.4 times for
the MSCI All-Country World Index. “Japan
has been stuck at 14 times for forever because
people didn’t expect it to be a great market,”
says Shuntaro Takeuchi, who manages the Japan
strategy for Matthews Asia. It’s one reason
Berkshire Hathaway BRK.A bolstered its stake
in five Japanese trading firms in 2023.
Increased Buybacks and Dividends
Japanese companies have net cash that could
be distributed to shareholders. According to
$OOLDQFH%HUQVWHLQFRPSDQLHVUHSUHVHQWLQJɚɘɚ TRENDS

RI-DSDQŒVPDUNHWFDSLWDOL]DWLRQKDGDQHW
FDVKSRVLWLRQRQWKHLUEDODQFHVKHHWVDWWKHHQG
of ɗɕɗɗFRPSDUHGZLWKɘɞəLQWKHUS and
ɗɗɝLQWKHHXUR]RQH
Investor Activism
7KHQXPEHURIVKDUHKROGHUSURSRVDOVLVRQWKHULVH
,Q1RYHPEHUVKDUHKROGHUVYRWHGRYHUZKHOPLQJO\
IRUDEX\RXWRIVWRULHGFRQJORPHUDWH7RVKLED
726<</DVW\HDU6HYHQ L+ROGLQJV691'<
WKHSDUHQWFRPSDQ\RIɜ(OHYHQ DQQRXQFHGD
UHVWUXFWXULQJDIWHUEHLQJSURGGHGE\DFWLYLVWV
-DPHV5RVHQZDOGIRXQGHURI'DOWRQ,QYHVWPHQWV
DQGDGYLVRUWRWKH/RQGRQOLVWHG1LSSRQ
$FWLYH9DOXH)XQGVD\Vœ,QVWHDGRIEHLQJ\RXU
HQHP\WKHJRYHUQPHQWZDQWVWRVHHDFWLYLVP
WRVHHJOREDOOHDGHUVVXUYLYHDQGWKULYHŔ
A Push for Shareholder Value
7KH-DSDQ([FKDQJHLQWURGXFHGKDUGFRUH
UHTXLUHPHQWVWRUHPDLQDOLVWHGFRPSDQ\
LQFOXGLQJPLQLPXPOHYHOVRIIUHHĬRDWDQGLQVLVWHG
WKDWFRPSDQLHVWUDGLQJEHORZERRNDQQRXQFH
KRZWKH\SODQWRGREHWWHU,Q0DUFKɗɕɗɘ
WKH7RN\R6WRFN([FKDQJHVDLGWKDWMXVWKDOIRILWV
VRFDOOHGSULPHOLVWLQJVRIOLTXLGVWRFNVWUDGH
DERYHERRNYDOXHœZKLFKUHSUHVHQWVH[SHFWDWLRQV
RIIXWXUHYDOXHFUHDWLRQŔ
A Rise of Individual Investors
-DSDQLVERRVWLQJKRZPXFKSHRSOHFDQVDYH
WKURXJKLQGLYLGXDOVDYLQJVDFFRXQWVZLWKVRPH
WD[DGYDQWDJHV%UXFH.LUNRI*ROGPDQ6DFKV
ZULWHVWKDWRQO\ɖɘRI-DSDQŒV-3<ɗTXDGULOOLRQ
RIKRXVHKROGDVVHWVDUHLQHTXLWLHVFRPSDUHG
ZLWKDOPRVWəɕ of USKRXVHKROGV
'LYHUVLīFDWLRQ,QVLJKW3ULYDWH,QYHVWPHQWV
&RUUHODWLRQV9DU\&RQVLGHUDEO\
3ULYDWHLQYHVWPHQWVDUHYDULHGEXWVKDUHVHYHUDO
VWUXFWXUDOFKDUDFWHULVWLFVLOOLTXLGLW\DKLJK
EDUULHUWRHQWU\IRULQYHVWRUVDQGFRPSOH[
UHSRUWLQJ3ULYDWHLQYHVWPHQWVDUHQŒWVFUXWLQL]HG
SXEOLFO\RURQDSHULRGLFVFKHGXOHVRWKHSDFH
DQGPDJQLWXGHRIWKHLUUHWXUQVGLĭHUIURP
PDUNHWDEOHSXEOLFVHFXULWLHVZKLFKFRQWULEXWHV
WRDSHUFHSWLRQRISRUWIROLRGLYHUVLīFDWLRQ
%XWLQSUDFWLFHPDQ\RIWKHVHSULYDWHLQYHVWPHQWV
DUHVLPSO\OHYHUDJHGYHUVLRQVRIHTXLW\DQG
ī[HGLQFRPHPDUNHWG\QDPLFV
9HQWXUHFDSLWDODQGSULYDWHHTXLW\DUHPRUH
FRUUHODWHGZLWKPDUNHWDEOHHTXLWLHVWKDQSULYDWH
FUHGLWDQGDOOWKUHHRIWKHVHW\SLFDOO\
H[KLELWKLJKHUFRUUHODWLRQVZLWKSXEOLFO\WUDGHG
Private Investments: Rolling Three-Year Correlations vs. Morningstar US
Market Index
ɖɕ
ɕɚ
VWRFNVWKDQUHDODVVHWVDQGUHDOHVWDWH
6HFRQGDULHVDQGIXQGVRIIXQGVH[KLELWWKHORZHVW
ORQJWHUPDYHUDJHFRUUHODWLRQVŜEXWHYHQVR
WKHLUUROOLQJWKUHH\HDUFRUUHODWLRQZLWK
WKH0RUQLQJVWDUUS0DUNHW,QGH[KDVUDQJHG
IURPɕɜɞ to negative ɕɘɗ2QWKHRWKHU
HQGRIWKHVSHFWUXPSULYDWHHTXLW\FRUUHODWLRQV
KDYHUDQJHGIURPɕɞə to ɕɖɚZLWKERWK
HQGVRIWKHUDQJHRFFXUULQJLQWKHODVWīYH\HDUV
:LWKVXFKYDU\LQJFRUUHODWLRQVRYHUWLPH
SULYDWHLQYHVWPHQWVPD\QRWSURYLGHFRQVLVWHQW
GLYHUVLīFDWLRQYDOXH
Private Equity
ɕɛɛ
Funds of Funds
ɕɛɖ
Venture Capital
ɕɛɕ

Private Debt
The Yen Is Still Cheap ɕɚɛ
7KLVLVJRRGIRUH[SRUWHUVDQGJOREDOLQYHVWRUV ɕ
([SRUWHUVDUHDODUJHFKXQNRI-DSDQŒVOLVWHG Secondaries
FRPSDQLHVDQGJOREDOLQYHVWRUVEHQHīWZKHQWKH ɕɚɕ
\HQULVHVDJDLQVWWKHFXUUHQF\LQZKLFKWKH\
Real Assets
NHHSVFRUH$WWKHHQGRIɗɕɗɘWKH\HQVOLGWRD
ɕɘɝ
ɘ<HDU&RUUHODWLRQ

PXOWLGHFDGHORZRIDURXQGɖɚɖWRWKHUS dollar śɕɚ

IURPɖɕɘ in ɗɕɗɕ7KDWŒVHDVHGVOLJKWO\DPLG Real Estate
H[SHFWDWLRQVWKDWWKH%DQNRI-DSDQFRXOGWLJKWHQ ɕɗɞ
FUHGLWEXWWKH\HQUHPDLQHGFKHDSLQ0DUFK
śɖɕ
ɖɗɗɕɕɗ ɖɗɗɕɕɞ ɖɗɗɕɖɛ ɕɛɗɕɗɘ
/HVOLH1RUWRQ LVHGLWRULDOGLUHFWRUIRUVXVWDLQDELOLW\
6RXUFH3LWFK%RRN0RUQLQJVWDU'LUHFW'DWDDVRI-XQHɘɕɗɕɗɘ&RUUHODWLRQVDUHEDVHGRQDGMXVWHGTXDUWHUO\UHWXUQVRIWKH3LWFK%RRN3ULYDWH&DSLWDO
DW0RUQLQJVWDU
,QGH[HVDQGTXDUWHUO\WRWDOUHWXUQVRIWKH0RUQLQJVWDUUS0DUNHW,QGH[

ɗɖ

Artificial Intelligence
Advisors Need to Embrace
AI—but Carefully
Like computers before it,
artificial intelligence
will transform your practice.
AI
Sheryl Rowling
It’s all over the media: Artificial intelligence is
about to take over the world. AI will either
solve any problem, make life easier, and grow
the economy, or it will replace all workers,
eliminate human contact, and destroy life as we
know it. While predictions can be extreme,
the real ramifications of AI will unfold over time.
“There’s a hype curve on these early iterations
of AI,” says Kendrick Wakeman, CFA, co-founder
Spotlight
Decoding AI Uses
Advisors Await SEC Rule for AI
27
31
Are There Any Undervalued Opportunities Left in AI? 34
and CEO of WealthTech Strategy Partners.
“Reality needs to catch up with expectations.”
On the edge of the AI revolution, financial advisors
need to balance excitement with caution and
distinguish between hype and usefulness.
One thing we know for sure: AI will change how
advisors work, and ignoring it is not an option.
The Computer Revolution
The early days of gigantic mainframes couldn’t
begin to foreshadow how much the financial
industry would be affected by computers.
We quickly went from taped-together, multipage
morningstar.com/products/magazine 23
 Spotlight: Artificial Intelligence
columnar pads and fill-in-the-squares paper
tax returns to personal computers and
laptops loaded with spreadsheet software and
tax programs. Then came customer-relationship-
management tools, rebalancing software,
portfolio-accounting programs, risk-tolerance
calculators, financial planning applications,
and investment analysis tools. Soon, advisors
couldn’t practice without computers.
The computer revolution didn’t replace human
interaction, nor did it eliminate the need
for employees. Rather, it changed the way things
were done, increased the quality and
complexity of services, and required employees
to develop different skills. Advisors should
view AI in the same way.
Financial-services technology expert Joel
Bruckenstein, CFS, CMFC, CFP, who publishes
Technology Tools for Today, or T3, says
advisors don’t need to worry about AI taking
their place. “AI will supplement advisors,
making them more efficient,” he says.
“By streamlining back-office tasks, advisors
will have more client-facing time.”
Bruckenstein used Morningstar’s Mo as an
example: “Advisors will be able to ask Mo to identify
funds with particular characteristics rather than
input a complex series of filters into some
software. This will enable advisors to provide
quality services in a more efficient way.”
As advisors look to add AI to their practices,
they must be prepared to embrace it without
blindly diving in.
What Is AI and How Can It Help?
Tech writer Margaret Rouse of Techopedia offers
a succinct explanation of AI:
“Artificial intelligence, also known as machine
intelligence, is a branch of computer science
that focuses on building and managing technology
that can learn to autonomously make decisions
and carry out actions on behalf of a human being.
AI is...an umbrella term that includes any type
of software or hardware component that supports
machine learning, expert systems, generative
AI, and certain types of robotics.”
24 Morningstar Q2 2024
In theory, AI can help in all aspects of the advisory
business. It can assist with marketing, client
communication, client service, data analysis,
risk-tolerance assessment, portfolio optimization,
financial planning, compliance, organization,
continuing education, scheduling, and more.
For simplicity, let’s categorize where AI tools can
contribute into three main areas: marketing and
communication, back office, and financial services.
Marketing and Communication
At its most basic form, AI can help advisors write
articles and blog posts. Simply enter a prompt
into a chatbot, and it will produce an article in
seconds. Of course, advisors will need to
fact-check it, and they should only use the article
as a road map for their own words. Advisors
need to guard against plagiarism and inaccuracies.
AI can go much further than writing blog posts and
articles. It can help analyze trends, determine
target markets, create custom content and
infographics, provide personalized client outreach,
and manage social media.
AI can also help advisory firms communicate
with clients. A chatbot on an advisor’s website can
provide on-demand service with frequently
asked questions or appointment scheduling. Other
AI tools provide fraud warnings on credit
cards, alert clients on spending trends, and even
remind them of important financial deadlines.
AI can customize communications based on
individual clients’ interests, summarize meetings,
and schedule follow-ups.
Back Office
AI can assist with many back-office tasks,
including compliance, data analysis, organization,
and continuing education.
AI tools can make compliance tasks easier by
monitoring activities, transactions, and
communications. AI can flag potential issues
in a more sophisticated way than the methods
advisors typically use, such as searching
for keywords.
The sky’s the limit when it comes to AI’s data-
analysis capabilities. Predictive analysis
and AI can find patterns and trends beyond
what human advisors or basic software can.
AI data analysis can also be useful for
client retention, internal financial management
and analysis, human resources, and
practice management.
Any repetitive administrative tasks can
be candidates for AI, including appointment
scheduling, employee reviews, client/employee
events, work allocation, market salary
comparisons, and office-supply ordering.
AI can assist with professional education. It can
create content, update information (such as
IRA contribution limits and tax rates), find
appropriate online or in-person courses, and
track continuing-education credits.
Financial Services
There are countless software tools for financial
services, including programs for investment
analysis, financial planning, risk tolerance,
portfolio construction, rebalancing, reporting,
billing, and portfolio accounting. Augmenting
these tools with AI can greatly increase
efficiency and accuracy.
Wealthfront is an example of an automated
investment platform that has been using
AI for years. Its AI uses clients’ risk-tolerance
scores to build portfolio allocations. Other
options can use various client inputs to build
optimized portfolio models.
AI can make a significant impact on risk
management. Not only can it assess a client’s risk
tolerance based on various inputs, it can also
easily assess risk in a client’s current investment
holdings, identify problem positions, and help
build a more effective portfolio.
All this sounds great, but tools for advisors are
only in the early stages of development. With
that in mind, let’s look at some of the AI tools that
are available to advisors now.
AI Chatbots
ChatGPT and ChatGPT Plus
OpenAI’s ChatGPT is perhaps the most widely
used consumer AI tool. Available in free and paid
 versions, ChatGPT works like a sophisticated
search engine. Its output can range from a simple
answer to an entire treatise with citations.
Here’s how to get the most out of ChatGPT (or any
other chatbot system):
gCreate thorough, specific, thoughtful prompts.
Remember the adage “garbage in, garbage out”?
ChatGPT’s output will only be as good as the
prompt. For example, don’t ask, “What conference
should I attend?” With that question, ChatGPT’s
response was: “To recommend a conference,
I need more information. What industry or field
are you interested in?”
Instead, try: “I am a financial advisor who owns
my own practice. I am planning my conference
schedule for 2024 and want to attend the top
conferences focusing on technology for financial
advisors. Please recommend three conferences
to be held in the US during 2024.” This prompt
generated three conference recommendations but
with bare-bones information about each.
gEstablish context and ask for how you want the
answer formatted. In the above example,
let’s say I want to recommend conferences to my
study group. I might say, “Please format the
response as an email I can share with my study
group colleagues recommending these
conferences.” This resulted in a formatted email
describing each conference.
gRefine until you get the response you want.
I started by asking about a conference, gave more
information to identify conferences relevant
to my needs, and then asked for a specific format
for the response.
gDon’t assume that ChatGPT provides accurate
answers. Double-check all information.
gDon’t claim ChatGPT’s words as your own—
especially if you plan to use it for publication
or client communication. As with any
content, use the results as an input to your
work, not verbatim.
For these examples, I used the free version of
ChatGPT, which runs on GPT-3.5. You might find
the paid version, ChatGPT Plus, a worthwhile
investment at $20 a month. Powered by GPT-4,
ChatGPT Plus has a broader and more up-to-
date knowledge base, and it browsed the
web using Bing. It also gives users priority access,
faster response times, and access to custom
GPT bots.
Alternatives to ChatGPT
gGoogle’s GOOG Gemini, formerly Bard, operates
similarly to ChatGPT. I also asked Gemini about
advisor conferences. It provided much more
information about each conference than did
ChatGPT, including detailed descriptions,
highlights, and their 2024 dates and locations.
gChatsonic is similar to Gemini. It provided a list of
conferences with dates and locations and gave
“why attend” synopses of each.
gMicrosoft MSFT Copilot (formerly known as
Bing Chat) offers ChatGPT-4 technology for free
and integrates the Bing search engine.
How do you know which one to use? Try
them! Use more than one to compare results.
Other Types of AI Tools
Besides these chatbot-style tools, there are
other AI solutions that are also suitable for use
by financial advisors:
gSales Cloud Einstein is the turnkey AI solution
from Salesforce CRM. It provides client
data insights, leads prioritization, and analytics
to assist in the sales cycle.
gAdobe ADBE Marketo Engage claims to be
the world’s largest marketing automation platform,
providing customer-driven communications
that includes email, social media, paid media, texts,
and events. The platform also enables customized
content using in-depth profiles and real-time
behavioral and demographic data. The solution
also integrates with CRM systems and provides
marketing insights.
gHubSpot covers many areas of client engagement
and internal work processes through a single hub,
including task automation, client insights,
workflow streamlining, content generation, and
data analysis.
gHypotenuse AI is a writing assistant that uses an
interactive process to help users produce content
that “sounds like you.” Other content-creation
tools include Frase, Jasper, Claude, and Writer.
gMagic Design and Highcharts GPT are visualization
tools that help create graphics and charts.
AI Tools Specifically Built for Financial Advisors
The current crop of AI tools made for financial
advisors is the tip of the iceberg compared with
what will eventually be available. Wakeman, of
WealthTech Strategy, says advisors should consider
tools other than portfolio-management solutions
(“since advisors feel comfortable creating
portfolios”). Instead, advisors need tools that help
with other tasks, such as prospecting, customer
engagement, and compliance.
Bruckenstein says that current AI tools are
designed to solve a single problem. “We’re
at the very beginning of what AI solutions will be
developed,” he says. Bruckenstein finds two
programs especially appealing: FP Alpha and
Conquest Planning. FP Alpha provides advanced
planning by uploading client records such
as tax, insurance, and legal documents.
It produces visual reports and recommendations
advisors can use to demonstrate their value.
It claims to supplement, not replace, traditional
planning software.
Conquest, created by Mark Evans, the founder of
NaviPlan, uses a digital assistant, named SAM,
that combines client data, financial strategy best
practices, and client preferences to create
financial plans, action items, and visuals that are
updated on an ongoing basis.
Two tools that made a splash at Bruckenstein’s
T3 conference in January were Sora Finance
and Powder.
Sora Finance, which won the 2024 T3 Emerging
Technology Award, allows advisors to provide clients
with full debt-management services. Sora uses
AI to predict when clients will incur debt and alerts
advisors when it might be time to refinance
debt. Most useful is the ability to scan hundreds
of lenders, choose the best offer for clients, rate
the likelihood of loan completion, prequalify clients,
morningstar.com/products/magazine 25
 Spotlight: Artificial Intelligence
and even automate the application process.
Providing clients with this service is not only a
differentiator; it also satisfies a huge need.
Powder is an AI-powered portfolio “co-analyst.”
When signing a new client, advisors typically
analyze the prospect’s portfolio by piecing together
statements, entering data into spreadsheets, and
doing arduous comparison calculations to
demonstrate why the advisor-structured portfolio
is superior. Powder’s AI engine reads documents,
listens to conversations, quickly analyzes the
data, gives actionable items, provides a fee alpha
analysis, and generates a presentation to show
the advisor’s value.
Other advisor-specific AI tools:
gMo is a chatbot available to users of Morningstar
software that relies on Morningstar’s data,
research, and editorial content. Advisors can ask
Mo an investing question and receive a response
in natural language in seconds.
gSigFig is a tool that helps create optimized
portfolios based on investors’ individual needs,
restraints, and goals.
gQuantumStreet AI is a platform that uses AI for
risk analysis and stress testing to create portfolios
based on parameters such as themes or ESG.
gNitrogen Wealth (formerly Riskalyze) uses AI to
provide a range of services for advisors, including
risk tolerance, proposals, portfolio analytics,
retirement planning, engagement, lead generation,
compliance, and firm financial insights.
gAladdin Wealth is BlackRock’s BLK platform that
employs AI to assist advisors in creating and
managing clients’ portfolios.
How to Integrate AI Into Your Practice
As with any use of technology and third-party
providers, advisors must exercise caution
when it comes to the quality of the product,
privacy, and protection of confidential and
proprietary information.
Beth Haddock, CEO and founder of Warburton
Advisers, believes that advisors need to be
26 Morningstar Q2 2024
careful before jumping into AI. Caution is critical
to upholding fiduciary duties to clients, she
says, as well as complying with what will surely
be strict regulatory safeguards.
She cites SEC Chair Gary Gensler’s speech on AI,
in which he said that a company must be
“truthful about its use of AI and associated risk.”
Instead of disclosing those risks using “boilerplate”
language about AI, Gensler said, “executives
should consider whether artificial intelligence plays
a significant part in a company’s business,
including its internal operations, and craft specific
disclosures that speak to those risks.”
Haddock expects regulations to be issued soon.
(See also “Advisors Await SEC Rule for AI,”
Page 31.) “Implement safeguards as you would
with robo-advisors,” she says. “Human oversight
is critical. Be careful of errors. Know the
technology before you use it in your practice.”
She says that not all uses of AI will necessarily be
subject to SEC regulation. It depends on how
advisors will be using it. “If you use AI in advising
clients, that will be covered by the SEC,” she
says. “But if you use AI within your practice—
to handle internal administrative tasks—that’s
outside the purview of the SEC.”
Haddock recommends first trying out AI in low-risk
ways, using it to increase back-office productivity.
For compliance purposes and to protect clients
and the firm, Courtney Sukitch, operations
team lead at Waldron Private Wealth, recommends
creating an AI policy before using AI. “You need
to document safeguards,” Sukitch says. “Written
procedures that are adhered to are essential.”
Start Now by Learning the Basics
Bruckenstein says that advisors should begin using
AI now: “The best way to start is with learning
the basics. You don’t need to be an expert. Just try
it and be creative.”
Begin by trying AI for routine tasks using tools
such as ChatGPT, Gemini, or Chatsonic.
Sukitch turns to AI for almost any administrative
task, from interview questions and blog
posts to travel planning and risk assessment.
Once you’ve mastered basic AI tools, you may
decide to add a dedicated AI tool. The decision
requires a delicate balance. It might seem
ideal to jump into an AI tool that handles all
aspects of an advisory practice. But even if such
a tool advertises itself as a “total solution,”
there are two major caveats:
1 Will it really work? It’s usually a bad idea to risk
your entire practice management on a new
technology. It might not work—and even it does,
separate tools that address one aspect of
the practice might work better. And at this stage
of AI development, something better might
soon come down the line.
2 Will you be able to implement it? Sometimes,
making a major effort to incorporate a new
software is worth it. Other times, the return isn’t
worth the pain and taking on such a major
project is unrealistic.
The best way to choose your first AI tool is to
pick one aspect of your firm that isn’t working as
well as you’d like or a service that you’d like
to add to your practice. Then find an AI solution
that helps you get the job done. Be realistic
about the time it will take for you and your team
to learn how to use the tool, and factor that
into your integration process.
Don’t Fall Behind
What is important is that you don’t ignore AI.
Says Bruckenstein, “If you’re five years behind on
adopting AI, you’re out of business.”
Advisors who are apprehensive about AI need
to remember that it will not replace investors’ need
for personal, human advice. AI’s primary benefit
to advisors is the ability to handle administrative
and research tasks more efficiently, freeing
up their time for more face-to-face interaction
with clients. At the same time, AI will allow
advisors to handle more clients and provide better,
more responsive service.
Now is the time for advisors to accept
and embrace AI—or risk being left behind. K
Sheryl Rowling, CPA, is an editorial director at Morningstar.
Decoding AI Uses
Fidelity’s head of data strategy
reveals how the firm is evaluating
this latest technology.
FIDELITY
Julie Willoughby and Ben Johnson
In the financial-services industry, artificial
intelligence has sparked enthusiasm with its
promise to automate tedious tasks and
revolutionize efficiency, products, and services.
But it’s also raised concerns, as financial
regulators explore guardrails and practitioners
evaluate potential biases.
To understand what AI means for financial
professionals and investors, we went to an expert:
Andrew Brzezinski, Ph.D., CFA, is the head of
data strategy, business intelligence, and
advanced analytics at Fidelity Investments. He
has advanced degrees in electrical engineering
from Stanford and MIT and has been at
Fidelity since 2007. We interviewed Brzezinski
for an episode of Big Picture in Practice,
Morningstar’s podcast for enterprise wealth
professionals, about what AI is and what
it means for the future of financial services. Here
is an excerpt of our conversation, which
took place in December. It has been edited
for clarity and length.
Julie Willoughby: Andrew, we’d love to get your
thoughts about the definition of AI. You hear
things referred to as AI, which to me, not being an
expert, just seem like computer logic: if-then
kind of things. How do you define AI and what
types of AI should people know about?
Andrew Brzezinski: It’s a great question. The
definition gets into this idea that there
is old AI and new AI. I want to spell that out.
In many people’s minds, AI hadn’t really arrived
until this year. But as a terminology and
an area of focus for computer scientists and
mathematicians, AI has been out there since the
1940s, ’50s, ’60s, but it was theory. We
developed ways of describing quantitatively with
math and computer algorithms concepts like
neurons and the ways that the brain functions,
with those neurons firing signals and being
interconnected with one another. At the time,
obviously, we didn’t have the computing
power or the types of data that you need to be
able to put those into practice. So, it was
all a lot of theory.
What is artificial intelligence? Well, it’s machines
being able to accomplish tasks that would
ordinarily require human intelligence. So, from
the 1940s to the ’70s, and onward, even today, the
way we can represent those types of tasks is
with rules engines and if-then statements. One of
the branches of AI that still is completely
legitimate and very powerful is this notion of
expert systems—where you speak with an expert,
understand the ways that they make decisions,
and then program that with a rules engine, with
if-then statements. That is an artificial
intelligence—we used an expert to train it, and
it can outperform an ordinary individual.
Fast forward to the 1980s, ’90s, and early 2000s,
and computers were able to process
information more effectively. New statistical
techniques were being developed, and
machine learning was getting talked about more.
So, we get into things like forecasting,
pattern detection, and creating predictions
and trends that have data.
Now, once you hit the 2000s, data companies
started to build up massively scalable storage
and computation, and the scientific community
continued to build up the theory of neural
networks and AI. Bringing all those pieces together,
neural networks, deep learning, and natural
language processing were able to be
implemented in practice. In the 2000s and 2010s,
they became real applications of use cases
across industries.
So, we’re getting closer to the new AI. In the last
five, six, seven years, people started to focus on
all the unstructured data out there, which
represents a kind of collective intelligence across
the world. What can we do to parse through
that and create a so-called artificial intelligence
on top of that? This is where these really large
neural networks with billions of parameters
in them started to become applied. We could start
training these things first with words—things
like Wikipedia or other massive text repositories
that are freely available. We feed them into
these neural networks and ask those billions of
parameters to become tuned to understand the
patterns and interrelationships of all that
language that’s out there. How do words relate
to sentences and sentences to paragraphs? What
are the contents of those words and sentences
and paragraphs?
Through that process, things like ChatGPT and a
broader set of large language models have
become trained on these massive amounts of data,
so that they can understand the statistical
relationships of text or, now, images and videos.
Once the system like that is trained, it’s not a huge
step to ask it, “Well, what would you predict
as another sequence of words, or an image or a
video, in response to something?” You give
ChatGPT a question, and it can give you an answer
in relation to that question, because statistically,
that’s what it sees as what would follow a
question. This is the type of stuff that we’re seeing
with generative AI, and it’s the new AI.
Friend or Foe?
Ben Johnson: Andrew, as we’ve moved from
what you’ve typified as old AI to new AI,
morningstar.com/products/magazine 27
 Spotlight: Artificial Intelligence
a lot of age-old questions have surfaced. I think
a prominent one is one that’s always been relevant
to new technology, which is, is this a friend or is
it a foe? What’s your take?
Brzezinski: I am firmly in the friend camp.
I like the way you frame the question. While it’s
a transformational change, it is a technology
evolution that we have here, so it’s appropriate to
fit it into the continuing progression of technology.
We come to terms with its applicability, its
strengths, and its weaknesses and find good ways
to fit it into making things better for ourselves
in our lives and in our workplaces. It’s great
that we’ve gotten to the place we are with AI,
and it’s going to continue to develop.
On the foe side, could it be put to a poor use
or a bad use? Could it have bad outcomes?
We all want to pay attention and understand that
as this technology is evolving, as we’re
coming to terms with what it can do and what
it should do, we have some control over the
situation and an opportunity to try to make sure
that we put it to the best possible uses.
Johnson: I want to stick with that word, use, and
expand it to use cases and bring it local to what
you see today in the asset- and wealth-
management space. Are there any examples you
see that are successful or unsuccessful use cases?
Brzezinski: Let me start with a failure: the threat
that people perceived around robo-advice.
There was something interesting in the idea that
we could bring a technology solution that
takes some inputs about investor and household
characteristics, thinks about some financial
planning outcomes, thinks about investment
decision-making, and makes some
recommendations. What robo-advice was naive
about was that there are really complex financial
situations, and it was put into use in ways
it wasn’t built for. A human advisor can
understand your situation and think about what
you wrote down in response to a questionnaire
versus what you really mean. That human
element clearly played out as a much more
dominant force in financial planning and
investment advice, and it just couldn’t be replaced
by technology. The question becomes, could
28 Morningstar Q2 2024
the technology ever be sophisticated enough
to completely cut a human out of the loop?
I think it’s hard to argue that you can accomplish
that and have a really rich investment and
financial advice outcome.
On the success side, think about the things that
are going to help financial-services firms
Governance, ethics, responsibility—these
are words that we’re using all the time at
Fidelity. ... We want to make sure that we set
parameters and guardrails.
Andrew Brzezinski
be more effective. There’s voice recognition in our
phone trees. There’s image detection as part
of check processing or forms automation. There’s
phone call transcription. These are sophisticated
applications of specialized types of AI used by
businesses. We’ve seen firms apply next-best
action—recommendation systems that point their
sales associates at the right prospects. There’s
a body of work in many kinds of customer-facing
industries, including financial services, around
delivering more personalized experiences.
AI is in the loop on those types of things, as well.
Test and Learn
Willoughby: What can you tell us about how
Fidelity is testing and integrating some of these
capabilities?
Brzezinski: Some of the things I’ve mentioned, like
call transcription, image processing, and voice
recognition. Our operational and service
teams think about robotic-process-automation use
cases. That’s yet another AI. It’s not a super-
sophisticated type, but imagine not having to
“swivel-chair” between all sorts of technology on
your desktop and simplifying workflows.
Those are kind of pragmatic applications of AI that
are going on within our business.
When we get to the new AI, it’s test-and-learn
right now. We’re in a very nascent phase
of AI. Large language models and ChatGPT have
come onto the scene over the past year,
and the way Fidelity is approaching this is to say
that this is really interesting technology that
changes the game in terms of things that might
have needed data scientists or very technical
people to try to be accomplished. This thing seems
to do it almost out of the box in a no-code,
low-code kind of way. When I say low-code, I’m
talking about prompt engineering—writing good
prompts to get good answers back. That’s
the data science with these technologies these
days. So, knowing that it’s nascent and
understanding that there are some notable
examples out there where the technology gets
things wrong, let’s build prototypes—let’s
expose the capability to our own internal
associates and just show some of the basics of
what it can do, so it can spur creativity,
ideation, and the use cases that will pan out
internally and, potentially, with client-facing
applications of the technology.
Willoughby: You’re hitting on a topic that we’ve
been talking about here at Morningstar, and
that is how to use AI responsibly. You hear about
an AI program hallucinating. How are you
thinking about putting parameters around AI so
that it’s used responsibly?
Brzezinski: Governance, ethics, responsibility—
these are words that we’re using all the time at
Fidelity. If you use ChatGPT, it doesn’t take long for
it to give you back a response that isn’t right.
Sometimes, you do a double-take. You read it, and
you’re like, wow, it’s written so confidently.
This is why we’re being so careful as we work with
this technology. We want to make sure that we
set parameters and guardrails.
We make available technology like ChatGPT
to a very limited set of people in the data science
community because we’re trying to test
it and understand how it works. We’ve created
our own internal instance of it. That allows
us to start doing these test-and-learn types of
use cases.
You also have to think about this when creating
a customer experience, and when I say
customer experience, that includes our own
internal associates. So, shouldn’t we be
transparent that they’re dealing with an AI?
If I’m dealing with some kind of AI solution,
can I contest what it’s saying to me? These are
higher-order questions that we’re asking
ourselves as we talk through this technology.
Early Innings
Johnson: It feels like our experience with AI has
not been one of linear growth but of
exponential increments in the capabilities of these
platforms. Does that continue indefinitely?
And what are some of the applications and use
cases that you’re most excited about as you
look into the future?
Brzezinski: To use a baseball analogy, we’re in the
early innings. Technologies like ChatGPT have
started to help us harness all of this unstructured
data that just felt like a really big challenge for the
world to try to figure out, and we’re just at the
beginning. We were talking about hallucinations
and biases in AI. The practitioners who are
building these algorithms are starting to pay
attention to that. They should be able to overcome
a lot of these challenges or doubts about the
technology in these early days.
I’ll give you an example that gives a picture of the
future. ChatGPT, as many people know, recently
went multimodal. What that means is that it
doesn’t just take text as input, but you can put in
an image or a voice. That’s an impressive thing
because it’s a very different type of neural network.
In human terms, different sections of your brain
process images, video, voice, and text. With
ChatGPT’s release, there was a fun article posted
on LinkedIn. The author took a picture of a
super-complicated parking sign, put it into the new
premium version of ChatGPT, and asked, “It’s
Wednesday at four o’clock. Can I park here?”
The answer came back: “Yes, you can park here
for an hour at this time.” And it was right!
This is another step of innovation where you
don’t have to build a very specialized thing
that knows how to read parking signs. It’s already
Mo Leads Morningstar’s AI Initiative
The Morningstar Intelligence Engine—
Morningstar’s generative artificial intelligence
platform—was launched last year to help
financial advisors and investors quickly and easily
dig into Morningstar’s breadth of investment
research and data. No longer will investors
need to spend hours mastering an interface or
figuring out the parameters of a screen.
Mo, Morningstar’s new digital research assistant,
is the face of the Intelligence Engine. Mo
puts access to Morningstar insights just a prompt
away. Drawing from Morningstar’s extensive
investment data and research library (including
every article published for Morningstar.com),
Mo can do what no human can: read and recall
the hundreds of thousands of Morningstar
research reports and articles and within seconds
craft a response.
For the past year, Morningstar has rolled out
Mo across its professional and individual investor
built into these really smart neural networks.
Suddenly, I’m imagining forms processing
and image processing combined with policies and
procedures and other things in a regulated
environment that can be improved. The use cases
that will become applicable as this technology
evolves are going to continue to expand.
And it was another one of those instances
where it was low-code, no-code—that person
didn’t code anything. Their data was an
image, and the code was asking the question.
That’s really cool.
Johnson: I love your vision for the future and
have enjoyed our discussion today. We can’t thank
you enough for joining us.
Brzezinski: It was really good talking with you. K
Julie Willoughby is head of global sales with Morningstar.
Ben Johnson is head of client solutions, asset
management, with Morningstar.
products, including Morningstar Direct Compass,
Morningstar Advisor Workstation, and
Morningstar Investor.
Next up is the Intelligence Engine Management
Console, which is a site that will make it
easy for Morningstar clients to create, test, and
deliver their own generative AI-powered
applications. The console will be available to
clients later this year.
“While every firm is experimenting with
generative AI, one of the top concerns we’ve
heard from clients is how to build trust
in the outputs a model produces,” said Steven
Berger, a director of product management
in Morningstar’s AI Office. “We’ve designed our
console to help app developers build that
confidence, by making it simple to evaluate
the quality of generated answers, and
giving them tools to troubleshoot potential
errors or hallucinations.”
morningstar.com/products/magazine 29
Rich
Rich Resources.
Rich Resources.
Resources.
Expansive
Expansive Research.
Expansive Research.
Research.
Independent, in-house research is Loomis Sayles has the comprehensive, multifaceted
resources needed
hasto stand firm in the face of volatility.
Independent, in-house research is Loomis Sayles the comprehensive, multifaceted
the bedrock beneath
Independent, in-houseevery
research is Loomis Sayles
Our research
resources
has the comprehensive,
teamstobring
needed together
stand firm in athe
multifaceted
top-down
face of macro
volatility.
resources needed to stand firm in the face of volatility.
the bedrock
strategy webeneath
offer. every Our research teams bring together a top-downtomacro
focus with bottom-up security specific research
the bedrock beneath every Our research
unearth teamsvalues
compelling bring and
together a top-down that macro
focus with bottom-up security hidden
specificgems
research might
to
strategy we offer. focus with bottom-up
otherwise be overlooked. security specific research to
strategy we offer. unearth compelling values and hidden gems that might
unearth compelling values and hidden gems that might
otherwise be overlooked.
otherwise be overlooked.
loomissayles.com blog.loomissayles.com

loomissayles.com blog.loomissayles.com
loomissayles.com blog.loomissayles.com
 Spotlight: Artificial Intelligence
Advisors Await SEC Rule for AI
Proposal to tackle predictive data
analytics faces criticism.
REGULATION
Jasmin Sethi
The SEC has yet to directly address the use of
artificial intelligence by financial advisors.
Last summer, however, it issued a proposed rule
to prevent broker/dealers and registered
investment advisors from using “predictive data
analytics” and similar technologies, including
those that use AI, in a manner that results in the
firm placing its own interests above those
of its clients.
The commission said in its July 2023 proposal
that “the proposed conflicts rules would
require a firm to evaluate any use or reasonably
foreseeable potential use by the firm … of
a covered technology in any investor interaction
to identify any conflict of interest associated
with that use or potential use.” [Italics added
for emphasis]
The SEC is concerned that firms could exploit such
technologies to optimize revenue and to use
behavioral prompts and social engineering to the
detriment of the investor.
We, and Others, Have Concerns
This proposal has been met with a slew of
industry criticism. In comment letters,
trade associations, including the Investment
Company Institute and the Securities Industry
and Financial Markets Association, have argued
that the requirements of the proposal
are impractical and would cause firms to avoid
adopting technological innovations. The
groups argued that the rule lacks clear limits and
could effectively ban certain technologies.
They also said that the definitions of covered
technologies, investor interaction, and conflicts
of interest are too expansive and could impose
onerous testing processes on firms and
stifle innovation, which would discourage the
development of products that would
benefit investors.
Morningstar shares the concerns of these trade
groups. In its own comment letter to the
SEC, Morningstar said that the commission’s
definitions are overly broad and that the rule
would require burdensome testing. “We
believe a rule addressing emerging technologies
should be scoped to address those technologies
specifically, and we urge the commission
to revisit the requirements, guidance, and
enforcement around Regulation Best Interest …
instead of promulgating new definitions
and approaches to conflicts of interest,”
Morningstar wrote.
Proponents of the rule, such as the Consumer
Federation of America and the North
American Securities Administrators Association,
assert that it would safeguard investors,
effectively tackling conflicts of interest arising
from technology-based platforms.
Implications for Advisors
If adopted, the proposed rule would become
important in virtually every aspect of an
RIA’s or a broker/dealer’s business. The
regulations would mandate that whenever an
investment advisor or broker/dealer used a
technology covered by the rule to engage or
communicate with an investor, the advisor would
have to conduct a comprehensive review
of the process to uncover any conflicts of interest.
If it were found that the firm’s interests were
prioritized over the investor’s, the conflict
would have to be eliminated. The rule states
that firms would have to establish policies
and procedures to prevent any violations and to
ensure adherence to the regulations. These
regulations would apply even in dealings
with investors that fall short of recommendations,
including, for example, using technology to
send news articles to investors about securities
on their watchlist.
An Expansive Definition: Covered Technologies
The proposed rules come into play when
firms employ covered technologies to communicate
or interact with investors. The SEC defines covered
technologies as any “analytical, technological, or
computational function, algorithm, model,
correlation matrix, or similar method or process
that optimizes for, predicts, guides, forecasts, or
directs investment-related behaviors or outcomes
in an investor interaction.”
This definition extends far beyond what is
commonly understood as predictive data analytics,
which uses machine learning, statistical
models, and data mining to identify business
risks and opportunities.
“Rather than addressing emerging concerns from
artificial intelligence, [the proposed rule] sweeps in
many older, well-established, and well-regulated
products such as quantitative equity or fund
ratings and robo-advice,” Morningstar said in its
comment letter.
In fact, Morningstar believes that the SEC’s
definition is so broad that it would include
technologies designed to help firms mitigate
actual conflicts of interest that they may
face in making a recommendation. For example,
low-cost algorithmic investing through
managed accounts and robo-advisors has made
asset management accessible to the masses
in a way that mitigates conflicts of interest.
Retirement plan providers use managed accounts
programmed by third parties to avoid conflicts
that may arise if the plan provider has a
financial interest in recommending one fund over
another to retirement plan sponsors.
The rule could also include more-mundane tools,
such as correlation matrixes, which are
morningstar.com/products/magazine 31
 Spotlight: Artificial Intelligence
essentially Microsoft Excel spreadsheets with
a formula and which do not present the same risks
as, say, an AI chatbot.
The SEC’s broad scope fails to account for the
deterministic nature of some technologies,
creating a deterrent for products with predictable
algorithms that present little risk. It also fails
to directly address new, cutting-edge technology
such as AI that has the potential to reshape
the financial industry.
A New Concept: Investor Interaction
The proposed rule defines investor interaction
as “engaging or communicating with an
investor, including by exercising discretion with
respect to an investor’s account; providing
information to an investor; or soliciting an investor.”
How to Use Mo to Fine-Tune Your Communication Skills
One way to use artificial intelligence is with client
communication. When talking to clients, it’s
important to strike the balance between being too
technical and too patronizing, especially if
you’re explaining financial concepts. But doing
so is easier said than done. Here’s how
Mo, Morningstar’s AI digital assistant, can help.
One of the powers of generative AI is its ability
to create content in different tones, reading
levels, and contexts. Mo can be a useful tool for
improving advisors’ messaging. It’s important
to note that advisors should not take a response
generated by Mo, or any other AI tool, at
face value. AI is prone to “hallucinations”—
instances where it will provide false information.
Plus, it is essential that advisors write using
their own words and tone. AI cannot replicate
an advisor’s unique voice—one that has
resonated with clients over the years. Advisors
also have important insights into their clients
that AI cannot possibly know.
Therefore, the following exercise is designed to
combine the informational power of Morningstar’s
32
Again, this definition is overly broad. We think
it should distinguish between scenarios
in which an investor initiates an interaction with
a financial advisor or broker/dealer with
the intent of seeking information from one in
which a financial institution starts the interaction
with the investor. As is, the breadth of the rule
would make it nearly impossible for a firm to
respond to a request from an investor for objective
financial information that is educational.
“As an example, automated account support
may use a level of chatbot or language learning
models to provide answers to questions
around a client’s account. In these interactions,
no attempt to solicit a transaction, recommend
a product/service, or engage in activity
that is generally deemed to be ‘regulated’
Mo with the strengths advisors already possess
to communicate better with clients.
1 Generate Explanations
Prompt Mo to explain a financial concept twice:
one at a level too simple for clients and one that
is too complex.
As shown to the right, we prompted Mo to explain
REITs, first as though we were a 5-year-old and
then as a professor of economics.
2 Check for Accuracy
Fact-check the responses and be on the lookout
for any AI hallucinations.
3 Identify the Strengths and Weaknesses
of Both Explanations
Strengths of the simple explanation are its
succinctness and the use of a simile to illustrate
the concept in a tangible way. However, the
language it uses is too immature for clients.
Some strengths of the complex explanation include
identifying different beneficial factors of REITs,
may be present,” Morningstar wrote in its
comment letter.
A Risk-Based Approach: Conflicts of Interest
The SEC’s broad definition of conflicts of
interest raises concerns about the ability of the
financial industry to serve clients effectively.
According to the proposed rule, a conflict
exists if a covered technology considers any
interest of the firm, irrespective of whether the
firm prioritizes its interests over those
of investors.
The commission proposes the elimination or
“neutralization” (a term that is not properly defined)
of these conflicts of interest, but elimination
would make it virtually impossible for the financial
industry to service investors. Under the rule,
such as its diversification and dividends.
However, it provides more detail than clients will
likely need (or want) about such factors.
4 Fill in the Gaps
Start by identifying components missing from
the explanations, such as phrases you have found
that are particularly effective or any details
Mo may have left out. Then, write a few sentences
that incorporate client-dependent context,
such as how it fits into their financial goals and
their risk tolerance. Connecting your messaging
to a client’s unique situation can help them
resonate more with your explanation and may
prompt them to follow your advice.
5 Craft Your Messaging
Write your own explanation by combining the
strengths identified in Step 3, the gaps identified
in Step 4, and your own voice—after all, your
clients chose you for a reason!
Danielle Labotka is a behavioral scientist at Morningstar.
Samantha Lamas is a senior behavioral researcher
at Morningstar.
it’s unclear how an RIA or broker/dealer could
provide a service for revenue, and the additional
conflict requirements could increase the costs of
products and services beyond their worth.
Plus, investment advisors already have fiduciary
duties to disclose and address conflicts of interest
under SEC Rule 206(4)-7 and Finra Rule 3120,
and broker/dealers are obligated to identify and
mitigate conflicts under Regulation Best Interest.
In its letter, Morningstar encouraged the
commission to instead allow firms to follow a
risk-adjusted compliance approach. While
acknowledging the SEC’s goal of addressing
conflicts of interest, Morningstar said that the
commission should allow firms to determine their
regulatory requirements based on the varying
degrees of risk associated with different predictive-
data-analytics technologies.
What’s Next for the Proposed Rule
The SEC was slated to take final action on the rule
in April, but this date was not binding. The
critique of the rule is extensive, and the proposal
is facing heavy opposition. Sens. Ted Cruz,
R-Texas, and Bill Hagerty, R-Tenn., introduced a
bill aiming to prevent the SEC proposed rule
from being finalized and enforced. The bill faces an
uphill battle without Democratic co-sponsors
and navigating the Democratic-controlled Senate.
But given the proposal’s broad reach, Democratic
opposition would not be surprising.
Another avenue to thwart the regulation is through
the Congressional Review Act if the rule is
approved. The act requires only a simple majority
in the House and Senate. It allows Congress
to retroactively block federal regulations within
60 legislative days of their enactment.
So, the future of this proposal is uncertain.
What it has served to do is raise questions
about the appropriate use of AI by financial
advisors and how to equitably and consistently
regulate conflicts of interest for both human
intelligence and AI. For now, these questions
remain unanswered. K
Jasmin Sethi is an associate director of policy research
with Morningstar.

Explain REITs to me like I’m a 5-year-old.

REITs, which stands for real estate investment trusts, are like a special kind of Morningstar Mo is able to tailor the sophistication
investment that allows people to own a little piece of big buildings, like shopping of its response based on the prompt. Here,
malls, apartments, or office buildings. It’s kind of like when you buy a share we asked Mo to explain REITs to a 5-year-old and
of a toy and you get to play with it and also get some money when other then to an economics professor.
kids want to play with it too. With REITs, you can buy a share of a big building
and get some money when people pay rent to use the building. So, it’s like To explain REITs to clients, an advisor might use
owning a piece of a big building and getting some money from it. elements of both responses to craft a message
that strikes the right balance between being too
technical and too patronizing.

Explain REITs to me like I’m an economics professor.

REITs, or real estate investment trusts, are companies that own and operate
real estate properties such as office buildings, shopping centers, and apartments.
They generate income from rent and capital appreciation. Unlike traditional
stocks, REITs are required to pay out at least 90% of their income to investors
in the form of dividends. This makes them attractive to income-focused
investors. However, the performance of REITs can be influenced by factors such
as interest rates and economic conditions. They have historically had a
lower correlation with equities and fixed-income securities, providing potential
diversification benefits. However, the diversification benefits of REITs may
be waning. It is important to consider specific characteristics and performance
of REITs when including them in a portfolio.

33
 Spotlight: Artificial Intelligence
Are There Any Undervalued
Opportunities Left in AI?
Investors should look beyond big names
and focus on moats.
INVEST
David Sekera, Kenneth Lamont, and Grady Burkett
Few themes have caught the market’s attention
as much as artificial intelligence. AI
stampeded into the market consciousness in
November 2022 when OpenAI launched
ChatGPT. This large language model quickly
captured the imagination of users who
began to analyze how AI could be a catalyst
to boost productivity, drive revenue, and
enhance profitability.
In this modern-day version of the gold rush, the
first companies to benefit from the voracious
demand to build out AI capabilities were those
making the “picks and shovels”—which today are
the graphics processing units used to train AI
and the cloud resources and data centers
to house the vast amount of data that AI requires.
The stocks of the obvious immediate beneficiaries
of the growth in AI have surged and,
according to our valuations, are generally fully
valued to overvalued at this point. Looking
forward, investors will need to determine who will
benefit in the long term and be able to meld
AI into their business models to bolster growth
and increase productivity.
We have three pieces of advice for turning AI
ideas into actions for 2024:
1 Focus on second-derivative plays. Rather than the
big AI players, we see potential opportunities
in the next rung of AI adopters. This includes those
that can strengthen their products using AI,
without the valuation risk.
34 Morningstar Q2 2024
2 Beware of ultrahigh valuations. Prices have run
up very quickly, so there’s an expectation of
strong growth already priced in. As competition
rises, we could see disappointments.
3 Focus on moats. Companies that have the
greatest competitive advantages are likely to thrive.
They will also be less susceptible to obsolescence.
Taking Stock of the AI Landscape
Artificial intelligence is expected to change the
way business is conducted, especially with
the progression of generative AI. The pace of
change is remarkable, and investors are naturally
eager to understand the winners and losers.
While we’d warn them not to let hype dominate
their investment decisions, we are seeing a
tremendous shift in the makeup of equity markets
that’s worthy of note for all investor types.
By now, many investors have tested AI platforms
and have seen the power of AI firsthand.
We expect 2024 to be a year of phenomenal
change in this space, as the race to build market
share has begun. We expect rife competition
within the buildout of artificial intelligence
hardware, platforms, and usage. Practically every
company in the world is seeking to understand
how it can use this technology to increase revenue
and profit margins.
We see two main ways that AI can add to
company performance. The first is automation,
such as creating efficiencies in the back office
and improving processes. Anecdotally, back-office
efficiency is the primary motive for most large
companies at this stage. However, we expect
generative AI and predictive analytics to ultimately
play a greater role across practically every
business function and industry. The second
is product and service enhancement, potentially
creating new revenue growth opportunities
and improving the economic value for customers.
We expect rapid growth for both the hardware
and software needed to develop, train, and use
AI ( EXHIB IT 1 ). With only a small dose of
imagination, we can quickly identify use cases for
over 90% of the workforce in developed and
many emerging markets.
The list of major AI players includes many
familiar names to investors ( EXHIBIT 2 ). However,
valuations have increased significantly in
anticipation of success. While they may have
a first-mover advantage, they are still subject
to risk, and it will be even more difficult than usual
to forecast how artificial intelligence will
develop over the medium to long term. As such,
most of these stocks have either High or Very
High Morningstar Uncertainty Ratings, and
their stock prices could be highly volatile in the
years to come.
Risks to Be Aware of in AI Stocks
Regarding investment risks, AI does bring some
new challenges to the table.
Valuation
Even fast-growing businesses can be poor
investments if investors overpay for their stock.
It’s also important to keep in mind that the largest
portion of a growth company’s value is
derived from cash flows generated many years in
the future. Companies that develop durable
competitive advantages are more likely to maintain
long-term free cash flow growth and could
warrant higher valuations. However, this is a
very expensive race with significant uncertainty
about the future winners and losers. A lot
must go right for the primary AI stocks to continue
to deliver, but the risk/reward trade-off can
deteriorate if investors overpay.
Regulation and Safety
Let’s start with the risk of artificial intelligence
itself. The technological capabilities are under
immense scrutiny from both users and
governmental regulators. While it is acknowledged
 EXHIBIT 1

as a force that can be used for good, it also Long Growth Runway Between AI semiconductors and software, revenue should
creates significant threats. We do expect rise rapidly.
an increase in regulation and new policies over the
next few years, yet this will often be developed
at a country or regional level. $400M
137 Estimated AI
300 117 Semiconductor
Concentration
98 Revenue
As with any emerging technology trend, AI brings
200 82 220
new uncertainties to companies and 180 Estimated AI
industries. As investors, we should acknowledge 150 Software Revenue
68 125
this increased uncertainty when considering 100
0 60
position sizes.
2023 2024 2025 2026 2027
Source: Morningstar, company documents. Data as of Feb. 22, 2024.
Obsolescence
It’s far too early to confidently identify companies
whose products and services will become
EXHIBIT 2
less relevant because of AI. Still, AI will likely bring
change to many industries, and we should Major Players Here are the top 10 stocks held by AI and Big Data exchange-traded
$15B
remain alert to potential shifts in a firm’s industry funds and mutual funds globally. Cumulative
structure. We’re equally skeptical of company 10 Net Flow
managers who downplay AI’s risks as we are of Stock Sector Morningstar Rating Economic Moat
those who overhype AI’s benefits. 5
Nvidia NVDA a Technology QQQ Wide
Hidden Portfolio Risks Alphabet
0 GOOGL i Communication Services QQQ Wide
Even well-informed investors have limited insight Microsoft
–5 MSFT a Technology QQQ Wide
into the distant future. We shouldn’t assume 03/2019 06/2021 12/2023Wide
Amazon.com AMZN t Consumer Cyclical QQQ
that a company that seems insulated from AI risks
today will remain so. Further, investing heavily Advanced Micros Devices AMD a Technology QQ Narrow
in AI-related companies can also bring significant ServiceNow NOW a Technology QQQ Wide
portfolio tilts that could adversely alter the Meta Platforms META i Communication Services QQ Wide
risk/reward trade-off in a total portfolio context.
Tesla TSLA t Consumer Cyclical QQQ Narrow

The AI Opportunity in 2024: Secondary Plays
Share prices for the companies that have been
identified by the market as obvious beneficiaries
of the growth in artificial intelligence have
surged over the past year. At this point, we see
very little margin of safety in most of these
stocks as they are now fully valued and, in many
cases, overvalued. According to our valuations,
the excess returns for most of these stocks
are already behind us. However, investors can look
for undervalued opportunities in sectors and
companies that are likely to be second-derivative
plays on AI.
For example, many mid- and small-cap companies
do not have the expertise or financial wherewithal
to build and maintain their own AI platforms
and will need to hire assistance. That’s where an
IT consulting company such as Cognizant
Taiwan Semiconductor TSM a Technology QQQ Wide
Palo Alto Networks PANW a Technology QQQ Wide
Source: Morningstar Global Thematic Database. Data as of Feb. 29, 2024. For illustrative purposes only. Please note that references to specific
securities or other investment options in this piece should not be considered an offer (as defined by the Securities Exchange Act) to purchase or sell
that specific investment.
Technology Solutions CTSH comes in with networks will need to be refreshed and demand
its technical capabilities in artificial intelligence for components should increase. We expect
services. Data management providers, such Arista Networks ANET to have proficiency at the
as Snowflake SNOW, are another example. These highest networking speeds to allow it to reap
firms host the enterprise data on which the benefits of spending brought on by
AI models are run and offer the tools used to investments in generative AI. However, the stock
train them. is currently overvalued.
AI requires extremely high network speeds to train Lastly, artificial intelligence requires a huge
its data models. We think Nvidia’s NVDA amount of data to train its models. As such, we
technology will continue to be a leader here. And expect data centers to experience a long tailwind
as companies build out their AI capabilities, from the explosion of growth in AI. As AI is built,

morningstar.com/products/magazine 35

200 82
Spotlight: Artificial Intelligence
68 125
100
0 60
2023 2024
EXHIBIT 3
Popular Theme Cumulative flows into AI and Big Data thematic funds have risen
over the past year.
$15B
10
5
0
–5
03/2019
Sources: Morningstar Direct, Morningstar Global Thematic Database. Data as of Dec. 31, 2023. For illustrative purposes only.
trained, and rolled out, it will require a great
deal of computing power and data storage.
Companies such as Digital Realty DLR stand to
benefit by hosting these needs.
Focusing on Moats Is a Sensible Approach
When new product development is in overdrive,
it can be a dangerous game to chase the
winners. A sensible approach is to focus on
durable competitive advantages. Companies with
economic moats could be more likely to benefit
and may be less susceptible to disruption
from AI than those without moats. Moats based
on a combination of customer switching
costs, unique data sets, and brands could be
particularly valuable. Companies with
durable advantages could use AI to improve their
products and services and strengthen their
competitive positions.
For example, Adobe ADBE has a wide moat rating
arising from switching costs and network
effects. We think Firefly, launched in 2023, is an
important AI solution that will attract new
users. Adobe is also introducing AI features across
its cloud offerings to create a more cohesive
experience, upsell users to higher-price solutions,
and cross-sell digital media offerings.
On the other hand, change brought about by
AI could erode companies’ moats or shift
consumer demand away from their products and
services. Investors should be on the lookout
for paradigm changes in industry structures and
customer preferences.
36 Morningstar Q2 2024
98
220
180 Estimated AI
150 Software Revenue
2025 2026 2027
Cumulative
Net Flow
06/2021 12/2023
We also expect better investment outcomes
at companies with stronger management teams
that allocate capital effectively. Integrating
AI into existing products and services will be a
complex endeavor for managers, and navigating
new competitive threats will require sound
strategy and solid execution.
Moreover, managers may be tempted to overspend
on AI-related product development or pursue
ill-advised acquisitions. Consider investing in
businesses whose managers have a track record of
sensible capital allocation and effective execution.
Fund Investors Who Want AI Exposure
Investors can also use funds to gain exposure to AI.
Flows into this theme continue to rise ( EXHIB IT 3 ).
Thematic funds have multiplied, and now investors
can choose from a smorgasbord of options.
A look back at the commercialization of
technologies in the past shows that picking the
eventual winners can be anything but
straightforward. It’s just likely that some of the
biggest winners in AI will not be those the markets
have crowned today. If you own a thematic fund
rather than a single stock, you are less likely to
entirely miss the biggest winners.
When evaluating thematic funds, the fundamental
characteristics that boost the chances of
long-term investment success, such as low fees,
a seasoned management team, and a trusted
parent organization, still apply and should
form the foundation of any analysis. That said, the
distinctive characteristics of thematic funds
require a more tailored approach to due diligence.
One manager may build a high-conviction
portfolio of stocks selected for their high growth
potential, while another may track the same
theme by building a broader portfolio of
stocks based on their exposure to a theme and
integrating other investment metrics, such
as quality screens, which will result in a strikingly
different exposure.
Looking beyond a name to really understand how
a fund targets its theme is even more crucial
when it comes to AI. It may not be straightforward
at a glance to determine whether fund
managers are using artificial intelligence to select
stocks or whether they’re selecting stocks
exposed to AI (or both).
Findings in our recent study “The Big Shortfall”
show that on aggregate, poor investor buying and
selling habits connected with thematic funds
over the past five years have destroyed most of the
returns provided by thematic funds. It goes to
show that investors can pick the right theme and
the right fund, but if they use them in the wrong
way, they can still end up empty-handed.
The Bottom Line on AI
Artificial intelligence is an exciting investment
opportunity, and we expect market interest
will remain elevated for years to come. While the
obvious early investment opportunities appear
fully valued, one effective way to gain access to
the AI theme, without paying huge valuation
premiums, is via second-derivative plays. These are
not the chipmakers or those that offer technology
interfaces. Rather, look for companies that
can support the growth of this new technology,
embed AI into their workflows, and drive
new revenue growth opportunities. The principles
of good investing and investing with a margin
of safety still apply. K
Dave Sekera, CFA, is chief US market strategist at
Morningstar Research Services LLC.
Kenneth Lamont is a senior analyst, manager research,
passive strategies, at Morningstar Europe Ltd (UK).
Grady Burkett is an equity portfolio manager at
Morningstar Investment Management LLC.
Always-on
tax loss harvesting…
and more
Canvas® Custom Indexing
With flexible and opportunistic tax loss
harvesting and 100+ customization options,
Canvas empowers you to seamlessly pursue
tax-optimized, personalized portfolios for
your clients.
franklintempleton.com/canvas

All investing involves risk, including possible loss of principal.

Canvas is a technology platform and, as such, does not provide broker-dealer, custodian, investment advice, or related
financial services. Canvas is a property of O’Shaughnessy Asset Management, which is a subsidiary of Franklin Resources, Inc.,
a global investment management organization operating as Franklin Templeton.
 Strategies
Tugging on a Thread
A late SEC filing helps unravel a spool
of risk at a muni-bond fund.
Research PRINCIPAL STREET
41 ARK Tops List for Value Destruction Eric Jacobson
How-to
42 Is Your Active Manager Worth It? Principal Street Partners submitted a Notification
of Late Filing to the SEC in November 2023
Best Ideas for its municipal-bond funds’ annual report. The
45 Manager: Patience Required firm said it was unable to file the report by
46 Passive: Global Bond Exposure the usual deadline because of complications in
With a Razor-Thin Fee valuing certain bonds in the Principal Street
47 Equity: A Strong Core High Income Municipal Fund GSTAX.
A cursory look at performance could give the
impression that it must have been a technicality.
The fund lagged by nearly 2 percentage points
in 2023 but still turned in a 5.2% gain, and its
trailing returns of three years or shorter placed it in
the high-yield muni Morningstar Category’s
best half or better at the end of February 2024.
Shareholders have been fortunate not to suffer
more damage than a lagging 2023 performance,
though, because when you tug on the
loose thread of its accounting complications,
they quickly unravel.
The high-yield muni category is an outlier to
begin with because most of its members
hold big stakes in relatively small bond issues
that don’t carry third-party ratings. Like the
Principal Street fund, most specialize in
debt to fund private-sector projects with public
benefits, such as waste recycling, senior
housing, or healthcare facilities.
The bonds usually carry state or local governments’
names and tax-free status, but not their
guarantees. Once they help issue the bonds, the
government agencies wash their hands of
them, and private businesses are on the hook
for paying back the debt.
38 Morningstar Q2 2024
Income Above All Others
Borrowers often choose to forgo a rating if the
size of a deal makes paying for one uneconomical,
if they know the deal would get a low rating
anyway, or both. So, nonrated municipals usually
carry higher yields to attract investors, and
those willing to buy them need to do extensive
credit research and monitoring if they want
to avoid the duds.
The average fund in the category had a 12-month
trailing yield of 4.1% at the end of February
2024, but Principal Street High Income Muni’s was
2 percentage points higher at 6.1%.
In fact, the fund’s yield has been the category’s
highest in every month since it was first calculated
(a year after its 2017 inception) ( EXHIBIT 1 ).
Nothing to See Here, Literally
You don’t have to look far for the reason. Even
among the roughly 60 funds in the high-yield muni
category, Principal Street flies close to the
sun. At the end of November 2023, 96.2% of the
fund’s assets were in nonrated bonds, according
to Principal Street data ( EXHIBIT 2 ). That is
the highest weighting for any muni fund—ever—
in Morningstar’s database, except for Heartland
High-Yield Municipal Bond, which had its
own pricing problems, lost 70% in a single day,
and had to be liquidated in the early 2000s.
Meanwhile, Principal Street’s portfolio has held
140 bonds on average over the past three
years, making it among the category’s least
diversified. It doesn’t evenly distribute those assets,
either. The fund’s top 20 holdings took up
almost half of the portfolio in November 2023,
a figure more common among concentrated
equity funds. That ratio has been even higher:
It was 62% in May 2020, when the fund’s largest
holding accounted for 7% of its net assets.
An Exclusive Club
Other factors suggest that many of its bonds have
a small audience, too, including how widely
each one is held by other asset-management firms
in portfolios submitted to Morningstar.
In this case, more than 20% of the fund’s assets
were in bonds owned only by Principal
Street, according to our database, while 61%
of the portfolio consisted of bonds that were
trades or those of similar bonds on which to Large Level 3 stakes alone don’t mean problems,
rely. The framework is somewhat flexible, but they can when combined with other
though, and few funds report more than a small challenges, and there have been examples of
percentage of their assets as Level 3. Level 3 numbers spiking before big trouble.
For example, Third Avenue Focused Credit’s Level
That was true for Principal Street as recently as 3 holdings’ dollar value dropped between
August 2022, when the figure was only 3.4%, late 2014 and early 2015—which would normally
but it was 16.1% when the fund filed its annual lower their percentage share of assets—but
report in November 2023. outflows and a shrinking asset base drove them
EXHIBIT 1

reported to be held by three or fewer firms, Second to None Principal Street’s yield has been the highest in the category from
including Principal Street.
the get-go.
Fortunately for shareholders, whether that would Principal Street High Income Municipal vs. High Yield Muni Category
make it difficult for the fund to find buyers in
a pinch hasn’t been badly tested. Its asset flows 8
have been relatively stable, with the worst Principal Street High Income
Municipal Institutional
stretch of redemptions clocking around 7.5% over
6 6.14
Yield %12-Month Yield %

three months back in 2022 ( E X H I BI T 3 ).

10th Percentile of Category
8
What’s Fair? 4 4.72
Principal Street High Income
It’s no surprise then to see valuation challenges. Municipal Institutional
6
High
6.14 Yield Municipal
Small issues without ratings don’t trade very 2 Category Median
Trailing 12-MonthTrailing

often, so the third-party pricing services on which 4.09

0 10th Percentile of Category
most managers rely typically use external factors 4
to decide where to mark their prices. They 09/2018 09/2020 09/2022 02/2024 4.72
Source: Morningstar. Data as of Feb. 29, 2024.
look at a variety of data, including how similar High Yield Municipal
a bond is to others that have recently traded. 2 Category Median
0 4.09
In some cases, managers may know there’s EXHIBIT 2 09/2018 09/2020 09/2022 02/2024
a material factor—either good or bad— Outlier Among Outliers Principal Street’s 96% stake in nonrated bonds is the
affecting their bonds and are expected to share 100
that information with the vendor if it could
highest in Morningstar’s muni-fund database in decades.
Principal Street
affect pricing. High Income
75 Bond Exposure
Nonrated Municipal
Percentage of Portfolio

In some circumstances, though, a vendor Institutional

100
may not feel it even has sufficient information 50
High YieldStreet
Principal
to provide a price, and the asset manager
Municipal
High Income
has to conjure a “fair value” price with the best 75 Category
25 Municipal
information available. Such holdings show
Percentage of Portfolio

Median
Institutional
0
up in annual reports as Level 3 securities for 50
accounting purposes. 05/ 08/ 11/ 02/ 05/ 08/ 11/ 02/ 05/ 08/ 11/ High Yield
2021 2021 2021 2022 2022 2022 2022 2023 2023 2023 2023 Municipal
Every mutual fund’s annual report includes 25 Category
Median
information about how its holdings have been 0
valued, and those labeled Level 3 are the 05/ 08/ 11/ 02/ 05/ 08/ 11/ 02/ 05/ 08/ 11/
most difficult. They typically lack coverage from 2021 2021 2021 2022 2022 2022 2022 2023 2023 2023 2023
pricing services and don’t have recent Source: Morningstar. Data as of Nov. 30, 2023 (most recent portfolio submitted to Morningstar).

$40M
morningstar.com/products/magazine 39
 High Yield

Percentage of
Municipal
25 Strategies Category
Median
0
05/ 08/ 11/ 02/ 05/ 08/ 11/ 02/ 05/ 08/ 11/
2021 2021 2021 2022 2022 2022 2022 2023 2023 2023 2023
EXHIBIT 3

Stable Flows Shareholders have largely stuck with Principal Street, so the fund has never had to rush to find buyers for its thinly
held bonds to meet redemptions.

Principal Street High Income Municipal: Estimated Monthly Inflows (Outflows)

$40M

20
Estimated Monthly Asset Flows

–20
09/2017 09/2018 09/2019 09/2020 09/2021 09/2022 02/2024
Source: Morningstar. Data as of Feb. 29, 2024.

to 20% of that portfolio by October 2015; the fund
halted redemptions that December and eventually
parceled out what was left to investors.
More (Trouble) Than They Were Worth
The valuation problems that led to Principal
Street’s late annual report filing—and
their impact—became clearer as the firm made
more disclosures through March 2024. Those
documents noted that several securities
were mispriced beginning in January 2023 all
the way through late October.
It turned out that the errors overstated each
share’s price by $0.13, representing approximately
1.77% of the fund’s net asset value. The firm
had to reprocess shareholder transactions as a
result and make up any shortfall from attempts
to recover nearly $600,000 for the fund.
That issue dovetails with an even more concerning
factor: Three of its nine Level 3 bonds were in
default, according to the fund’s data released
in November. In fact, there were 37 bonds reported
in default, accounting for more than 25% of
the portfolio—more than double the ratio from
February 2023.
Some funds occasionally buy bonds already in
default with the hope of getting a windfall
when deals are eventually struck to repay them,
but a large number here appear to have
defaulted, and fallen sharply in price, after the
fund originally bought them.
Although it has had a smoother ride more
recently, the fund’s 2020 covid shock experience
gave a peek into the vulnerabilities that
have weighed on the fund’s longer-term record.
The portfolio’s institutional shares trailed
the median return of its category by more than
8.6 percentage points in 2020, thanks
in part to pain from the pandemic-driven
selloff. The fund actually had inflows for most
of the year, though, so it wasn’t forced to
unload bonds.
Will Shareholders Make the Market Decide?
In fact, that’s really the ultimate concern
here: Would the market be willing to pay Principal
Street’s prices if the fund were forced to sell
a lot of bonds in a hurry? Another stretch of major
liquidity challenges would clearly be bad
for this portfolio. A streak of significant outflows,
however, would almost certainly be worse.
It’s been a long time since any fund faced
that kind of difficulty, but that’s what happened
in the early 2000s when big outflows
forced Heartland’s muni funds to dump bonds
in a hurry. SEC allegations of bond-pricing
malfeasance led to a 70% single-day drop in
Heartland’s high-yield muni fund and its
eventual closure. No one accused Third Avenue
Focused Credit of wrongdoing, but it lost
30% in 2015.
Fire-sale events like those of Heartland and
Third Avenue have been few and far between,
but they demonstrate how important it
is to make sure you can live with the risks your
fund takes. K
Eric Jacobson, is director of manager research,
US fixed-income strategies, at Morningstar Research
Services LLC.

40 Morningstar Q2 2024
ARK Tops List for Value Destruction based on asset size ( EXHIBIT 2 ). Credit Suisse,
for example, is a giant in the world of Swiss

Even during a generally bullish

banking but a relatively small player in the US
fund industry.

market, these fund families managed ARK, home of the flagship ARK Innovation ETF
ARKK, tops the list for value destruction.
to lose value for shareholders. After garnering huge asset flows in 2020 and 2021
(totaling an estimated $29.2 billion), its funds
were decimated in the 2022 bear market,
with losses ranging from 34.1% to 67.5% for the
year. Many of its funds enjoyed a strong rebound
in 2023, but that wasn’t enough to offset their
WEALTH DESTROYERS American Funds. This reflects a positive previous losses. As a result, the ARK family
Amy C. Arnott feedback loop of size and performance: Strong wiped out an estimated $14.3 billion in shareholder
performance attracts more assets, which value over the 10-year period—more than
in turn means the biggest fund shops twice as much as the second-worst fund family on
Mutual funds and exchange-traded funds have the most impact on wealth creation in the list. ARK Innovation alone accounts for
created a total of $11.1 trillion in shareholder value dollar terms. about $7.1 billion of value destruction over the
over the 10 years through 2023, thanks to trailing 10-year period.
the generally bullish market during most of this Then there are the biggest wealth destroyers,
period. The top wealth creators were all a motley crew of offerings in more specialized fund In most cases, the fortunes of the other worst-
well-known funds in plain-vanilla fund categories categories that have lost value for shareholders performing fund families are a product of
such as large-cap blend, allocation—50% over the same period ( EXHIB IT 1 ). I calculated how their investment focus. Many of the firms on our
to 70% equity, and foreign large blend. The much depreciation each fund generated in list have lineups that are heavy on specialized
winners list—led by Vanguard Total Stock Market dollar terms over the trailing 10-year period. Most and volatile categories, such as commodities,
VTSMX—was dominated by the biggest of the firms that have destroyed shareholder natural resources, and emerging markets—areas
fund families, including Vanguard, Fidelity, and value are on the smaller end of the fund industry that failed to enhance shareholder value
during most of the decade covered in our study.
Credit Suisse and Global X are two examples
of this trend. ProShares’ focus on inverse
EXHIBIT 1 EXHIBIT 2
and leveraged ETFs also led to wealth destruction.
Top 10 Wealth-Destroying Categories Top 10 Wealth-Destroying Fund
Over the Past 10 Years Families Over the Past 10 Years The biggest value destroyers in the fund industry
illustrate that there’s no guarantee of success,
Estimated Estimated
Wealth Wealth even during a generally favorable market.
Size Size
Morningstar Category $B Destroyed $B Fund Family $B Destroyed $B They also provide a valuable case study in how not
to invest. (As Charlie Munger was fond of
Trading-Inverse Equity 14.1 –41.8 ARK ETF Trust 16.1 –14.3
saying: “Invert, always invert.”) Investors have
China Region 27.7 –14.8 KraneShares 7.2 –6.5 been far better served by plain-vanilla fund
Trading- Misc 2.6 –12.0 Credit Suisse 2.3 –5.3 categories. They’ve also generally fared well by
Commodities Broad Basket 39.8 –9.6 Global X Funds 39.5 –4.6 sticking with the industry’s biggest and
most established fund families. Volatile and
Trading-Leveraged Commodities 2.2 –6.1 ProShares 68.8 –4.3
speculative categories—as well as unproven fund
Misc. Sector 16.2 –4.3 Barclays 1.3 –3.0 shops that attract a lot of short-term hype—
Trading-Inverse Debt 1.0 –3.8 AdvisorShares 1.0 –2.2 on the other hand, are best avoided. K
Latin America Stock 9.7 –3.3 Cromwell Funds 0.4 –1.9
Amy C. Arnott, CFA, is a portfolio strategist for Morningstar
Misc. Region 40.4 –2.2 ETF Managers Group 3.7 –0.5 Research Services LLC.
Systematic Trend 18.0 –0.6 Roundhill Investments 0.7 –0.5
Source: Morningstar. Data as of Dec. 31, 2023. Source: Morningstar. Data as of Dec. 31, 2023.

morningstar.com/products/magazine 41
 Strategies

HOW-TO

Is Your Active Manager Worth It?

How to compare active fund managers
relative to their fees.

Tony Thorn 1

Earlier this year, total assets in passive strategies

officially passed those in active ones. With this
increase in passive funds’ popularity, many
investors may be wondering whether active funds
are still worth their higher fees.

There are many ways to answer that question. One

common method is to determine how active
an active fund really is. Those that merely hug their
benchmarks arguably aren’t adding much value
for the fees they charge, while managers
whose portfolios are different than their indexes
might be worth their fees, if the differences
lead to good results.

To help determine which active funds are

2
delivering the most activity for their fees, you can
divide funds’ active share, a measure of how
different a portfolio is from its benchmark, by their
expense ratios (you can do the same thing for
other measures, like tracking error). The ratio won’t
tell you whether a manager’s activity has
produced good or bad results, but it can reveal
whether it’s charging a lot for only a little
bit of management.

You can use Morningstar Direct to isolate the data

for the calculations. Here’s an example looking
at large-cap funds.

1 To start, I used Search Criteria in Workspace

to pull one share class for each fund in the three
US large-cap Morningstar Categories. Because
fees vary across share classes and not all
funds offer the same share classes, I simplified the
analysis by selecting each fund’s cheapest
share class.

2 There is no cheapest share class data point, but

there is a workaround. At the bottom of the search

42 Morningstar Q2 2024
 Morningstar Direct
https://www.morningstar.com/products/direct

2 criteria, I checked the box for User Defined Primary 3

Class Only. This feature will choose one share
class per fund, based on the rules set up in
the User Defined Settings. To select the cheapest
share class, I set the Annual Report Net Expense
Ratio data point as the first criterion and set
it to Lowest in my Direct settings (File > Set User
Preferences > User Defined Primary).

For the rest of the search, I excluded passively

managed funds by setting the Index Fund
data point to No. I also included a filter to make
sure that each fund was benchmarked to
its Morningstar Category index, as several of
the calculations for “activeness” will be measured
against the category index. Including a
fund that is benchmarked against a unique index
(say, a large-growth fund closely following the
Nasdaq 100 Index) could create the illusion 4
that a fund is distinctive versus its category index,
despite it hugging its unique index.

3 After building a list of eligible funds, I added

several data points: Prospectus Net Expense Ratio,
Active Share (ETF Benchmark Proxy), and
Tracking Error.

Active share is a measure of portfolio

distinctiveness from its benchmark, with higher
values being more unique. Tracking error is a
measure of performance deviation from its
benchmark, with again higher values meaning
performance tends to stray more.

4 I had to change the calculation settings for

tracking error to make sure it was calculated
versus the Morningstar Category Index, but I kept
the time period over the trailing three years
through January 2024.

5 To calculate each fund’s activeness per unit of

fees charged, I exported the results to Excel. There,
I created two new columns and divided each
fund’s active share by its expense ratio as well as
each fund’s tracking error by its expense ratio.
I then added two more columns to rank those
scores and then finally added one more column for
a combined equal-weighted ranking of the
two (active share rank and tracking error rank).

morningstar.com/products/magazine 43
 Strategies
Morningstar Direct
https://www.morningstar.com/products/direct

HOW-TO

Valic Company Systematic Core VCGAX had one 5

of the lowest levels of activity for its fee in
the large-blend category. It charged an expense
ratio of 64 basis points and had an active
share of just 25% and a tracking error of 1.3.
Subadvisor Goldman Sachs uses a quantitative
model to try to outperform the Russell 1000
Index while sticking close to the benchmark’s
characteristics. It failed to beat the bogy
over the trailing one-, three-, five-, and 10-year
periods through January 2024.

Schwab Large-Cap Growth SWLSX was one of the

least unique funds in the large-growth category.
The $400 million fund uses a fundamentally
driven approach, but it had an active share of just Active Funds Ranked by Active Share Per Unit of Fees and Tracking Error Per
31% and a tracking error of 2.4 while charging Unit of Fees
an expense ratio of 0.99%. The fund’s performance Tracking Combined
looks strong compared with active peers Active Share Active Error Tracking Rank
Net Expense Per Unit Share Per Unit of Error (Equal-
since the Russell 1000 Growth has been difficult Name Ratio of Fees Rank Fees Rank Weighted)
to beat, but it has lagged the index over the
Wilmington Large-Cap Strat Instl WMLIX 0.25 2.44 1 0.81 1 1
trailing five, 10, and 15 years.
Valic Company I Systematic Core VCGAX 0.64 38.78 8 1.96 3 6
In the large-value category, Dunham Large Cap Schwab Large-Cap Growth SWLSX 0.99 31.77 3 2.46 10 7
Value DNLVX was one of the least active
funds per unit of fees. Subadvised by Great Lakes Wilshire Large Company Gr Instl WLCGX 1.00 34.65 6 2.21 7 7
Advisors, the fund had a modest active share Optimum Large Cap Growth Instl OILGX 0.97 31.77 5 2.83 18 12
of 70% but a low tracking error of 2.1, all while Morgan Stanley Pathway Lrg Cp Eq TLGUX 0.47 47.83 15 2.32 8 12
charging a staggering 1.26% expense ratio
(its other two share classes charged even more Sit Large Cap Growth SNIGX 1.00 41.41 10 2.79 16 13
at 1.51% and 2.26%). Despite the high fees, Knights of Columbus Large Cap Gr I KCGIX 0.90 42.60 11 2.80 17 14
the fund’s performance was narrowly ahead of
American Century Disciplined Gr Y ADCYX 0.75 38.41 7 3.24 29 18
the Russell 1000 Value Index over the trailing
one, three, and five years. Alger Responsible Investing Z ALGZX 0.95 50.27 21 2.69 15 18
Dunham Large Cap Value N DNLVX 1.26 55.48 34 1.70 2 18
High tracking error or active share doesn’t
PGIM Jennison Diversified Gr Z TBDZX 1.00 41.21 9 3.21 28 19
guarantee superior performance, but one way that
active funds can justify their fees is by offering Victory Value Class A UAVAX 1.16 56.84 39 2.03 4 22
something different than their cheaper passive Victory RS Growth Y RGRYX 0.83 47.13 14 3.53 38 26
alternatives. Comparing active share and
Commerce Growth CFGRX 0.75 50.25 20 3.39 32 26
tracking error to fees can help determine whether
a fund is really differentiated. K BlackRock Advantage Lrg Cp Gr K BMCKX 0.57 55.39 33 2.86 19 26
Buffalo Large Cap Institutional BUIEX 0.80 47.11 13 3.69 45 29
Tony Thorn is a manager research analyst for Morningstar
Research Services LLC. Wilshire Large Co Value Instl WLCVX 1.00 59.17 49 2.45 9 29
Hodges Blue Chip Equity Inc Retail HDPBX 1.30 54.94 32 3.50 36 34
PACE Large Co Growth Equity P PCLCX 0.88 49.47 16 4.01 60 38
Optimum Large Cap Value Instl OILVX 0.92 66.76 73 2.20 5 39

44 Morningstar Q2 2024
Patience Required
LSV Small Cap Value should reward investors over the long run.

BEST IDEAS: MANAGER

Jack Shannon LSV Small Cap Value LSVQX

This article is adapted from a Morningstar research report dated March 27, 2024. Stats 03/31/2024
Morningstar Medalist Rating Morningstar Category Expense Ratio
LSV Small Cap Value’s LSVQX deep-value approach goes through peaks and Œ Small Value 0.85%
valleys, but its impressive roster of researchers is committed to the philosophy.
Total Assets 1-Year Return 1-Yr % Rank in Cat
Over the long run, investors should be rewarded. $430.3 Million 7.38% 46

The five comanagers of this strategy, including firm co-founder Josef Morningstar Pillars 03/31/2024
Lakonishok, are deep-value investors to their core. Their investment style is Process People Parent
rooted in the idea that the market mistakenly projects current growth Above Average High Above Average
rates for companies indefinitely, resulting in overexuberance for high-growth
stocks and undue pessimism toward slower-growth stocks. Lakonishok Growth of 10K 03/31/2024
and his comanagers target the latter group and want to own companies that
are selling at a discount to peers and their own histories. They don’t $14K
LSV Small Cap
simply buy cheap companies, though, as some of them are beaten down Value
for good reason. Instead, they use a quantitative model to look for those 12 $12,661
whose stock prices are depressed over the long term but have shown recent Morningstar US
upticks in financial and stock performance. Small Value
10 $12,155

Lakonishok and Menno Vermeulen are the longest-tenured managers 8

and have overseen this small-value offering since its February 2013 inception. 04/2021 04/2022 04/2023
Both have been in the industry for more than three decades and have
exceptional credentials: Lakonishok’s work as an academic on contrarian Morningstar Style Box 12/31/2023 Morningstar Ratings 03/31/2024

investing underpins this strategy’s philosophy, while Vermeulen created Value Blend Growth Snapshot as Mstar Mstar Mstar
the firm’s proprietary quant model. The two work alongside three of most recent Period Return Risk Rating
Large

portfolio.
comanagers who average nearly 20 years at the firm, as well as a capable 3-Yr Above Avg Above Avg QQQQ
group of quant analysts and academic advisors. Team members conduct
Mid

5-Yr Average Above Avg QQ

research to continuously improve upon the systematic investment process
that drives the firm’s strategies, including this one. 10-Yr Average Above Avg QQ
Small

Overall Rating QQ
This strategy experiences periods of both deep underperformance and
sharp outperformance, and investors need to stay invested to reap Top 5 Sectors 12/31/2023
the long-run benefits. For instance, between February 2020 and February 2021,
■ Fund ❙ Category Average
the institutional shares trailed the Russell 2000 Value Index by more
y Financial Services 23.25 27.82
than 12 percentage points. However, it quickly rebounded, and between
February 2021 and February 2022 it outperformed the same index t Consumer Cyclical 14.84 18.08

by 11 percentage points. Over Lakonishok’s tenure through February 2024, p Industrials 12.50 18.00
it topped the index by nearly 110 basis points annualized. K o Energy 7.81 8.91

Jack Shannon is a senior manager research analyst for Morningstar Research Services LLC. u Real Estate 5.89 8.28
0% 10 20 30

morningstar.com/products/magazine 45
 Strategies

Global Bond Exposure With a Razor-Thin Fee

IShares Core International Aggregate Bond ETF should
maintain a performance edge.
BEST IDEAS: PASSIVE

Lan Anh Tran IShares Core International Aggregate Bond ETF IAGG
This article is adapted from a Morningstar research report dated March 27, 2024. Stats 03/31/2024
Morningstar Medalist Rating Morningstar Category Expense Ratio
IShares Core International Aggregate Bond ETF IAGG delivers a slice of the ´ Global Bond-USD Hedged 0.07%
global bond market for a razor-thin fee. It tracks the Bloomberg Global
Total Assets 5-Yr Annlzd Return 5-Yr % Rank in Cat
Aggregate ex USD 10% Issuer Capped (Hedged) Index. The index sweeps in $5.79 Billion 0.91% 38
investment-grade bonds denominated in currencies other than US dollars and
weights them by market value, capping issuer weightings at 10%. It also Morningstar Pillars 03/31/2024
hedges its currency exposure back to the US dollar monthly. Process People Parent
Above Average Above Average Above Average
The fund’s top country exposures reflect the size of the global debt markets.
As of February 2024, the fund carried an 18% stake in Chinese bonds Growth of 10K 03/31/2024
and another 10% in Japanese bonds, followed by developed European markets
such as France and Germany. These allocations are higher than those $11K
iShares Core
of a typical category peer and come at the expense of its allocation to Latin International
America. The strength of these markets will continue to be an important Aggregate Bond ETF
10 $9,761
influence on the fund’s performance. The Chinese market is still
in the process of opening up to foreign investors, and its bonds are more Morningstar Global
9 ex-US Core Bond
difficult to trade. Hdg USD
$9,582
8
Sovereign bonds hover between 70% and 80% of assets. The fund’s largest 04/2021 04/2022 04/2023
issuer was the Japanese government, at 10.5% in February 2024,
followed by the Chinese government at 9.6%. These securities are relatively Morningstar Style Box 03/31/2024 Morningstar Ratings 03/31/2024
Interest-Rate Sensitivity
more liquid than corporate bonds, which should help keep trading costs Limited Moderate Extensive Snapshot as Mstar Mstar Mstar
down. The fund has smaller weightings in corporate bonds and a muted credit of most recent Period Return Risk Rating
High

risk profile relative to peers. This has cushioned category-relative performance portfolio.
3-Yr Above Avg Below Avg QQQQ
Credit Quality

when credit spreads widened but is a headwind when investors favor

Medium

5-Yr Average Below Avg QQQQ

riskier assets. The fund outpaced the category average by nearly 4 percentage
10-Yr — — —
points during the worst of the coronavirus pandemic shock, but it lost all
Low

of that excess return in the ensuing credit rally of 2020. Overall Rating QQQQ

The fund’s diversified and low-fee portfolio should provide better Top 5 Sectors 03/31/2024
protection during credit shocks while maintaining broad exposure to the
■ Fund ❙ Category Average
opportunity set. In the long run, it should maintain a performance edge
Government 42.72 82.38
over its category peers. K
Corporate 10.80 12.62
Lan Anh Tran is an analyst with Morningstar Research Services LLC. Securitized 3.53 5.36

Cash & Equivalents 1.05 18.98

Derivatives 0.42 22.09
0% 25 50 75 100

46 Morningstar Q2 2024
A Strong Core
Hasbro’s renewed focus on its core strengths should support
profit expansion.
BEST IDEAS: EQUITY

Jaime M. Katz Hasbro HAS

This article is adapted from a Morningstar equity research report dated Stats 03/31/2024
March 1, 2024. Morningstar Rating Sector Industry
QQQQQ t Consumer Cyclical Leisure
Hasbro HAS continues to hold a leading position in the nearly $30 billion
North American retail toy industry, developing, manufacturing, Price Fair Value Estimate Uncertainty
$56.52 $84.00 Medium
and marketing well-known global brands that include Transformers, My Little
Pony, and Nerf. The firm operates a relatively differentiated business Economic Moat Capital Allocation Market Cap
model, thanks to its digital properties exposure, content creation ability, Narrow Standard $7.84 Billion
and key licensing arrangements, which can be better monetized
now that it has divested its Entertainment One (EOne) entertainment-related
Price/Fair Value 03/31/2024
assets. Production capabilities support Hasbro’s multimedia presence,
as does Discovery Family, a joint venture that brings Hasbro’s brands $120
to television, bolstering the firm’s brand blueprint strategy. Hasbro has
Fair Value
historically dominated the big screen, building brand loyalty and generating Estimate
90 Per Share
new streams of revenue from its licensing businesses, such as Star
84.00
Wars and Marvel. We think Hasbro and the toy industry have a modest runway
for growth ahead through international expansion (Asia-Pacific and 60 Month-End
Closing Price
emerging markets still provide longer-term potential through share gains) 56.52
30
and acquisitions of strategic players that fit into Hasbro’s portfolio
04/2021 04/2022 04/2023
(most recently D&D Beyond).

We rate Hasbro’s moat as narrow; it is a market leader with a differentiated

niche in the entertainment space. It also has rich exposure to games
through the Wizards of the Coast line, where peers have failed to erode
share, given the history of player loyalty in the category. However,
the strong returns on invested capital that Hasbro generates will continue
to attract competition, which will force it to continuously innovate
to maintain its leading position, resulting in elevated development costs.
We view Hasbro’s shares as significantly undervalued relative to our
$84 fair value estimate and contend that the weak performance reflects
a business in transition that has faced idiosyncratic risks in 2023,
such as slower entertainment growth owing to the writers strike and
the overhang from the pending sale of the majority of the EOne production
business, which was completed in December 2023. With Hasbro now
largely liberated from the low-margin EOne segment, we expect a solid
lift from an improved revenue mix, with the high-margin Wizards
of the Coast and digital segment set to represent around 35% of sales
in 2024, from 29% in 2023.
With a renewed focus on core strengths, we think Hasbro stands to benefit
from more-concentrated innovation and a streamlined operating model—
helped by the licensing of less-productive brands to partners, which should
help free up working capital. Additionally, thanks to a stringent focus on
expenses, Hasbro is set to reduce its gross costs by $750 million by the end of
2025, supporting profit growth. Hasbro forecasts a 20% operating margin
by 2027, but we think it can reach it by 2025, with long-term operating margins
stabilizing around 23% – 24%. As such, we think Hasbro can outperform
expectations given its renewed focus on product innovation, cost management,
and a lean operating profile. K
Jaime M. Katz, CFA, is a senior equity analyst for Morningstar Research Services LLC.

morningstar.com/products/magazine 47
 Investors
Value Investing in the Age of Intangibles
Two top managers take stock of
the industry and the opportunities.
Undiscovered Manager MORNINGSTAR CONVERSATION
54 A Healthy Blend Tony Thomas
Sector Rap
57 Changing Playbook What’s the state of value investing? It’s a
perennial question, but it has gained new interest
User Profile after the death of famed value investor
60 Navigating Newfound Financial Success Charlie Munger and the renewed dominance
of growth investing over the past year.
I spoke with the chief investment officers of two
shops that exemplify the best of value investing
today: David Hoeft of Dodge & Cox and Bill
Nygren of Harris Associates. The conclusion: Value
investing is alive and well.
David Hoeft, chief investment officer and
investment committee member at Dodge & Cox.
48 Morningstar Q2 2024
Hoeft and Nygren noted where they dare
to differ from Munger and how they’ve evolved
as value investors. They also mused on
the state of active management and the future
of mutual funds. Our conversation took
place on Feb. 28. It has been edited for length
and clarity.
Tony Thomas: Let’s start with this Charlie Munger
comment from the 2023 Berkshire shareholder meeting:
“I think value investors are going to have a harder
time now that there are so many of them competing
for a diminished bunch of opportunities. My advice
to value investors is to get used to making less.”
Do you agree?
William C. Nygren, partner, chief investment
officer, and portfolio manager at Harris Associates.
Bill Nygren: It gives me great pause to say
I don’t agree with Charlie on something. If the
statement is that investors need to get used
to making less, I can go along with that. The S&P
has been going up significantly more than
earnings growth plus dividends, and I don’t think
it’s fair to expect that to continue. So, I would
say both value and growth investors should be
expecting lower returns.
But I would object to the first statement, that
we have a larger pool of competitors than
we’ve ever had. I think there are fewer value
investors today than at any time during my career.
Almost everyone other than my esteemed fellow
panelist incorporates momentum into their
purchase and sale discipline to some extent. That
means that when the stocks start going down,
they can go down farther than they used to.
And I would suggest the “bunch of opportunities”
is not diminished relative to my 40-plus years
of doing this. There might actually be a
larger subset of the market today that looks
unusually cheap than there has been most of the
rest of my career.
David Hoeft: You want to choose the places that
you disagree with Charlie Munger very carefully,
but I do disagree here. I think the valuation
spread between the expensive and inexpensive
stocks in the S&P is exceptionally wide. As
an initial condition, that makes the prospect for
value investing over, say, a period of five or
10 years very bright.
If you look at the Russell 1000 Value today, it’s
cheaper relative to the Russell 1000 Growth
than it has been for nearly 90% of the time since
the late 1990s. That’s our estimation based on
different valuation metrics. That bodes well for
value outperforming growth. The Russell Value has
outperformed the Russell Growth for every
five-year period when the valuation spread has
been wider than the 80th percentile.
I would also mention that there’s a big difference
between value stocks and value investing.
If you just go out and buy a Fama-French value
stock basket defined as stocks with very low price/
book or even a very low P/E, that methodology
is likely not going to be successful. I think that’s
part of what Charlie was pointing to. But value has
migrated. Compared to 30 years ago, the ratio
of intangible to tangible assets of the collective
S&P 500 is up over 3 times, and more than 10 times
for tech companies. So, if you narrowly define
value as low price/book stocks, that isn’t likely to
be a viable long-term investing strategy if you
don’t have a more holistic insight into intangibles
and other sources of value that may not show up
directly on the balance sheet.
Value Evolves
Thomas: You both work hard to educate shareholders
about your firms’ approach to value investing. What
does value investing mean to you?
Nygren: To us, value investing is paying a price
that’s a significant discount to the business
value of the company. To David’s point, for
probably too long, most of our competitors defined
business value based on price/book or P/E ratios.
At the beginning of my career back in the
’80s, that worked decently well because it was
a more tangible economy back then.
But the problem is that GAAP accounting takes
pride in its conservatism. If you can’t touch
or feel something, the accountants believe it
doesn’t belong on the balance sheet. Consider an
auto-parts company building a new plant
expected to last 20 years. It goes on the balance
sheet, and you depreciate 5% of it a year to
try to match the cost of that plant to each year’s
flow of revenue. But if I spend money today
on customer acquisition costs and I expect that
customer to be with me on average for 10
years, that goes straight through the income
statement. It’s a growth expenditure, but it’s
immediately expensed. Brand advertising, research
and development—straight through the
income statement. And these expenditures have
become so much more important today as
we’ve gone to a more information- or knowledge-
based economy.
There have always been stray examples of
companies that GAAP didn’t do justice to. Early in
my career, it was the cable-TV companies—
they had negative income each year, negative
book value, yet there was a consistent flow
of going-private transactions. Why? Because the
accountants made customer acquisition
costs an immediate expense of the business, even
though the cable customer tended to stay
for a very long time. They had a relatively quick
write-off of wires that were in the ground,
even though useful lives lasted for a very long
time. When you adjusted for that, you could
see why private equity firms were willing to pay
10 times cash flow for cable companies.
We had examples of that in our portfolios in the
’80s, but it was one or two names out of 50.
Today, there are probably 10 to 15 names in the
Oakmark Fund OAKMX that are not going
to look cheap on book value or P/E. You have to dig
into it, make adjustments for growth investments,
for the cheapness to jump out at you.
It’s important to educate our shareholders and
potential shareholders so they don’t look at the
portfolio and say, “They’re not value investors
because Alphabet GOOG was a big holding for
them.” Alphabet looks really cheap if you separate
out the cash, the venture capital investments
they’re making, and you make an adjustment for
that. We think you’re buying the search business
at a significant discount to the market.
Hoeft: I’ll break it into two questions: the “what”
question of how our investing principles are
constructed to create value for our investors and
the “how” question of how that investment
philosophy meshes with the firm.
A number of years ago, my predecessor as
CIO, Charles Pohl, pulled together an anthology
of academic research that focused on the
characteristics that distinguish successful active
managers. We found that in addition to
the expected set of fund characteristics—low
expenses, low fees, low trading costs—there
were a few other characteristics that were
intuitive, but maybe a little bit less obvious. One
of them was a high active share with a long-
term investment horizon. Another was a
collaborative investment process that has teams
making decisions. And the third was managers
who are aligned with their investors through fund
ownership. These characteristics of successful
active managers aren’t exclusive to value investing,
morningstar.com/products/magazine 49
 Investors
and they don’t guarantee success. But when
they’re present, they tilt the odds of success in
the fundholders’ favor. That’s the “what.”
The “how” we find value is more creative and
differentiating. Everyone is trying to assess
the same characteristics of a company: growth,
profitability, capital intensity, franchise
strength, management, governance. The challenge
is that you rarely get these with an attractive
valuation. To us, value investing means assessing
the trade-offs along these dimensions. Whether
a company is an attractive investment is
driven by the individual dynamics of that company,
so you tailor the valuation analysis to it. With
pharma, for example, you might start with the
valuation, subtract out an estimate of the value of
the drugs in production or in the FDA pipeline,
and then back into what value the market’s
ascribing to the R&D. If that value is exceptionally
low, it tells you the bar for future discovery is
very low. What do you think their probability of
success is? What reasons do you have for taking a
position different from the market?
At different points over the past 15 years, software
companies such as Cadence CDNS, Synopsys
SNPS, Autodesk ADSK, Adobe ADBE—a pretty
long list of companies—traded at exceptionally
attractive valuations. These companies were
shifting from upfront revenue recognition, where
you might recognize a multiyear contract in
day one or year one, to a ratable business model,
where you’re spreading out the revenue
recognition over multiple years. That transition
obscured the true economics of the business.
To Bill’s point, were these companies optically
cheap by conventional valuation metrics? No,
because profitability was depressed by expensing
high R&D that legitimately added value, and
the revenue recognition was also transitioning,
which obscured their profitability and free cash
flow potential. But they did offer exceptional
value relative to price when you considered how
they could monetize this long-term value that they
were creating for their customers.
Value investing isn’t just about finding companies
with cheap prices and valuations. It’s also about
thinking creatively about the underlying business
50 Morningstar Q2 2024
value. We want our clients to understand
how we invest, to share our long-term perspective,
and we think that’s key to them being able
to stay the course when there’s a market
drawdown and the opportunities are actually more
attractive, so that they are able to benefit from
the long-term opportunities that we’re uncovering
on their behalf.
Thomas: Under this more holistic approach to valuation,
how do you think about when to sell?
Hoeft: We regularly have off-site discussions
where we focus on our investment process and
how we can improve it. We typically crunch
a lot of numbers to generate questions and queue
up topics. One of our findings several years ago
was that what we refer to as our sins of omission—
meaning the things that we did not own, or
the things that we had owned but then sold—
were far greater than our sins of commission,
or the companies we owned that underperformed.
This was a consistent finding as we went
back in time, so this was not just a byproduct of,
for example, being underweight the “Magnificent
Seven” or something.
Much of the underperformance was from
companies that we sold as valuations were
beginning to expand. The question was,
why did we sell these companies too soon? One
source of the problem is human psychology.
It’s classic risk aversion to want to sell a stock
when you’ve made a substantial profit rather
than stay invested when the long-term investment
thesis remains intact. We’ve done a couple
of things to try to balance out that tendency.
We try to explicitly track each component of
our investment thesis over time, across companies.
We’re trying to itemize how our thinking has
changed, to be explicit about that as part of our
trim/sell conversation. There’s no way you
can totally inoculate yourself against thesis drift,
but this is our attempt to do that.
A second step we’re taking is based on analysis
we’ve done that decomposes equity returns
into sales growth, margin change, capital return,
and change in valuation. As the investment period
extends, the contribution from valuation
declines relative to the contribution from these
other components of return. That makes sense,
since valuation typically has a mean-reverting
aspect. Valuation can’t grow to the sky.
We typically have our analysts look out three to
five years when they’re doing their scenario
analysis, but our average holding period is a little
bit longer than that: seven years. Another question
we’re asking ourselves before we trim or sell
is whether our answer might change if we extend
the time horizon. Obviously, no one has a crystal
ball, especially one that works that many
years out, but it’s a good exercise that helps clarify
the analysts’ conviction. What we’re focused
on is trying to understand whatever we can about
the durability of the business model. How
defensible is the moat? Have the conditions of the
company or the industry dynamics improved?
Nygren: I like the idea of the off-site meeting
with big data dumps on what we’ve done
right and wrong. We may copy that. We’ve seen
in our own history a tendency for analysts
to be too anxious to claim a win. You think
something’s worth $100 a share. You recommend
it at $60 and set your sell target at $90. But
rarely does a stock go from $60 to $90 without
there being some new fundamental information.
To us, the important thing is to make sure
that the analyst has fully incorporated that in
terms of a revised sell target and not just
sat with their sell target from the day they first
recommended the stock.
We found that value investors tend to be
conservative when they pitch an idea the first time,
and they’ll only go out as far on potential
P/E appreciation or growth expectations as they
need to make the stock look cheap today.
We very much focus on trying to make sure we
squeeze out all of that conservatism before
we actually sell the stock.
One of the things we’ve noticed in studying
patterns in stocks that we’ve purchased is what
I would call fundamental momentum. We
don’t want to ever respond to price momentum,
but companies that start doing better than
you expected tend to keep doing better for a while.
Analysts tend to underincorporate that
change into their estimates. And companies that
disappoint tend to continue disappointing for
a while. An analyst might have a knee-jerk
reaction to a disappointing quarter: My estimate’s
down 10%, the stock’s down 15%, so it’s more
attractive today than it was yesterday. But we
found that’s generally not true, that the analyst
has only partially incorporated the negative news
into their longer-term outlook. Focusing on
trying to make sure that all new fundamental
information has been incorporated into our
sell targets before we execute on them has been
an important change for us, and it has led to
somewhat longer holding periods on average.
it out, has a forward P/E multiple of over 33,
and the cheapest quartile is under 11 times.
This massive spread is a real tailwind for our style
of investing.
You also asked about economic conditions.
We’re in the preparation business, not the macro
forecasting business. While we don’t take
a top-down approach to investing, we do monitor
our risk exposures to make sure we understand
where we have macroeconomic factors that
could impact portfolio returns. Having said that,
we think today that the market seems pretty
confident that there’s going to be a soft landing,
full employment, lower rates. And that relative
unanimity of expectations can create opportunities.
There’s a lot of concern over office commercial
real estate, in particular, and that’s probably
justifiable. But has that focus led to punitive
valuations on some financials? Have a lot
of financials been tarred with the same brush?
And is there any insight that we can come
up with about the magnitude or timing of office
CRE losses that could create opportunities for
bottom-up investors like us?

Another thing we’ve required analysts to do

is what we call a postmortem, for lack of
a better term, a year after something gets sold,
to put out a note about the fundamentals tracked
relative to the fundamentals we underwrote
in our sell decision. We often see that we checked
out on the idea way before the margin
improvement story had completed or the growth
improvement story had run its full course. The
biggest thing is to make sure you don’t stick to an
original conservative sell target. Make sure you’ve
incorporated new fundamental developments.

Tailwinds Ahead
Thomas: How favorable are current market and
economic conditions to your style of value investing?
Hoeft: In an absolute sense, the market is fairly
expensive. It’s something like 20 times forward
P/E at year-end and still about 18 times if you
exclude the “Mag Seven.” We probably have even
more concern with the market expectations for
earnings growth. The ’23 to ’26 FactSet consensus
EPS growth is 12.5% per year. The S&P 500
has not managed to grow earnings that quickly
over a three-year period in the last 35 years unless
you’re starting from a depressed base—and
EBIT margins, per FactSet, are 17.5% today, which
is very high by historical standards. We’re The spread of valuation is really wide …
just not excited by the prospect of paying a high
multiple on high margins.
This massive spread is a real tailwind for our style
But that’s when everything is aggregated.
of investing.
The spread of valuation is really wide, and that’s
where the opportunity is created. The most
expensive quartile of the S&P 500, when you tease David Hoeft

morningstar.com/products/magazine 51
 Investors
We’re very excited about the opportunity
for value investors to perform significantly better
today than we have over the past decade.
Bill Nygren
Nygren: We, too, don’t have much conviction in
our macro forecasts. I’ve been at Harris Associates
for 40 years. Our macro forecast for those
40 years has always been that seven years from
now will be normal. There are only a couple
times that that’s actually made us an outlier
relative to other forecasts.
It’s hard to argue the S&P 500 is historically cheap
at more than 20 times forward earnings. I think
the average over the past 50 or 60 years has
been 16 times earnings. But David mentioned how
wide the spreads are today, and we definitely
52 Morningstar Q2 2024
agree. They’re not as wide as they were at the end
of the dot-com market in 2000, but they’re just
about as wide as anything we’ve seen since then.
Something that we have in our client presentation
books for this quarter is a look at how different
our portfolio additions were in 2022 compared
with 2023. In ’22, we were adding names like
Adobe, when you only had to believe in two years
of growth to get to a market multiple, or Uber
UBER when it was at a double-digit free cash flow
yield. Those opportunities disappeared in
last year’s market after growth names rallied so
much. For the names that we added in 2023,
the median P/E was 11 times 2024 earnings
expectations, while the median for names we sold
was 21 times. While we concede that the quality of
business we’re buying isn’t quite as good as
what we’re selling, we think a gap of nearly 100%
on P/E multiples doesn’t make any sense at all.
An analogy that I like: Back in ’22, we were
selling a little less than three shares of CVS CVS
to buy one share of Adobe. CVS was at about
$100, Adobe was just under $300. Then last year,
CVS had fallen to $70, and Adobe had risen
to $450—and we were selling a share of Adobe to
buy six to seven shares of CVS. In just a year’s
time, the growth name was performing so
well and the value name performing so poorly
that it allowed us to swap back into twice as many
CVS shares as we had originally sold.
The other thing we find unusual is how diversified
the portfolio of names in the bottom quartile
is today. People think you’re just buying energy
stocks and banks, but it’s broadly throughout
financials, and it includes consumer staples, a
number of healthcare names, industrial technology,
the materials space, traditional media. You can
build a nicely diversified portfolio today out
of the bottom quartile of the S&P 500, and that’s
just as unusual as how wide the spread is. We’re
very excited about the opportunity for value
investors to perform significantly better today than
we have over the past decade.
Hoeft: We are finding a fairly rich variety of
business models in this discounted neighborhood.
Companies are cheap for a reason. For example,
Wells Fargo WFC: Concerns about regulation
have been hanging over the company for years.
But sources of past weakness could be a source of
prospective strength. I’m referring to the asset
cap imposed on Wells Fargo’s growth as part of
the consent decree, which has prevented
substantial asset growth late in a credit cycle. As
any watcher of financials over multiple cycles
would observe, growing assets too quickly at the
wrong point in the credit cycle could be hugely
dangerous. We think once the regulatory issues
are resolved, it’s likely that the opportunity set will
expand. And right now, it’s trading at something
like 1.3 times price/tangible book. Its estimated
return on tangible equity for 2024 is 12%. That’s
a really attractive set of characteristics.
How do we calibrate the risks? Wells has been
in the regulatory penalty box for longer than
expected, but we do expect that the asset cap is
going to be lifted. Also, Wells Fargo has one
of the highest office commercial real estate
exposures of anything in our portfolio, and we are
overweight financials writ large. Our stress
test indicates that potential losses might be in the
range of 1% – 3% of market cap—meaningful,
but manageable.
Another one that I’d touch on is Norfolk Southern
NSC. A rail system is typically not something
that you’re going to find on sale. It’s an asset-
heavy business, but the asset intensity is what
provides the moat. It would probably cost north of
$100 billion to replicate the Norfolk Southern
network. Just imagining the complexity of trying to
permit 19,000 miles of track through the midst
of all the cities they traverse is mind-boggling.
When we were buying last year, it was trading at
a substantial discount to its peers. You might recall
the Ohio derailment that Norfolk Southern
suffered. In the two or three quarters after that
derailment, Norfolk Southern lost relative market
cap of about $10 billion. Our view was that
while the accident was tragic, Norfolk Southern
was likely to spend much less than that $10 billion
to make things right. And a year later, the bulk
of the dollars going toward remediation have been
spent, and it appears to be in the $1 billion
to $2 billion range. That’s before any insurance
recoveries, which might be material.
Overall, we’re finding lots of interesting
opportunities out there. Some of them are
traditional deep value, and some of them might be
considered higher-quality franchises.
Earning Your Fees
Thomas: Our data shows that total assets in passively
managed funds finally surpassed those of active funds
at the end of 2023. What are the implications of that?
Nygren: Some of that has been self-inflicted
by the active industry. What do you need to
do to justify the fee that you’re charging? That
has changed over my career. The average person’s
access to the stock market 50 years ago might
have been the neighborhood stockbroker, and that
was a very expensive way to access the market.
Just offering a fund of lots of big companies
and charging 1% for that provided a better deal.
Then the index fund came in and said we’ll
give you that big old diversified portfolio almost
for free. And too many active managers clung to
the old business model of providing basically
a closet index fund, never taking enough risk to
risk getting fired from their accounts.
Paying attention to active share and the fee
you’re charging relative to active share is really
important. Our diversified large-cap portfolio tends
to have an active share of around 85% relative
to the S&P 500. If you look at active share
divided by our fee, our fee goes from looking like
we’re in the upper half of the mutual fund
universe to being very low. That’s something fund
managers need to think about.
Tax efficiency is also something they need to
think about. We’ve seen advisors shifting out of
open-end mutual funds to separate accounts
because they think they’re getting better
tax efficiency. Funds that are tax-aware can have
significantly better tax efficiency than a separately
managed account can. But it’s an argument
that the fund industry is not spending much time
making and is, therefore, losing.
We’ve also allowed the passive investors to get
away with defining risk. If you define risk as
how I deviate from the index, Oakmark looks like
a very risky fund. Well, we don’t think our
investors should care how much we deviate from
the index. Our investors are trying to grow capital
over time. They should care a lot about how
far below zero we are in bad years. And we look
pretty good relative to the S&P 500 on that
metric of risk. But we’ve allowed the industry to
define risk by tracking error and standard deviation
of returns as opposed to drawdown risk.
Hoeft: We don’t think it’s an either/or between
active and passive. Clearly, there’s room for both.
But rising passive assets, we believe, make the
role of a successful active manager more valuable,
and I’d argue the active task becomes easier.
For example, we’ve seen a decline in the quantity
and quality of sell-side research resources over
the last 20, 30 years, and we would connect that
to the increase in passive investing. If you have
your own internal research team, as we do, and as
Harris does, you have a relative advantage today
that has only improved.
Burt Malkiel and others have pointed out in recent
years that less and less of the movement of a
company’s equity price—something like 15% less,
versus 20 or 25 years ago—is linked to things
that are specific to the firm. This increasing
disconnect between what’s actually happening
with the companies and what’s reflected in
equity prices is consistent with increased passive
flows. Passive investors are still making an active
investment choice if they go with a passive
alternative. It’s just that they’ve outsourced the
decision to the index manager who follows
what is popular. Growth in passive assets just
sets the stage for future outperformance
for active managers that have a repeatable
investment process that could add value, because
the premium grows for price discovery.
There have been too many high-cost, low-
performing active mutual funds in the marketplace.
This is probably the largest single driver of passive
gaining share in the past. But not all active
funds are created equal. We look at the net-of-fee
performance we have provided for our fundholders
over the benchmark and then denominate that
by the fee. Over the past 25 years, we’ve
generated about $4.50 for our clients in returns
above that which was generated by the S&P for
each $1 we’ve earned in fees.
We think there are lots of opportunities to perform
well for clients. And we think this mutual fund
model has a lot of longevity. The question that
prospective fundholders should ask is whether the
fund and manager that they’re evaluating are
capable of generating long-term returns relative to
a passive option in excess of its fee. K
Tony Thomas is associate director of equity strategies
for Morningstar Research Services LLC.
Photography by Matthew Gilson and David Lees.
morningstar.com/products/magazine 53
 Investors
A Healthy Blend
Victory RS Global’s U-Wen Kok strikes
the right balance between quantitative
and qualitative analysis.
UNDISCOVERED MANAGER
Laura Lallos
If you screen Morningstar Direct for a top-
performing global core fund, U-Wen Kok’s
Victory RS Global RGGYX will make the
cut, any way you slice it. The fund’s Y shares,
which make up more than half of the fund’s
total assets, rank among the very best in
the global large-stock blend Morningstar Category
over the past one-, three-, five-, and 10-year
periods through March 31. Even the priciest C
shares rank highly. And the fund hasn’t
taken on undue risk to achieve that performance:
All five of its share classes earn a 5-star
Morningstar Rating for a combination of high
returns achieved with average downside
risk for the category.
When Ashley Gilbert, a Raymond James research
analyst, was screening for a global core
option to add to the firm’s recommended list,
Victory RS Global rose to the top.
“The numbers U-Wen has been able to put up have
been strong in recent years. It’s hard for others
in the space to beat her out,” says Gilbert, who’s
based in St. Petersburg, Florida. “And it’s
always fun to add a niche manager that not many
people have heard of.”
Several years later, the strategy remains relatively
unknown: The fund still had less than $1 billion
in assets across share classes as of March.
That made it a good candidate for Morningstar
Prospects, a collection of up-and-coming
or under-the-radar investment strategies that
54 Morningstar Q2 2024
Morningstar’s manager research analysts think
are worth watching for possible inclusion on their
coverage list.
Victory RS Global made the list earlier this
year. Andrew Daniels, associate director of equity
strategies at Morningstar Research Services,
noted that the strategy benefits from an
“experienced management team, a well-codified
investment approach, and relatively low fees.”
An Investor’s Path
Kok, chief investment officer for global equities
at RS Investments, has headed that experienced
team since 2013. As for the well-codified
investment approach, she has been honing
it for much of her 33-year career.
Kok started on the sell side in 1990 at a smaller
securities firm in Toronto, where she was
raised and went to college. She was excited to be
accepted into an equity research rotation program
after graduating with an economics degree,
but her enthusiasm waned as she encountered
“inconsistencies of assumptions that could
skew fundamental models.” Then she rotated into
the firm’s quantitative group.
“It was like night and day,” she recalls. “I was
intrigued by the large amounts of financial
data available in the databases, by the
insights you could get with just a few lines of
code.” Kok wasn’t a coder, “so I had to
invest a lot of time and effort to learn. But it
was worth it. I wanted to bring efficiency
to my work, to develop more robustness and
consistency and depth in the way that
I evaluated financial information.”
After a stint at the Ontario Teachers’ Pension
Plan—where she designed a long-short index
anticipation fund, among others—Kok
moved to San Francisco to join Barclays in 2001.
“It was an opportunity to learn from the best
people in quantitative investing. It’s where the
academics and the practitioners meet.”
It was a big move for Kok, who arrived with
a backpack and a bit of luggage, knowing
nobody in her new city. “It felt strange and a bit
lonely,” she remembers. “But it’s a beautiful
city. Besides these stunning views, there’s
so much going for it. If you go south, you’re
in Silicon Valley. Right up north is Napa. Across
the ocean, you’re in Hawaii, and if you feel
like doing some skiing in the winter, Tahoe is
just around the corner.”
San Francisco has become home. With a
13-year-old in the school system, Kok has built
meaningful connections outside of work.
Family time with her husband and son often
includes the city’s diverse restaurant scene:
“Trying new foods and cuisines is high
on our list. We’re lucky we’re in the land of great
produce and great food.” They also indulge
this passion at their property in the nearby
wine country, where Kok’s husband
experiments with growing vegetables, citrus
fruits, and avocados.
Building a Model and a Team
At Barclays, Kok learned how to build
sophisticated models that use statistical metrics
to glean information from large datasets
that is “as reflective, as concise, and as accurate
as possible.”
She also learned that even a strong model has
its limits: “You should put some human
oversight on the model. Let the computers and the
data do what they do best, the mundane
work, and let the humans do what they’re best at,
which is taking that work and making sense
of it, and then projecting it forward.”
Kok brought what she terms her “blended
approach” to San Francisco-based RS Investments
(now a franchise of Victory Capital
Management) in 2012. At the time, RS was
 a purely fundamental shop, but it saw the
value of a quantitative model to sort
through the thousands of names available
to global investors.
“I was a nice hybrid,” says Kok. “I spoke the lingo
that fundamental people speak.” She took
the helm of the Global fund, as well as its smaller
sibling Victory RS International, which has
a solid record in the foreign large-blend
Morningstar Category. (Four of the share classes
U-Wen Kok, chief investment officer of the global team
and portfolio manager at RS Investments.
have 4- or 5-star ratings, but high expenses
have hamstrung the C shares, which have
a 3-star rating.)
The blended approach helped seal the deal
for Raymond James, says Gilbert: “We
hear a lot about ‘quantamental’ strategies, but
their approach is differentiated, with the
quantitative aspect first and then layering
fundamental research on top of that. You get
the best of both worlds.”
Kok has assembled what might be termed
a blended team to support the strategies:
comanager Adam Mezan, quantitative researcher
Bud Vigil, and analysts Mac Rygiel and
Rose Ziegler. In Kok’s experience, it’s unusual
to have quantitative and fundamental
professionals working so closely together. She
notes that when hiring fundamental analysts, one
of her priorities was finding candidates who
“exhibited the least biases” against working within
a quantitative framework.
morningstar.com/products/magazine 55
 Investors
Victory RS Global RGGYX
Growth of $10K
$14K
12
10
8 might get names we can’t even pronounce, but
6 we have to look into them because that’s
04/2021 03/2024
Morningstar Category Global Large-Stock Blend
Morningstar Rating
QQQQQ
Expense Ratio (%) 0.60
Source: Morningstar Direct. Data as March 31, 2024.
Everyone on the team has a primary responsibility,
whether for particular sectors or the
quantitative piece, but the goal is for all to be
generalists who can work comfortably within
the model and discuss positions across
all sectors. There are formal weekly meetings
on portfolio risk positioning and daily meetings
that may include stock pitches, company
updates, and the like. The team members are
rewarded for overall fund performance, not the
success of their individual picks.
“It’s not about the five names that you bring to
the table. It’s about what the model is
bringing to the table,” Kok says. “We’re all driving
for the same thing, which is to consistently
deliver the [kind of] risk-adjusted returns that
you see now.”
A Systematic Process
The model is calibrated to rank prospective
investments using 19 quality, valuation,
and sentiment factors. It is designed to identify
companies with a history of creating shareholder
value (the quality factors) that aren’t trading
at a premium (the valuation factors) but
56 Morningstar Q2 2024
aren’t value traps, either (the sentiment factors).
This allows the team to identify prospects
that might otherwise remain overlooked among
a worldwide universe of options.
Victory “Any fundamental analyst will tell you that coming
RS Global
up with unique ideas for alpha generation is
$13,172
one of the toughest things to do. You can waste
Morningstar hours and likely end up with names that are
Global similar to everyone else’s because they’re all going
Markets to the same conferences,” says Kok. “We enjoy
$12,192
the names that come out [of the model]. We
just how the process is. We must look at the best
one and then start going down the list.”
The model ranks stocks by sector, which means
that quality is relative. In energy, for example,
the team will own “the best of the worst,”
says Kok. The humans use their industry expertise
to home in on picks that have a high probability
of continuing to create shareholder value.
Before adding a new name, they assess how
it will contribute to or detract from the portfolio’s
active risk as well its impact on various risk
factor exposures.
The process is designed to keep portfolio exposure
neutral relative to the strategy’s benchmark,
the MSCI All Country World, in order to reduce
volatility caused by top-down variables.
Morningstar’s Daniels says that “the team has
done a solid job minimizing the impact of
style, country, and sector exposures over the years,
while also maintaining a consistent quality tilt.”
“If you focus on stock selection, that allows
for much higher predictability of returns because
you’re focusing on company business
fundamentals,” Kok asserts. “Marry the stock
selection with our proprietary risk-
managed framework and you’re going to get a
portfolio that looks something like the benchmark
but performs nothing like the benchmark.”
The result is a portfolio of 90 to 110 names,
which the team finds optimal for achieving
outperformance while minimizing risk
relative to the benchmark. According to
Morningstar data, its largest holdings as of
year-end, such as Microsoft MSFT, Apple AAPL,
and Nvidia NVDA, were similar to the stakes
in its benchmark, but the portfolio also had
noticeable differences, such as heavier stakes in
names like McDonald’s MCD and Mastercard MA,
as well as positions in lesser-known names
such as South African fashion retailer Mr. Price
MRP:SA and French engineering company
Gaztransport et Technigaz GTT:FR.
The differences have been enough to result in
significant outperformance for the fund
relative to its benchmark under Kok’s tenure.
The annualized 10-year return of the fund’s
Y shares is 11.2% through March 31, well ahead
of the benchmark’s 8.7%, while its 10-year
Sharpe ratio is 0.72 to the benchmark’s 0.58.
Long-Term Appeal
Kok says that performance will lag during
“junk rallies,” as it did in early 2021, but says such
episodes tend to be short-lived. She says
the strategy is well designed for accounts such
as retirement pensions because of its lower
risk profile.
Gilbert believes the fund is “appropriate for a
broader swath of investors because it protects well
on the downside. It’s a core portfolio that
consistently does well and isn’t super volatile
compared to category peers.”
Kok isn’t resting on her laurels. She enjoys her free
time, which includes playing the piano “well
enough to enjoy my own playing” and travel, such
as recent visits to Thailand for a family reunion
and Japan for cherry blossom season. But at work,
maintaining the viability of her blended strategy
is a constant endeavor.
“The framework continues to be refined,” Kok says.
“It’s nonstop.” K
Laura Lallos is managing editor of Morningstar magazine.
Photography by David Lees.
Changing Playbook
Some streaming companies are turning
to sports to help boost profits.
SECTOR RAP
Ivanna Hampton
Live sports, once the prized programming of cable
and satellite television, are now being recruited
to streaming services.
That’s because streamers are shifting their
focus from subscriber stats to profits, says Michael
Hodel, director of communication services for
Morningstar Research Services, in a recent
Communication Services Observer. And a strong
sports roster could help boost bottom lines.
Tech firms with lots of cash are competing for
sports rights against traditional linear TV giants
that are in more precarious financial positions,
says Matthew Dolgin, senior equity analyst for
Morningstar Research Services.
“It’s the evolution to a streaming world, where
people want to watch streaming, and
sports is a critical piece to having consumers
pay for television service,” Dolgin says.
But the stakes are high as a game seven.
Tech companies are disrupting the media industry.
Apple AAPL offers MLS Season Pass. Amazon
AMZN hosts Thursday Night Football. The OG
streamer, Netflix NFLX, will become the new home
for WWE Raw. Meanwhile, traditional media
companies are still figuring out how to stem losses
and make money in streaming.
I spoke with Hodel and Dolgin on March 13.
Our conversation, which has been edited
for length and clarity, reflects conditions and
valuations as of that date.
Ivanna Hampton: Netflix’s dominance extends beyond
streaming. Your research highlighted that Netflix
likely reaches more US homes than traditional TV.
How did we get here?
Michael Hodel, CFA, is director of
communications services equity
research for Morningstar Research
Services LLC.
Michael Hodel: The shift to Netflix from traditional
television is a tale of two classic dilemmas.
The first is the innovator’s dilemma that was
outlined famously by Clayton Christensen in
the ’90s, involving up-and-coming tech companies
that find ways to disrupt industries. The Netflix
streaming service began as a niche offering
that was perhaps inferior to traditional cable
television, but it had attributes that made it
attractive, such as no advertising, broad content,
and delivery to any device anywhere at an
unbundled price point.
The traditional media companies initially dismissed
the threat Netflix posed. But even after they
realized it, a second dilemma prevented a
strong response. That’s the prisoner’s dilemma,
where players acting in their own interest
undermine the group’s interest. The traditional
television business is a complex web of
relationships between media companies and
distributors. As these firms looked out for their
own individual interests, the industry has
consistently moved in the wrong direction. Cable
TV has gotten more expensive, and the experience
hasn’t meaningfully improved. One of the key
decisions most traditional media firms made was
to launch individual streaming platforms.
While each firm, acting in their own interest,
wanted to hedge its future, the collective
result is that more content is no longer included
in—or not exclusive to—the cable-TV bundle.
That’s only accelerated the decline.
Hampton: Would you say we’re now in a time
of alliances with the joint sports streaming service?
Matthew Dolgin, CFA, is a senior
equity analyst for Morningstar
Research Services LLC.
Matthew Dolgin: We’re moving in the direction
of alliances. It seems part of the natural evolution
of the industry. We had been in a world where
each of these companies was looking to build their
subscriber bases almost at any cost and not
worrying if they were losing money.
We think we’re part of an evolution now that is
necessary due to the number of streamers
and the amount of content in different places.
These companies are looking to have streaming
businesses be financially good, which they
had not been. They’re realizing that what’s going
to be in their best financial interest is to come
together. The sports joint venture with Disney DIS,
Fox FOX, and Warner Bros. Discovery WBD
is one of the early steps to bundle similar content.
It’s to the benefit of all, even if it’s less individually
they can make per subscriber. It’s part of the
industry maturing.
Hampton: Peacock and Paramount PARA have
a partnership in Europe. Could that work in the US?
And for full disclosure, I own Comcast CMCSA
stock. [Peacock is a subsidiary of Comcast-owned
NBCUniversal.]
Hodel: We think that a partnership like that
could work in the US. Part of the reason
why they team up in Europe is to have enough
content to remain interesting or relevant to
viewers. I think similar to what’s happening on
the sports joint venture side, partnerships
make sense on the entertainment side of the
business as well, almost recreating the traditional
cable bundle in a way that creates more
options for consumers and hopefully lowers the
price point. Then creates value for the
companies, giving them an audience of scale
for the content they’re producing.
morningstar.com/products/magazine 57
 Investors

EXHIBIT 1

Hampton: How can companies that financially depend Major and Minor Players These companies have varying stakes in the evolving
on cable and satellite balance that with expanding streaming media industry.
into streaming?
Dolgin: It’s difficult, and they’re still trying Morningstar Fair Value Economic
Company Rating Price $ Estimate P/FV Moat
to figure it out. It seems the companies
have focused more on improving the streaming Alphabet GOOG QQQ 152.26 171.00 0.89 Wide
businesses while operating the linear Amazon.com AMZN QQQ 180.38 185.00 0.98 Wide
businesses as they always had. This has led
Apple AAPL QQQ 171.48 160.00 1.07 Wide
to a continuing decline in linear. Most
streaming businesses have moved toward Comcast CMCSA QQQQ 43.35 60.00 0.72 Wide
or into profitability, as opposed to being Electronic Arts EA QQQ 132.67 150.00 0.88 Narrow
big money-losers.
Fox FOX QQQQ 28.62 43.00 0.67 Narrow
These companies need to find a better balance Meta Platforms META QQ 485.58 400.00 1.21 Wide
between streaming and traditional pay-TV Microsoft MSFT QQQ 420.72 420.00 1.00 Wide
services. They’re going to be best served by maybe
Netflix NFLX QQ 607.33 425.00 1.43 Narrow
looking at them as one and looking at a
way to stem or slow down the decline in linear Paramount Global PARA QQQQ 11.77 20.00 0.59 None
while not worrying as much about what that Walt Disney DIS QQQ 122.36 115.00 1.06 Wide
means for streaming results. That’s going
Warner Bros. Discovery WBD QQQQQ 8.73 20.00 0.44 None
to be in the long-term best interests for these
Source: Morningstar. Data as of March 28, 2024.
companies’ financial health.

Hampton: 2025 looks like it will a big year for streaming.

WWE Raw is set to debut on Netflix. Disney’s
stand-alone ESPN app is expected to launch. Talk about
the role sports is playing in this next era.
Dolgin: In many cases, it’s like the prior era.
Traditional media companies still see
sports as a critical piece to their networks. It’s
also become more important for streaming.
Disney’s move to bring linear ESPN sports
programming to streaming mostly seems to be an
acknowledgment that keeping ESPN solely
as part of that pay-TV bundle isn’t a viable strategy.
They probably have some concerns about how
streaming ESPN will coexist with the bundle. It’s
the evolution to a streaming world, where
people want to watch streaming, and sports is
a critical piece to having consumers pay for
television service.
Netflix is the wild card. It is taking baby steps.
It started putting out some sports-related content.
They have secured the rights to WWE Raw.
They announced a boxing match with Mike Tyson.
They are moving in that direction. They
haven’t been anywhere near taking that huge
step into a major sports league that costs
billions of dollars.
Companies like Amazon, Apple, Alphabet GOOG
will bring more players into this market. It’s even
more competitive with the number of providers
that are going to bid on it and distribute it.
Hampton: A big fight is expected over the upcoming
NBA TV deal. What kind of competition do you expect,
and does winning matter?
Dolgin: Winning does matter. It depends on what
the cost is. Disney with ESPN and Warner Bros.
Discovery with Turner are in an exclusive
negotiating window. That’s from the beginning
of March through mid-April. The most likely
outcome is those two incumbents keep the bulk
of the rights, including the playoffs.
The wild card is to what extent some of these
more traditional tech companies want to
get involved, and what that does to the price. The
linear businesses of some of these traditional
media companies are struggling. They are paying
attention to cost.
At some point, we think it will be too expensive for
the incumbents. Maybe some of these tech
companies do what they have done with Major
League Baseball with Apple, or with Amazon
getting a single football game per week. Maybe
they get some rights.
Hampton: Your research emphasized that not all
companies view streaming the same. Apple’s
and Amazon’s goals differ from their rivals. Talk about
why that makes them tough competitors.
Hodel: Apple, Amazon, Alphabet’s Google, and
even Meta META have massive financial
resources. They have cash on the balance sheet
and generate massive cash flows. What makes
them tough competitors is that they can
afford to experiment in ways that could disrupt
the media industry.
These firms also have subscription businesses
or other services they can tie in with content.
That creates the potential to offer something the
traditional media companies can’t match.
Apple has a variety of services. Adding MLS to
Apple TV+ is easy for Apple to do. You could
see them doing something similar with
another sports league. Amazon has Prime, which
gives the company a massive customer
base. Alphabet has YouTube. Those ecosystems

58 Morningstar Q2 2024
that traditional media companies can’t
match also make these companies extremely
tough competitors.
Hampton: Streamers are rolling out plans with
commercials to lean more into digital advertising.
Explain why Amazon has an edge.
Dolgin: Amazon has an edge over some but not
necessarily all competitors. But it’s nuanced.
Amazon has a track record and more experience
in selling digital advertising. It’s offering
its Prime service with ads. They should have
a smoother transition than some.
The traditional companies also have a long history
in advertising. Most of them are offering
ad-supported subscription services. They’re not
brand new, like Amazon’s or Netflix’s. They
don’t necessarily have the same digital capabilities,
but they’re not starting from scratch. Those
traditional companies are in a good spot
to take advantage as the ad-supported model
becomes more prominent.
Netflix is the one that’s kind of last to the party.
Advertising was never a part of its business
until it started offering the ad-supported service
[in 2022]. It has more work to do to monetize
advertising. However, it’s also the reason why
Netflix has a lot of room to grow. It has
probably some ground to make up in becoming
an efficient advertiser, but it leads to what we
see as mostly upside for the company.
Hampton: Netflix is developing games. Disney has
announced a partnership with Epic Games.
Can you talk about whether gaming is the right
revenue move?
Hodel: It’s the right move for media companies
as a means of generating additional revenue
around their existing intellectual property,
extending the life of key franchises, key characters.
The question is what the business model
should look like. There’s a long history of media
company tie-ups with gaming companies that
have had varying degrees of success.
In our view, given where we’re at in the video
game development world and how specialized
firms like Microsoft MSFT—not just on
its own, but also with its Activision acquisition—
or Electronic Arts EA have become and how adept
they’ve become at developing games, it makes
the most sense for media companies to partner
with video game firms that have expertise
rather than try to develop games on their own. So,
to the extent Netflix is actually going to end
up developing its own games, we think that’s
probably not the smartest move.
The Disney move with Epic is odd, in our view.
I think that deal kind of came out of left field.
Disney has partnered with multiple major video
game publishers to develop games around
its core intellectual property. Tying up with a single
partner seems like an odd move to us at this
point. We think the best strategy for Disney would
be to remain agnostic about which companies
they partner with for each individual piece
of intellectual property that they want to turn into
a game and leave themselves that flexibility.
Hampton: Password crackdown is spreading. Could this
lead to more subscriber sign-ups or cancellations?
Dolgin: It depends on how the companies
go about it. Because what Netflix has done, what
Disney says it intends to do, is not completely
cut off that sharer and say you’re going to
be on your own, have them subscribe for yourself,
but instead saying you can still be part of
this plan. It’s going to be a little incremental cost
per month. They’ll pay extra and be able to
essentially share.
If that’s the case, it ends up being very likely to
boost subscribers. It ends up being lower
average revenue per subscriber, but you have more
people watching.
If the company were to take the tougher stance,
it would be less clear that it would boost
subscribers. But it still seems the right thing to do.
We don’t expect it to lead to big subscriber
losses. We need to get away from thinking about
what’s the subscriber count and more about
what do the financials look like.
Hampton: Which streamers are telling the most
compelling growth stories to convince investors to stick
around for the next five years?
Dolgin: Putting aside the valuation of the stock,
we would say Netflix is in a class by itself,
and it’s the only one that has really shown that it
can survive and thrive in this new media world.
The boost that we expect it to get from advertising
should only help. Its ability to continue growing
sales and enhance profitability looks good.
We’d say it’s more of an incomplete type of
grade for other streamers. They’re still evolving.
They’re still trying to balance their streaming
services with those traditional linear
television networks that are still crucial to their
businesses. We think there are reasons like
their assets and content that they will figure
it out. But they’re not there yet. It would be tough
to tell investors to be comfortable that the
economics associated with streaming are going
to more than offset the declining economics
of the traditional linear business.
Hampton: Name the companies that top your
favorites list.
Hodel: My favorite stock right now is Comcast.
It’s trading at about a 30% discount to what
I think it’s worth. My take on Comcast is primarily
related to its broadband business, which is
a little separate from the media companies that
we’ve been discussing, although Comcast does
own NBCUniversal. I think that the market
is overly pessimistic about the long-term growth
prospects of that core broadband or internet
access business. Comcast is in a great spot with
a very strong balance sheet enabling it to
repurchase shares aggressively. With the stock
trading where it is, we think share repurchases are
going to add a lot of shareholder value.
Dolgin: Paramount and Warner Bros. Discovery
are the most undervalued on my list. They’re being
priced like they will never figure it out, and that
they’ll perpetually erode. We think they have some
very valuable assets.
Disney is in between. It has many of the same
challenges as Paramount and Warner Bros.
Discovery, but it has a much higher valuation. We
think there are reasons why that valuation
is warranted, but we see it as more close to
fair value. K
Ivanna Hampton is lead multimedia editor
for Morningstar.
morningstar.com/products/magazine 59
 Investors
Navigating Newfound Financial Success
Advisor Lawrence Smith
guides clients who have achieved
first-generation wealth.
USER PROFILE
Charles Keenan
To Lawrence Smith, building wealth for those
who don’t come from money entails hard work,
but keeping it is even more difficult. Smith,
founder and president of Dallas-based ELS Vision
Wealth Management, likens accumulating
60
wealth to mountain climbing. Often climbers reach
the summit and all its glory, only to encounter
tragedy on the way down.
“Solutions for building wealth in the Black
“If you did not inherit wealth, how do you know
how to pass it down?” Smith says. “People come
to me because I know that that’s a conversation
that they need to have, but they don’t necessarily
always know how to express it.”
Focus on the Long Term
Smith, 45, has homed in on a niche: professionals
who are the first generation of their families
to find significant financial success. His clients are
typically executives, entrepreneurs, former
professional athletes, doctors, and lawyers—
people who have built their wealth over time.
He says that clients new to wealth often encounter
advisors who don’t understand their fears,
concerns, and goals. For example, with his Black
clients, who represent about 15% of his book
of business, there’s sometimes the need to
overcome a fear of the “intangibility” of certain
investments, Smith says.
community that are well intended often center the
conversation around tangible products such
as real estate or solutions promising fast results,”
Smith says. “This ultimately leaves even high-
earning Black professionals undiversified and shut
 out of the greater wealth-building opportunities
that are happening in America.”
Those opportunities include the slow and steady
approach of building wealth through stocks
and bonds with long-term goals in mind. For
portfolio construction, Smith uses modern portfolio
theory and the efficient frontier to construct
optimal risk/reward portfolios for clients. When
searching for funds, Smith favors managers
who have been at the helm for 10 years or more
and focuses on long-term performance.
“That tells me how [a fund has] performed within
different market settings and market scenarios,”
he says.
He uses Morningstar Advisor Workstation to
gauge that performance and do other research, as
well as to keep tabs on how portfolio construction
matches a client’s goals. He also uses Advisor
Workstation’s reporting features to show clients
he’s acting in their best interest.
Lawrence Smith, CFP, CRPC, CRPS, president
and wealth planning advisor, ELS Vision
Wealth Management
How he caught our eye: Works with clients
to build generation-to-generation wealth.
Career path: Graduated from Paul Quinn College
in 2003 with a bachelor’s degree in business
administration. Worked as a licensed banker for
JPMorgan Chase, then as a retirement
consultant at Lincoln Financial Group. Became an
independent investment advisor in 2015 while
working for another advisor with Lincoln Financial
Advisors. Formed his own firm, ELS Vision
Wealth Management, in 2017. Obtained his
certified financial planner designation in 2021.
Favorite funds: Capital Group’s American Funds,
in part due to the company’s emphasis on team
management.
Personal: Lives and works in Dallas. Married
with two kids, ages 11 and 8. Likes spending time
supporting their endeavors. Also serves on
the board of Guide Right Foundation of Dallas, an
organization that teaches life skills to at-risk
youth and families.
Achieving Greater Wealth
It’s not a surprise that Smith became a financial
advisor, given his exposure to finance and
small business growing up in Columbus, Ohio.
His dad worked as a bank examiner and manager
for the US Office of the Comptroller of the Currency,
giving Smith exposure to finance. Smith credits his
mom, who ran her own business as an event
planner, for giving him an entrepreneurial spirit.
“They were part of the first generation of African
Americans to experience opportunities their
parents never had,” Smith says.
He got his first job flipping burgers at a fast-food
chain. He did it for a month, then switched to
working on the floor at a clothing store. He says
the experience was eye-opening. “If I was going to
work hard no matter what, I figured I had
better decide on where I wanted to work hard.”
He earned a bachelor’s degree in business
administration at Paul Quinn College, a historically
black college based in Dallas, financing his
own education with loans and savings from jobs.
After graduating, one of his first jobs was
selling subprime auto loans to consumers, which
he found unfulfilling. He set his eyes on assisting
others in finance. A Kappa Alpha Psi fraternity
brother and mentor helped him get a job as a retail
banker at JPMorgan Chase JPM in 2008. But he
wanted to become a financial planner, and seeing
little opportunity for advancement at JPMorgan,
he went to work as a retirement consultant at
Lincoln Financial Group in 2011.
At Lincoln, he earned his unit’s rookie-of-the-year
award, helping participants in employer-sponsored
plans with enrollment, education, and investment
selection. In 2014, he worked for an advisor at
Lincoln Financial Advisors—Lincoln’s broker/
dealer unit—winning another rookie-of-the-year
accolade in 2015 for being a top revenue generator
among the newcomers.
Practice Takes Off
Surviving relied on partnerships and smart
decision-making, Smith says. One key relationship
was a program through Lincoln Financial
that allowed Smith to gain access to the employer
markets. By tapping the market of 401(k), 403(b),
and 457(b) plans, Smith was able to cultivate
future business. “That gave me the ability to talk
to lots of people,” Smith says. “I could tell
them, ‘This is what I can bring to the table to help
you meet your goals.’”
Referrals streamed in, and by 2017, Smith was able
to form his own practice. Other advisors took
notice, allowing Smith to take over their books of
business when they retired, knowing their clients
were in good hands. “Those advisors trusted
me ultimately to take over their practices, helping
them to reach their own financial independence,
but also knowing their clients would be taken
care of,” he says.
Smith looks for new clients with $1 million or
more in assets. He helps clients with estate
planning, liability and life insurance, tax
management, and investments. Smith also works
with companies and nonprofits to develop
employer-sponsored plans, which has acted as a
springboard to add more high-net-worth households.
His practice has boomed in recent years.
Smith’s book of business is about $200 million,
up from about $70 million three years ago.
Yet for Smith, plenty of work remains to be done.
Black Americans face a limited choice if
they want to work with an advisor who might
share a similar cultural experience: Only
1.9% of roughly 99,000 certified financial planners
are Black, according to the CFP Board.
Smith is in a program run by the National Football
League Players Association that vets financial
advisors to work with players: “As a Black CFP,
I felt a duty to join the program to make sure that
African American players and agents knew
they could work with an African American CFP
who understands the nuances of Black culture.”
It all relates back to Smith’s penchant to
help others find their way with newfound wealth.
“I wanted to be in a career where the reward
comes from a long-term perspective, that
not only helps one person or a couple, but also
helps people from generation to generation.” K
Charles Keenan is a freelance financial journalist.
Photography by Sheryl Lanzel.
morningstar.com/products/magazine 61
 Data Dashboard

Morningstar Global Market Barometer

Developed Markets 15.54%
Emerging Markets 10.52% US 29.78%

< –20.0% –10.0 to –19.9% –0.1 to –9.9% 0.1 to 9.9% 10.0 to 19.9% > 20.0%
Negative Returns Positive Returns

Morningstar Country and Regional Indexes 03/31/2024

1-Year Trailing Performance

Norway 6.8%

Canada 14.1% UK 10.6%

China –16.5%
Ireland 18.2%
Turkey 18.5%
Japan 24.0%
United States 29.8%
Italy 34.8% South Korea 14.8%
Mexico 23.8%
Egypt 17.2% Taiwan 28.2%
Colombia 50.5%
Brazil 27.9% India 38.7%
Peru 27.5%
New Zealand –3.6%
South Africa –5.3% Australia 12.2%
Chile –4.5%

Leading Developed Markets Lagging Developed Markets Leading Emerging Markets Lagging Emerging Markets
Poland Italy Denmark Hong Kong Portugal Finland Colombia Hungary India Thailand China Czechia
57.1% 34.8% 33.1% –24.6% –9.1% –8.1% 50.5% 48.6% 38.7% –18.5% –16.5% –7.6%

1-Year Trailing Performance and Risk Measures 3-Year Growth of $10K

Morningstar US Market Return Standard Deviation 14.26% $14K
US Market
TR USD 29.78% Sharpe Ratio 1.53% $13,325
1,317 Constituents Max Drawdown –8.82% 12
Developed Markets
Morningstar Developed Return Standard Deviation 15.45% ex-US
Markets xUS GR USD 15.54% Sharpe Ratio 0.66% 10
$11,455

2,971 Constituents Max Drawdown –11.11% Emerging Markets

$9,158
Morningstar Emerging Return Standard Deviation 15.35% 8
Markets GR USD 10.52% Sharpe Ratio 0.37%
6
3,764 Constituents Max Drawdown –11.18%
04/2021 04/2022 04/2023 03/2024

Morningstar, Inc’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for
such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Neither Morningstar, Inc. nor its investment management division markets, sells or makes any representations regarding the
advisability of investing in any investable product that tracks a Morningstar index. Country data per World Bank.

62 Morningstar Q2 2024
Morningstar Fixed-Income Indexes 03/31/2024

1-Year Trailing Performance and Risk Measures 3-Year Growth of $10K

Morningstar US Core Bd Return Standard Deviation 7.09% $12K

TR USD 1.56% Sharpe Ratio –0.52%
US High Yield Bond
$10,691
11
9,266 Constituents Max Drawdown –6.05%
US Corporate Bond
Morningstar US Return Standard Deviation 8.67% 10 $9,445
Corporate Bond TR USD 4.25% Sharpe Ratio –0.11%
US Core Bond
6,479 Constituents Max Drawdown –5.92% 9
$9,262

Morningstar US High Return Standard Deviation 6.25%

8
Yield Bond TR USD 11.13% Sharpe Ratio 0.85%
7
1,856 Constituents Max Drawdown –2.39%
04/2021 04/2022 04/2023 03/2024

Morningstar Allocation Indexes 03/31/2024

1-Year Trailing Performance and Risk Measures 3-Year Growth of $10K

Morningstar Aggressive Return Standard Deviation 14.53% $12K
Aggressive Target Risk
Target Risk TR USD 19.60% Sharpe Ratio 0.93% $11,770
15 Index Constituents Max Drawdown –10.12% 11
Moderate Target Risk
Morningstar Moderate Return Standard Deviation 11.43% $10,814
Target Risk TR USD 12.77% Sharpe Ratio 0.63% 10
Conservative Target
19 Index Constituents Max Drawdown –8.24%
Risk
$9,799
Morningstar Conservative Return Standard Deviation 8.03% 9
Target Risk TR USD 5.26% Sharpe Ratio 0.00%
8
17 Index Constituents Max Drawdown –5.65%
04/2021 04/2022 04/2023 03/2024

Morningstar Style Indexes 03/31/2024

Annualized Trailing Performance: < –10% –9.9 to –5.0% –4.9 to 0% 0.1 to 4.9% 5.0 to 9.9% > 10%

1-Year % 3-Year % 5-Year % 10-Year %

Large

Large

Large

Large

20.90 28.93 37.27 10.43 11.97 5.60 10.93 15.71 13.42 9.68 12.90 13.92
Mid

Mid

Mid

Mid

21.58 18.48 26.35 8.85 7.13 3.09 10.00 11.41 12.10 9.17 10.08 11.50
Small

Small

Small

Small

21.59 22.08 21.01 6.72 5.54 –4.02 9.72 10.11 6.18 7.26 8.34 7.87

Value Core Growth Value Core Growth Value Core Growth Value Core Growth

63
 Data Dashboard

Morningstar Global Valuation Lens

Emerging Markets –9.8%
Developed ex-US –7.6% US 2.2%

< –5.0% –4.9 to –0.1% 0.0% 0.1 to 4.9% > 5.0%

Undervalued Fairly Valued Overvalued

Valuation by Country 03/31/2024

Finland –9.1%

Norway –8.7%

Canada –4.1%
Sweden –3.1%
France 1.1% China –15.5%
Poland –11.8%
United States 2.2%
Italy –5.6%
South Korea –16.2%
Mexico –5.2%
Hong Kong –27.2%
India 5.8%
Colombia –19.3%
Singapore –14.1%
New Zealand –6.9%
South Africa –14.7% Australia –2.9%
Chile –18.1%

Cheaper Developed Markets Pricier Developed Markets Cheaper Emerging Markets Pricier Emerging Markets
Hong Kong Portugal Israel Netherlands United States France Colombia Turkey Chile India Peru Mexico
–27.2% –15.1% –13.6% 2.3% 2.2% 1.1% –19.3% –18.5% –18.1% 5.8% –2.2% –5.2%

Monthly Valuation by Region 03/31/2024

+30%
A percentage of 0.0 connotes fairly valued

15 US
2.2

0 Developed ex-US
–7.6

15 Emerging Markets
–9.8
P/FV

–30
04/2019 04/2020 04/2021 04/2022 04/2023 03/2024
Country fair value ratios are derived from P/FV ratios on underlying stocks in those nations, generated primarily from estimates by Morningstar analysts, or, when an analyst estimate isn’t available, a fair value generated using Morningstar’s
quantitative equity ratings. The data is then adjusted to account for market capitalization. Some countries are omitted due to outliers in the data: less than a $10,000 three-month median-dollar-trading volume or fewer than 20 total stocks
that clear the screens. Stocks that trade for 50 cents or less a share are also removed.

64 Morningstar Q2 2024
 Morningstar Global Star Rating Tracker 03/31/2024—Number of stocks that Morningstar’s US Breakdown 03/31/2024
global equity analyst team rated as undervalued (4 and 5 stars) or overvalued (1 and 2 stars) Valuation % Date
over time. 12-Month High* 2.1 03/31/2024
12-Month Low* –13.0 10/31/2023
1,500 *Month-end highs and lows over trailing 12 months.

Style Valuation
1,000

Large
Undervalued
Number of Stocks

–6.0 6.7 14.0 6.9

766
500
Overvalued
411

Mid
0 –12.0 –2.6 5.8 –3.5
04/2021 04/2022 04/2023 03/2024

Small
–22.7 –11.5 –9.0 –14.9
Morningstar Best Companies: 10 Cheapest 03/31/2024
Fair Value Morningstar
Company Sector Price $ Estimate $ P/FV Rating
–10.2 2.5 10.9 Averages
Yum China Holdings YUMC t Consumer Cyclical 39.79 80.00 0.50 QQQQQ
Roche Holding RHHBY d Healthcare 31.92 55.00 0.58 QQQQQ Value Core Growth
British American Tobacco BTI s Consumer Defensive 30.50 49.00 0.62 QQQQQ
Imperial Brands IMBBY s Consumer Defensive 22.60 36.00 0.63 QQQQQ
Moat Valuation
Pfizer PFE d Healthcare 27.75 42.00 0.66 QQQQQ Company
Reckitt Benckiser RBGLY s Consumer Defensive 11.37 17.10 0.66 QQQQQ Economic Moat Valuation % Count

Anheuser-Busch InBev BUD s Consumer Defensive 60.78 90.00 0.68 QQQQQ None –13.1 1,516
Ambev ABEV s Consumer Defensive 2.48 3.60 0.69 QQQQQ
Narrow –5.8 832
Polaris PII t Consumer Cyclical 100.12 145.00 0.69 QQQQQ
Comcast CMCSA i Communication Services 43.35 60.00 0.72 QQQQ
Wide 10.1 254

Morningstar Best Companies: 10 Priciest 03/31/2024

Fair Value Morningstar Sector Valuation
Company Sector Price $ Estimate $ P/FV Rating
r Basic Mat 0.9
Cyclical

Sherwin-Williams SHW r Basic Materials 347.33 214.00 1.62 Q

t Cons Cyc –1.8
Caterpillar CAT p Industrials 366.43 232.00 1.58 Q
y Fin Svcs –2.3
Fastenal FAST p Industrials 77.14 50.00 1.54 Q
u Real Estate –12.7
Ferrari RACE t Consumer Cyclical 435.94 287.00 1.52 Q
i Comm Svcs 0.9
Sensitive

Cintas CTAS p Industrials 687.03 460.00 1.49 Q

o Energy –3.3
Chipotle Mexican Grill CMG t Consumer Cyclical 2,906.77 1,950.00 1.49 Q
p Industrials 6.1
Stryker SYK d Healthcare 357.87 242.00 1.48 Q
a Technology 10.8
Costco Wholesale COST s Consumer Defensive 732.63 500.00 1.47 Q
s Cons Def 2.8
Defensive

Home Depot HD t Consumer Cyclical 383.60 263.00 1.46 Q

d Healthcare –2.8
O’Reilly Automotive ORLY t Consumer Cyclical 1,128.88 780.00 1.45 Q
f Utilities –8.8
Morningstar Best Companies have Wide Economic Moat Ratings; Capital Allocation Ratings of Exemplary or Standard; and Fair Value Uncertainty Ratings
of Low or Medium. –15% 0 15

morningstar.com/products/magazine 65
 Data Dashboard

Morningstar Wide Moat Focus Index 03/31/2024—This index provides exposure to companies in the Morningstar US Market Index with
Morningstar Economic Moat Ratings of wide that are trading at the lowest current market price/fair value ratios.

Growth of $10K Valuation

$16K
Morningstar US
Overall Index P/FV 0.87
Large Core
14 $14,040 1-Year Index Performance
Morningstar Wide Return 23.44%
12
Moat Focus Standard Deviation 17.50%
$13,638 Sharpe Ratio 0.98%
10
Max Drawdown –13.11%
8
54 Constituents
04/2021 04/2022 04/2023 03/2024

Five Cheapest Index Holdings Top Five Sectors

Fair Value Morningstar
Company Price $ Estimate $ P/FV Rating Moat Sector %

Etsy ETSY 68.72 140.00 0.49 QQQQQ Wide d Healthcare 21.7

Pfizer PFE 27.75 42.00 0.66 QQQQQ Wide p Industrials 18.3
International Flavors & Fragrances IFF 85.99 130.00 0.66 QQQQ Wide y Financial Services 14.1
Biogen BIIB 215.63 303.00 0.71 QQQQ Wide a Technology 14.8
Comcast CMCSA 43.35 60.00 0.72 QQQQ Wide t Consumer Cyclical 6.7

Morningstar Dividend Yield Focus Index 03/31/2024—This index is designed to deliver a portfolio of US stocks with attractive dividend yields
and strong financial quality. The index is weighted in proportion to the value of each constituent’s indicated dividend payments.

Growth of $10K Valuation

$16K
Morningstar US
Overall Index P/FV 0.98
Large Value
14 $13,468 1-Year Index Performance
Morningstar Return 12.42%
12
Dividend Standard Deviation 11.60%
Yield Focus Sharpe Ratio 0.60%
10 $13,003
Max Drawdown –7.49%
8
75 Constituents
04/2021 04/2022 04/2023 03/2024

Five Cheapest Index Holdings Top Five Sectors

Fair Value Morningstar
Company Price $ Estimate $ P/FV Rating Moat Sector %

Comcast CMCSA 43.35 60.00 0.72 QQQQ Wide o Energy 26.3

Verizon Communications VZ 41.96 54.00 0.78 QQQQ Narrow s Consumer Defensive 18.0
Medtronic MDT 87.15 112.00 0.78 QQQQ Narrow d Healthcare 17.3
Skyworks Solutions SWKS 108.32 133.00 0.81 QQQQ Narrow a Technology 8.8
The Western Union WU 13.98 17.00 0.82 QQQQ Narrow f Utilities 8.6
Morningstar, Inc’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such
use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Neither Morningstar, Inc. nor its investment management division markets, sells or makes any representations regarding the
advisability of investing in any investable product that tracks a Morningstar index.

66 Morningstar Q2 2024
 Morningstar Exponential Technologies Moat Focus Index 03/31/2024—This index includes companies in the Morningstar Exponential
Technologies Index* with Morningstar Economic Moat Ratings of wide or narrow that are trading at the lowest current price/fair value ratios.

Growth of $10K Valuation

$14K
Morningstar Global
Overall Index P/FV 0.82
Large Cap
12 $12,567 1-Year Index Performance
Morningstar Return 17.54%
10
Exponential Tech Standard Deviation 22.61%
Moat Focus Sharpe Ratio 0.58%
8 $10,163
Max Drawdown –15.56%
6
57 Constituents
04/2021 04/2022 04/2023 03/2024

Five Cheapest Index Holdings Top Five Sectors

Fair Value Morningstar
Company Price Estimate P/FV Rating Moat Sector %

Arcadium Lithium ALTM $4.31 $14.00 0.31 QQQQQ Narrow a Technology 46.4
Worldline WLN:FR EUR 11.48 EUR 28.90 0.40 QQQQQ Narrow d Healthcare 23.3
Albemarle ALB $131.74 $275.00 0.48 QQQQQ Narrow p Industrials 7.4
Aptiv APTV $79.65 $148.00 0.54 QQQQQ Narrow r Basic Materials 5.7
Baidu 9888:HK HKD 102.70 HKD 180.00 0.57 QQQQQ Wide i Communication Services 5.2

Morningstar Global Markets Sustainability Moat Focus Index 03/31/2024—This index targets stocks in the Morningstar Global Markets Index
with low or medium ESG risk and Morningstar Economic Moat Ratings of wide or narrow that are trading at the lowest current price/fair value ratios.

Growth of $10K Valuation

$13K
Morningstar Global
Overall Index P/FV 0.90
12 Large Cap
$12,567 1-Year Index Performance
11 Return 15.31%
Morningstar Global
10 Sustainable Standard Deviation 17.42%
Moat Focus Sharpe Ratio 0.59%
9 $11,455
Max Drawdown –13.54%
8
299 Constituents
04/2021 04/2022 04/2023 03/2024

Five Cheapest Index Holdings Top Five Sectors

Fair Value Morningstar
Company Price Estimate P/FV Rating Moat Sector %

China Education Group 00839:HK HKD 4.19 HKD 12.10 0.35 QQQQQ Narrow a Technology 18.4
Worldline WLN:FR EUR 11.48 EUR 28.90 0.40 QQQQQ Narrow y Financial Services 17.7
Continental CON:DE EUR 66.90 EUR 163.00 0.41 QQQQQ Narrow t Consumer Cyclical 17.0
Tencent Holdings 00700:HK HKD 303.80 HKD 704.00 0.43 QQQQQ Wide i Communication Services 13.5
Adient ADNT $32.92 $71.00 0.46 QQQQQ Narrow d Healthcare 10.8
Moat ratings and fair value estimates are determined through independent research conducted by the Morningstar Equity Research team.
*The Morningstar Exponential Technologies Index is designed to deliver unparalleled, thematically pure exposure to a range of key technology themes by drawing on the in-depth knowledge and forward-looking insights of the
Morningstar Equity Research team. It targets the stocks of companies well positioned to benefit from innovative technologies with exponential growth potential.

morningstar.com/products/magazine 67
 Data Dashboard

Morningstar US Fund Flows

Flows by US Category Group 03/31/2024

Organic Growth Rate % Total Net Assets

Category Group Q1 1-Mo 1-Mo Active 1-Mo Passive 1-Yr $Bil Mkt Sh% Rank
US Equity 0.18 0.23 –0.24 0.54 0.40 14,685 51.66 1
Sector Equity 0.14 0.39 –0.54 0.86 –3.12 1,363 4.79 5
International Equity 0.33 –0.03 –0.37 0.37 0.33 4,113 14.47 3
Allocation –1.48 –0.47 –0.48 1.83 –6.44 1,421 5.00 4
Taxable Bond 2.75 0.84 0.71 1.02 5.96 5,332 18.75 2
Municipal Bond 1.33 0.43 0.35 0.97 0.02 876 3.08 6
Alternative 7.44 2.76 2.87 2.38 6.05 256 0.90 7
Commodities –2.59 0.06 0.12 –0.11 –10.15 162 0.57 8
Nontraditional Equity 7.33 2.37 2.47 1.80 31.03 107 0.37 10
Miscellaneous –2.18 2.43 30.19 1.08 –4.97 114 0.40 9
All Long Term 0.71 0.32 0.02 0.63 1.02 28,428 100.00 —
–4 0 4 8

Quarterly Flows for Largest Morningstar Categories 03/31/2024

Continuing a trend, the technology Morningstar Category grew at a Fund investors flocked to the intermediate-government Morningstar
significantly higher rate than other equity categories. Investor enthusiasm for Category in the first quarter; the multisector-bond category had a similarly
emerging-markets funds, on the other hand, was more likely a value play. high growth rate. Intermediate-core bond funds were also popular.

Total Net Largest Fixed-Income Total Net

Largest Equity Categories Q1 Organic Growth Rate % Assets $Bil Categories Q1 Organic Growth Rate % Assets $Bil

Large Blend 0.69 7,539 Intermediate Core Bond 3.71 1,328

Large Growth –0.24 2,823 Intermediate Core-Plus Bond 3.37 784
Large Value –0.61 1,779 Short-Term Bond 0.35 492
Foreign Large Blend 0.92 1,585 Ultrashort Bond –0.35 340
Mid-Cap Blend 0.71 668 High Yield Bond 2.95 340
Diversified Emerging Mkts 1.16 661 Muni National Interm 1.50 320
Small Blend 0.14 592 Multisector Bond 5.45 300
Foreign Large Growth –0.82 528 Global Bond-USD Hedged 3.05 283
Mid-Cap Growth –2.02 409 Intermediate Government 6.18 260
Technology 3.72 398 Inflation-Protected Bond –0.66 215
–4 –2 0 2 4 –2 0 2 4 6 8
Money market and funds of funds are excluded when appropriate. U.S. data is survivorship-bias-free. In the broad asset class tables, equity includes U.S. stock, international, and sector fund flows. Organic growth rates are calculated
using beginning period asset levels and subsequent net fund flows.

68 Morningstar Q2 2024
Morningstar Medalists

The Best Active Large-Value Funds

Contrarian investors, take note: Large-value funds
suffered more than $10 billion in net outflows
during the first quarter, more than any other
Morningstar Category. In this issue’s Morningstar
Conversation (Page 48), David Hoeft of Dodge
& Cox and Bill Nygren of Harris Associates’ Oakmark Morningstar’s manager research team and
Funds discuss what they see as bright prospects are open to new investors. It includes offerings
for value investors. Below is a select list of actively run by Hoeft and Nygren.
managed large-value funds that have earned
Morningstar Medalist Ratings of Gold or Silver from

Morningstar Pillars 1-Year Performance and Risk (%)

Morningstar Morningstar Standard Fund Size
Name Medalist Rating Process People Parent Rating Return Deviation Sharpe Ratio ($Bil)

American Funds American Mutual A AMRMX ΠAbove Avg High High QQQQ 16.28 11.71 0.89 96.20
AMG Yacktman Focused N YAFFX „ High Above Avg Average QQQQ 21.39 12.93 1.15 3.82
AMG Yacktman I YACKX „ High Above Avg Average QQQQ 20.94 12.28 1.17 8.67
Avantis US Large Cap Value ETF AVLV „ Above Avg Above Avg Average — 28.03 16.08 1.29 3.18
BlackRock Equity Dividend Instl MADVX „ Above Avg Above Avg Above Avg QQQQ 20.05 13.30 1.04 19.37
Boston Partners All Cap Value Instl BPAIX „ Above Avg High Above Avg QQQQ 22.98 13.20 1.23 1.47
Brown Advisory BeutelGoodmanLg-CpValInst BVALX „ Above Avg Above Avg Above Avg QQQQ 20.84 17.91 0.84 1.91
Capital Group Dividend Value ETF CGDV „ Above Avg Above Avg High — 32.56 13.71 1.74 7.11
ClearBridge Large Cap Value I SAIFX „ Above Avg Above Avg Average QQQQ 22.83 12.80 1.25 3.05
Columbia Dividend Income Inst GSFTX „ High Above Avg Average QQQQQ 20.00 12.07 1.13 39.80
DFA US Large Cap Value I DFLVX „ Above Avg Above Avg High QQQ 23.37 15.70 1.07 25.01
Diamond Hill Large Cap Inv DHLAX „ High Above Avg Above Avg QQQ 26.29 15.91 1.21 9.13
Dimensional US Large Cap Value ETF DFLV „ Above Avg Above Avg High — 24.17 16.10 1.09 1.74
Dodge & Cox Stock I DODGX ΠHigh High High QQQQ 25.59 14.16 1.30 109.91
Fidelity Equity-Income FEQIX „ Above Avg Above Avg Above Avg QQQQ 19.95 12.35 1.10 8.32
Fidelity Value Discovery FVDFX „ Above Avg Above Avg Above Avg QQQ 15.36 11.31 0.84 3.12
JHancock Disciplined Value I JVLIX „ Above Avg High Above Avg QQQQ 27.68 13.74 1.46 14.70
JPMorgan Equity Income I HLIEX „ High Above Avg Above Avg QQQQ 15.08 13.49 0.71 46.23
LSV Value Equity LSVEX „ Above Avg High Above Avg QQ 23.85 16.73 1.04 1.37
MFS Value A MEIAX „ High Above Avg High QQQ 19.15 12.88 1.01 59.16
Natixis Oakmark A NEFOX ΠHigh High Average QQQQQ 34.12 15.88 1.60 0.83
Neuberger Berman Equity Income I NBHIX „ Above Avg Above Avg Above Avg QQQ 13.39 14.06 0.58 0.92
Oakmark Investor OAKMX ΠHigh High Average QQQQQ 33.52 15.74 1.58 22.12
Oakmark Select Investor OAKLX „ Above Avg High Average QQ 36.95 17.80 1.57 6.58
Putnam Focused Large Cap Value ETF PVAL „ Above Avg Above Avg Average — 31.10 14.53 1.58 0.43
T. Rowe Price Equity Income PRFDX „ Above Avg Above Avg High QQQ 20.10 15.37 0.92 18.01
Vanguard Windsor Investor Shares VWNDX „ Above Avg Above Avg High QQQQ 18.37 16.04 0.79 24.65
Source: Morningstar Direct. Data as of 03/31/2024. Medalist Ratings should not be used as the sole basis for investment decisions. Medalist Ratings are based on Morningstar’s current expectations about future events
and therefore involve unknown risks and uncertainties that may cause Morningstar’s expectations not to occur or to differ significantly from what was expected. Morningstar does not represent its Medalist Ratings to be guarantees nor
should they be viewed as an assessment of a fund’s or the fund’s underlying securities’ creditworthiness.

morningstar.com/products/magazine 69
Crossword Puzzle

The Sun Is but On May 16, 1984, Joe Mansueto founded

Morningstar in his Chicago apartment. For 40
financial success. To help mark our anniversary,
we thought it would be fun to publish this
a Morningstar years, we have worked to empower investors to
make confident investment decisions and achieve
Morningstar-themed crossword, created by former
Morningstar marketing executive Brian Addison.
Brian Addison

1 2 3 4 5 6 7 8 9 10 11 12 13 Down
1 Indian wrap
2 Goal-based output of 37D
14 15 16
3 Revise
4 At MORN, indicator of a strong
17 18 19 competitive advantage
5 Sends elsewhere
20 21 22 23 6 Came up, as a conversation topic
7 Diplomacy
8 Airport gate listing
24 25 9 Dog command, or something
to do with an old 401(k)
26 27 28 29 30 31 10 A fund with favorable fees
11 Chinese currency
12 Apple assistant
32 33 34
13 To be, in Latin
21 Fish eggs
35 36 37 23 Swedish actress Lena
25 Existed
38 39 40 26 “_____ Lama Ding Dong” by
Otis Day and the Knights
27 Coastal bird, or poet Gil Scott
41 42 43 44
28 Famed Bridgewater founder
29 Occur afterward
45 46 30 Blame-dodging reply to
“Who did this?”
47 48 49 50 51 52 53 31 Plumber’s fix, or coffee option
32 Flower stalk
33 Social uprisings
54 55 56 57 36 A 50A stock may be this
37 Professionals providing investment
58 59 60 expertise
39 Mystique
42 It could be sensitive or maybe
61 62 63
defensive
43 Songstress Cyndi
44 UK continent, abbr.
Across 46 Cursor controller
1 Gush out, like lava 25 Yellow-feathered showgirl of 49D 45 Makes a mistake 47 Sticker number at car dealership, abbr.
5 At MORN, a DBRS staffer, perhaps 26 Mocs, Crocs, and Docs, for example 46 Hawaiian island 48 Fencing sword
10 Where Ford gets an F 28 A value stock is likely to declare one 47 Major destinations 49 “The hottest spot north of Havana”
14 Supermarket chain founded by 32 Former stadium home of the Mets 50 At MORN, a moderately 50 Accomplishment
German brothers 33 Poe’s bird of inspiration undervalued stock rating 51 Phillies shortstop Turner
15 Muse of poetry 34 Companion to neither 54 Popular Dalmatian name 52 Blue, south of the border
16 Paris agreements 35 Pastry that’s often fruit-based 55 A stroke ahead, in match play golf 53 Tug of war prop
17 It’s been known to “kill bugs dead!” 36 Gretzky, as an NHL rookie 57 Rice shaped pasta 56 Word often found before maiden name
18 A point of the most importance 37 Sparkling Italian wine 58 Seized vehicle, in slang
19 Metallica drummer Ulrich 38 Angsty rock genre 59 Rental agreement
20 “Compound _______ is the eighth 39 Steer clear 60 Enlist again Scan this QR code or visit
https://bit.ly/43AsmGv
wonder of the world.” - Einstein 40 Pump’s partner, in securities fraud 61 Bosc or Bartlett
to check your answers.
22 Canadian coin 41 At MORN, he’s not your average Joe 62 Try to discourage
24 “The ____ the merrier!” 43 It helps prevent river flooding 63 Discount event

70 Morningstar Q2 2024
Morningstar
Investment Conference

June 26–27
Free admission for advisors

Evolve ahead.

Today’s evolving investor needs guidance that does more than keep up. The Morningstar
They need guidance that’s ahead of the curve. The Morningstar Investment Investment Conference
Conference brings advisors and financial experts together for cutting-edge Navy Pier, Chicago
research, expert insights, and thorough analysis. June 26–27, 2024

Now with free admission for advisors, join us for two days that’ll put you at the Scan to visit the
front of an ever-evolving investor lifecycle through fresh insights, analysis, and offical website
perspective. Get what’s next at the 2024 Morningstar Investment Conference.

©2024 Morningstar, Inc. All rights reserved. The Morningstar name and logo are trademarks of Morningstar, Inc.
 Ten Questions
Jean Hynes is the chief executive officer
and a managing partner of Wellington
Management. She heads the healthcare team
and serves as the lead portfolio manager
of Vanguard Health Care VGHAX, which
has a Morningstar Medalist Rating of Silver.
Hynes joined Wellington in 1991. She
has a Bachelor of Arts degree in economics
from Wellesley College.
Photography by Matthew Lomanno.
72 Morningstar Q2 2024
Wellington’s Jean Hynes on generating
alpha in the age of passive investing.
Laura Lallos, managing editor of Morningstar
magazine, interviewed Hynes in February.
1. You’ve spent your career at Wellington. What made
you stay?
The culture: People aren’t pegged into a square.
I started as an administrative assistant.
Opportunities await those who stretch for them.
2. Why did you keep managing Vanguard Health Care
after becoming CEO?
My being an investor attracts talent and helps us
evolve our investment platform. And I learn so
much from the CEOs that I interact with. There are
similarities in how you lead, whether at a biotech
company or an asset manager.
3. What drew you to asset management in the first place?
The industry wasn’t as prominent in 1991, and
I came from an immigrant family that never talked
about stocks. I had an internship with a
stockbroker in college, and that’s how I found
my way into the industry.
4. How can the industry attract more young women?
I have four daughters; one is in this field, and
another is interested in it. There are good
programs out there, such as Invest in Girls, which
we support. We don’t talk enough about the
mission of the asset-management industry:
How do you help people retire? How do you help
governments around the world support their
countries? If we did a better job of conveying that,
more people would be attracted to it.
5. What are the biggest industry changes since
you started?
In the 1990s, up to the global financial crisis,
there was a big shift from CDs to equities.
Then you saw enormous growth in fixed income.
In the past decade, it’s been the big shift
to passive. Over the last five years or so, it’s
a shift to alternatives.
6. What does this mean for active management?
Here’s an analogy with the pharmaceutical
industry: Around 2000, about 80% of the volume
was in branded drugs. Over the next 15 years,
the market shifted to generics. There may
not be the same volume of branded drugs now,
but they represent all the value of the
industry. Passive is like the generic drugs of
the asset-management industry.
7. How can Wellington continue to distinguish itself?
It’s much more complex to be an investor than
it was 20 years ago. A firm of our size can invest in
technology, risk systems, and data. We have
a collaborative ecosystem of about 600 investors
across equity, fixed income, long/short equity,
macro, and now private equity and private credit.
That allows us to generate alpha.
8. What is the most exciting trend in healthcare today?
The revolution we’ll go through in biology.
Everyone knows about mRNA: It could treat not
only covid but hundreds of viruses. Antibody-drug
conjugates could significantly reduce the use
of chemotherapy. There are major trends that are
going to change the standard of care.
9. What do you do when you aren’t managing money
and your company?
In winter, I ski every weekend. I’m up in Vermont
right now. Five of my six siblings are here,
my nieces and nephews, and my mom. It’s a good
way to spend quality time with my family.
I started as a terrible skier, and this season I can
actually do some black diamonds.
10. What are you reading?
I just finished Trust by Hernan Diaz, which won
the Pulitzer Prize in 2023. It was not what I thought
it was going to be. I love books like that.
CAPITAL AT RISK.

Hyperloops,
robots and playing
golf at 150…
Investing is getting interesting. Trends that change our lives forever are called Megatrends.
And aligning and adapting portfolios to Megatrends can reduce short term vulnerability and provide
better long-term certainty. Investing in the future could be the key to securing your client’s future.

blackrock.com

©2024 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock in the United States and elsewhere. 467700-0324.
Actual
investors
look to
the future.
Not the past.
Find out more at bailliegifford.com