The Takeaway
- The process of portfolio optimization can be used to target investment outcomes while also constraining deviation from the broad market—an approach that can be referred to as “beta plus.”
- The Morningstar Dividend Enhanced Select Indexes and the Morningstar ESG Enhanced Indexes represent two case studies of index methodologies employing a constrained optimization framework.
- Further areas where optimization can be employed in the service of "beta-plus” include the use of valuation signals, factor tilts, and the ownership lens.
Exposure to equity "beta," or the movement of the overall market, has served investors exceedingly well in recent years. The Morningstar Global Markets Index, a gauge of large-, mid-, and small-cap stocks spanning developed and emerging markets, averaged a nearly 11% annual gain for the past 15 years through the end of 2023. The Morningstar US Market Index was up closer to 14% per year. Given these impressive numbers, it's no surprise that plain-vanilla investments that track broad market indexes continue to attract the lion's share of flows.
But capital appreciation through broad equity market exposure can coexist with other goals—a two-pronged approach that can be referred to as "beta-plus." For example, many investors want to simultaneously build wealth through equities while also extracting income from their portfolio through dividend-paying stocks. Sustainability, through the integration of environmental, social, and governance factors, is capturing investor attention across the globe, yet investors want to minimize the degree to which their portfolios deviate from the market.
The process of portfolio optimization can be used to target investment outcomes while also constraining deviation from the broad market. By forecasting the covariance of asset returns, the optimizer aims to control tracking error. In addition to examining two case studies of index methodologies employing a constrained optimization framework—the Morningstar Dividend Enhanced Select Indexes and the Morningstar ESG Enhanced Indexes, it will explore other areas where optimization can be employed in the service of "beta-plus."
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