Advanced Asset Allocation Strategies

A white paper that details Morningstar Associates^® five-step asset allocation process. DOWNLOAD »

ESG Managers^® Portfolios are the first asset allocation funds that give investment advisors and their clients access to carefully selected managers who integrate environmental, social and governance (ESG) factors into their investment analysis and decision making. Asset allocation, manager selection and portfolio construction is conducted by Morningstar Associates, a leading provider of investment management services, widely recognized for its expertise in manager selection, asset allocation and multi-manager/multi-strategy portfolio construction. Pax World Management serves as investment adviser to the funds.

The portfolios currently represent targeted allocations to asset categories and investment styles represented by nearly a dozen experienced investment managers. The asset categories include:

• Large Cap Growth
• Large Cap Value
• Small/Mid Cap Growth
• Small/Mid Cap Value
• International Developed Growth
• International Developed Value
• International Developed Small Cap
• Short-Term Bond
• Intermediate Bond
• Long-Term Bond
• Mortgage-Backed Securities
• TIPS (Treasury Inflation-Protected Security)¹
• High Yield Bonds
• Cash

Morningstar Associates' approach includes the following components:

Morningstar Associates uses multiple statistical methods and econometric analysis to arrive at the asset allocation targets for the ESG Managers® Portfolios. The portfolios are managed strategically, based on a long-term time-horizon, but subasset class exposures may be over- or under-weight to their targets within a certain threshold based on Morningstar Associates' evaluation of the portfolio risk metrics and market conditions. 

The portfolios are diversified across more than a dozen subasset classes - the equity portion across the full range of market capitalization and investment styles for both domestic and international stocks, and the fixed-income portion across the investment-grade and credit-sensitive areas of the bond universe. The structure and specific allocations reflect what Morningstar Associates believes is an optimal risk/return profile on the efficient frontier based on today's market conditions.

Drawing on years of experience, Morningstar Associates has incorporated the tenets of Morningstar, Inc.'s respected independent fund analysis into an institutional-quality manager evaluation process.

To select managers for the ESG Managers® Portfolios, Morningstar Associates tapped Morningstar, Inc.'s vast database of mutual funds, separate accounts, off-shore funds and ETFs to identify a broad universe of ESG managers from which to choose. While a key consideration was an identifiable and well-articulated ESG process, each manager also had to have a consistent investment strategy and process, an established track record of strong risk-adjusted performance versus its benchmark or Morningstar category and sufficient organizational resources to continue to support their investment efforts. The evaluation process draws on proprietary quantitative measures of risk-adjusted performance, style consistency and performance consistency; on holdings data collected by Morningstar for each manager's portfolio over time; and on fundamental research including the manager interviews that have long been a key component of Morningstar analysis. Finally, managers are evaluated based on how well they would fit together in a combined portfolio.

In summary, key considerations for manager selection include:

• Identifiable and well-articulated ESG process
• Established, consistent investment strategy and process
• Successful track record
• Style and performance consistency
• Organizational strength
• Portfolio fit

Morningstar Associates continually validates the rationale for each manager's selection and the role it plays in the portfolio. This is done through frequent contact with the underlying managers and quarterly performance evaluations. Underperforming managers or those that undergo significant changes in investment approach, management or overall organization may be replaced.

Morningstar Associates takes a bottom-up approach to constructing a portfolio that meets the allocation targets using the individual holdings-level data for stock and bond holdings. Manager portfolios are analyzed together for stock and sector overlap and Style Box placement to determine the optimal weighting of each manager, resulting in efficient and appropriately allocated, diversified portfolios. Manager allocations are also subject to an evaluation of correlations among the managers, the portfolio's risk metrics, economic and market factors, and measures of market volatility.

Morningstar Associates continually evaluates the portfolios' holdings, risk and managers. Holdings are monitored daily to ensure the portfolios' allocations remain within their target ranges. The overall risk of the portfolios is evaluated to ensure that it is appropriate given their targeted risk levels and current economic and market factors. Ongoing communication with underlying managers helps ensure that Morningstar Associates is aware of decisions that may impact each manager's performance or its overall role in the portfolio.

Morningstar Associates attempts to construct the portfolios to align them with their holdings-based subasset class targets as well as to maintain each portfolio's risk within its target risk range. It directs daily cash flows to maintain the appropriate asset and subasset class exposures. This means it often directs cash inflows to underweighted areas within a portfolio rather than selling overweighted categories. This approach tends to reduce turnover, to be more tax efficient and takes advantage of dollar cost averaging at the portfolio level without requiring additional investments by shareholders. When larger adjustments are needed, Morningstar Associates will occasionally shift the assets within a portfolio from one or multiple managers to others. Overall asset allocation targets are revisited once per year, although individual manager allocations are continually reviewed based on economic and market conditions.