Morningstar Target Value and Momentum Indexes

The Morningstar Canada Target Value and Morningstar Canada Target Momentum Indexes have recently hit their 10-year launch anniversary. Over the past decade, these indexes, and many of the others in the family, have established a strong long-term record. These equity indexes were built to deliver potent exposure to their targeted factors, and they have lived up to expectations. They were also crafted for investability, taking steps to diversify firm- and sector-specific risk and screen for quality. While their bold factor tilts give them ample room to run when those factors are in favor, that positioning can also cut the other way. Pairing the Morningstar Target Value and Morningstar Target Momentum Indexes in a portfolio can help reduce risk while allowing investors to participate in the upside.

Strong Underpinnings 

Value and momentum are among the most well-documented return-enhancing factors in the financial literature. Researchers have known about these bedrock factors since the early 1990s, and they have paid off out-of-sample (not just in the original studies) and in practice, which breeds confidence they are likely to persist and are not just the product of data mining. 

Value investing is about buying stocks trading at low valuations, which have often fallen out of favor. This buy-low, sell-high strategy has intuitive appeal. More importantly, it is backed by strong economic rationale and empirical evidence. Lower valuations should reflect higher expected returns, either as compensation for risk or because investors may be overly pessimistic about these stocks’ prospects. 

Momentum is driven by short-term performance persistence. As such, momentum strategies aggressively chase hot areas of the market with strong recent performance. However, there’s substance to this strategy. Prices may adjust more slowly than they should to new information, as investors may initially underreact. This alone can cause performance to persist. Once a trend is established, more investors may jump on the bandwagon, further fueling price momentum. 

On the surface, value and momentum may seem like contradictory strategies. But these concepts do not conflict at all; they might even be two sides of the same coin. Value is a long-term effect, while momentum is short term. Herding behavior associated with momentum can cause prices to overshoot fair value. This may lead to the long-term performance reversals associated with the value effect. 

Portfolio Construction 

The value and momentum factors defined in the academic literature are not directly investable, as they ignore transaction costs and often favor illiquid stocks. There are many strategies that attempt to harness these factors, but differences in portfolio construction can lead to very different portfolios and performance. Morningstar Target Value and Morningstar Target Momentum Indexes are designed to provide strong exposure to their respective factors, while ensuring investability and considering stock quality. Morningstar offers indexes in both these families covering Canada, U.S., Developed Markets ex-North America, and Emerging Markets. 

Morningstar Target Value Indexes 

The Morningstar Target Value Indexes target a fixed count of stocks with strong value characteristics. Each eligible stock is assigned a Weighted Average Fundamental Factor Rank, or WAFFR, based on five metrics: 

• Price/earnings (TTM) 
• Price/cash flow 
• Price/book 
• Price/sales 
• Three-month EPS estimate revision 

Together, these metrics paint a more complete picture of each stock, mitigating the biases any single metric might introduce. For example, price/book is one of the most widely used valuation metrics in the academic literature, but it does not account for profits or intangible assets. Price/earnings addresses profitability but could be influenced by accounting choices, which is less of an issue for price/cash flow and sales. The earnings-per-share revision metric favors stocks with earnings likely to improve, reducing the risk of picking up stocks with deteriorating fundamentals, or so-called value traps. 

Stocks are screened for liquidity and ranked on their WAFFR each quarter. The Morningstar Target Value Indexes select the top-ranking stocks until they reach the fixed counts shown in the paper. To improve diversification, these indexes limit their exposure to each sector and equally weight their constituents. This approach tends to yield deeper value portfolios, and often less sector concentration, than traditional market-cap-weighted value benchmarks. It also leads to more differentiated exposure relative to the market. 

Morningstar Target Momentum Indexes 

The Morningstar Target Momentum Indexes are also designed to deliver potent exposure to their targeted factor, following a similar fixed-count approach to portfolio construction. These indexes do not look at recent performance in isolation, but do consider profitability to better target stocks with momentum backed by solid and improving fundamentals. 

Each eligible stock is assigned a WAFFR based on six metrics, which capture both price momentum and profitability: 

• Percentage change in price from 12-month high 
• Price change from month-end nine months ago 
• Price change from month-end three months ago 
• Three-month fiscal EPS estimate revision 
• Latest fiscal period earnings surprise 
• Trailing return on equity 

Similar to the WAFFR the Morningstar Target Value Indexes use, this composite approach reveals a more complete picture of each stock than any single metric in isolation. The inclusion of three price metrics favor stocks with more consistent momentum, which may be more likely to persist. The earnings per share, or EPS, revision and earnings surprise metrics favor stocks with improving profitability, while return on equity emphasizes strong past profitability. The inclusion of these fundamental factors reduces the risk of loading up on stocks that are climbing on nothing but speculation. 

Each quarter, liquidity-screened stocks are ranked on their WAFFR and the highest-ranking securities are selected until the indexes reach the fixed count targets shown in the paper. Like the Morningstar Target Value Indexes, the Morningstar Target Momentum Indexes are equally weighted and constrain their sector exposure to limit concentration.