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Page 1: The Morningstar Associates Portfolio Construction …corporate.morningstar.com/.../MornAssocPortfolioConstruc.pdfThe Morningstar Associates Portfolio Construction ... to active portfolio

The Morningstar AssociatesPortfolio Construction Process

A Fundamental Approach toCreating Diversification

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At Morningstar Associates, constructing a portfolio of investments is about more than creating an effi-

cient frontier. The process begins with understanding our clients’ investment goals. Only then do we truly

know how to apply our approach to the particular needs of that client. Diversification is a key principle—

we work to embed it in every stage of portfolio construction. A primary strength of our team is our ability

to select high-quality investment managers and to combine them effectively in a portfolio. Above all, we

use our investment expertise to build, manage, and monitor a portfolio that will help our clients achieve

their long-term goals.

Our experienced investment professionals oversee the entire process, working to understand the invest-

ment objectives of our clients, tailoring an asset allocation targeted to their needs, selecting premier

investment managers that work well in combination with each other, and monitoring the portfolio on an

ongoing basis.

The three phases of our investment process are:

Phase 1: Asset Allocation

Phase 2: Selecting Investments

Phase 3: Ongoing Monitoring

Our ApproachBuilding customized, long-term portfolios

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r

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The first step in the investment process is to identify an asset allocation target appropriate to the client’s

investment goals. During this phase, our investment professionals work to determine time horizon, risk

tolerance, and long-term objectives. The resulting long-term strategic asset-allocation target is designed

to meet those objectives.

At the heart of the Morningstar Associates approach to asset allocation is common-sense diversification.

Our allocations go beyond the most general asset-class targets (stocks, bonds, and cash) to provide broad-

based exposure to both the equity and fixed-income markets.

How Common-Sense Diversification Works

Common-sense diversification produces equity exposures that cover all areas of the stock market. This

is evident when you evaluate the style boxes below, which compare the holdings of a typical Morningstar

Associates equity allocation with those of the S&P 500 Index. While it seems as though it would be

highly diversified, the S&P 500 Index has a roughly 90% allocation to large-cap stocks and a 10% alloca-

tion to mid-cap stocks.

The Morningstar Associates portfolio, by contrast, provides exposure to stocks across the full capitaliza-

tion range (small, mid, and large) while also achieving a balance between value and growth stocks.

We seek to achieve comparable levels of diversification, whenever possible, in our international-equity

and fixed-income exposures in similar ways.

S&P 500 Index Allocation (as of 12-31-05) 1

Large Cap 92%Mid Cap 8%Small Cap 0%

Typical Morningstar Stock Allocation 1

Large Cap 65%Mid Cap 23%Small Cap 12%

Phase 1 : Asset AllocationMeeting clients’ goals through common-sense diversification

Source: Morningstar Inc., proprietary data. Graphics are for illustrative purposes only.1

Value Growth

Small

Mid

Large

Blend Value Growth

Small

Mid

Large

Blend

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Investment Style

Within the grid, nine possible combinations exist, ranging from large-cap value to small-cap growth.

The Morningstar® Style Box™ was introduced to helpinvestors more easily determine the investment style of a fund. The equity Style Box is a nine-squaregrid that classifies securities by size along the vertical axis and by value and growth characteristics alongthe horizontal axis. Different investment styles often have different levels of risk and lead to differ-ences in returns. Therefore, it is crucial that investorsunderstand style and have a tool to measure theirstyle exposure.

Morningstar, Inc.’s equity style methodology uses a"building block," holdings-based approach that is con-sistent with Morningstar’s fundamental approach toinvesting. Style is first determined at the stock leveland then those attributes are "rolled up" to determine

the overall investment style of a fund or portfolio.This framework can link what are often treated asseparate processes—stock research, fund research,portfolio assembly, and market monitoring—in thebelief that a shared analytical framework will lead to better portfolio construction and fund usage.

Morningstar, Inc. uses 10 different stock characteris-tics to measure value and growth, and this producesmore accurate and stable stock and portfolio styleassignments. Morningstar, Inc. uses both forward-looking and historical-based components to ensurethat information available to active portfolio managers is incorporated in the model. This robustapproach to style analysis is a powerful lens for understanding stocks, funds, and portfolios.

Median

MarketCapitalization

12.4 11.7

11.7

13.3

11.3

13.2 14.7

11.8 12.5

M

Value Growth

Small

LargeM

id

Blend

14.1 14.0

13.5

15.5

0.2

24.3 19.1

24.0 23.6

Value Growth

Small

LargeM

id

BlendV

25-Year Annualized Category Returns(as of 12-31-05) 2

Category Returns for 2004 1

3

Smoothing Volatility: A Long-Term Perspective

Within the broad asset class of stocks or bonds, there are always short-term leaders and laggards

across investment categories. Because of our long-term investment perspective, we aren’t in the difficult

business of predicting which specific investment categories will outperform over short time periods.

Instead, by providing a high level of diversification across investment categories and adhering to long-

term targets, our portfolios avoid the short-term volatility that occurs in less diversified portfolios.

Broad-based diversification helps smooth a portfolio’s volatility. For example, in any given year, invest-

ments may perform in dramatically different fashion even within a single asset class. In 2004, mid-cap

and small-cap value stocks significantly outperformed large-cap growth counterparts (as highlighted

in the style box on the left above). Over the longer term, however, returns tend toward equilibrium, as

evidenced by the style box on the right above. By maintaining constant exposure to all areas of the

stock market we can help to smooth volatility, but still help investors get prudent long-term exposure

to the stock market.

The Morningstar® Style Box™

This style box represents the percentage returns for the year ended December 31, 2004.

Source: Morningstar Inc., proprietary data. Graphics are for illustrative purposes only.

1

2

LargeM

idSm

all

Value Blend Growth

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At Morningstar Associates, asset allocation is only the first step in building a portfolio. Selecting the right

investment managers is just as important. Our fully credentialed investment team has years of experience

at Morningstar evaluating investment managers, mastering the nuances of different styles, and comparing

managerial track records.

Investment Manager Quality: Managers Matter

Investment manager quality is a critical component of a portfolio’s investment success. As the graphic

below illustrates, despite funds in the same category having similar asset allocations, there can be a

significant gap between the best- and worst-performing manager even among those who share similar

investment styles.

Our investment experts’ ability to thoroughly assess the available managers in a given category assures

that our portfolios contain high-quality managers. As a result of our long history assessing managers’

styles and strategies, we have developed a highly credible manager selection process.

The Manager Selection Process: Applying our Experience

Our manager-selection process has both quantitative and qualitative elements. We first calculate a

numerical score or ranking of all of the managers in a particular peer group based on risk, return,

expenses, and manager tenure. This allows our investment consultants to focus their attention on a

shorter list of managers that score highest on our quantitative analysis.

Next, our consultants bring to bear their significant experience in manager evaluation as part of our

qualitative process. At this stage, our consultants evaluate the remaining fund managers to understand

their investment style, risk-return profile, and track record relative to their peers. Finally, they assess

the suitability of the manager for use within an asset-allocation framework and how well that manager

will fit with other managers under consideration.

Value Growth

Small

LargeM

id

Blend

Equity Investment StyleThree-Year Trailing Returns (as of 12-31-05) 3

Good Fund 28.18%Poor Fund 5.08%

Good Fund 32%Poor Fund 12%

Good Fund 39%Poor Fund –43%

Quantitative Screens

Performance consistency

Style consistency

Manager tenure

Qualitative Screens

Investment style

Risk-return profile

Track record

Fit with other managers

r

r

r

r

r

r

r

Phase 2: Selecting InvestmentsApplying expertise to find the right investment managers

Source: Morningstar Inc., proprietary data. Graphics are for illustrative purposes only. For the purpose of this analysis, a good fund was

defined as one whose returns rank in the top decile of its category, and a poor fund is one that ranks in the bottom decile.

4

3

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Holdings-Based Construction: Drilling Deeper

This final element of the investment selection process involves understanding managers in combination.

This means drilling down into an investment’s holdings and comparing them with the holdings

of other managers being used in the overall portfolio. The goal is to establish a specific role for each

manager in the portfolio that minimizes overlap among managers and maximizes diversification.

At Morningstar Associates, we use Morningstar, Inc.’s vast holdings-based database to uncover the

individual characteristics of each investment. We go beyond the simple prospectus objective and returns-

based style analysis approaches that many others use. Instead, we judge investment style based on

the actual holdings in a manager’s portfolio. One insight we gain from knowing the underlying holdings

is that few portfolios are stylistically pure. Most domestic stock funds, for example, have significant

exposure to stocks that place outside their Morningstar category. With access to holdings-based

information, we can select managers whose holdings complement each other rather than overlap. And,

more importantly, we can engineer the overall portfolio weightings for each investment category to hit

our asset-allocation targets with near precision.

Morningstar’s unique ability to understand the composition of a particular fund’s holdings enables

Morningstar Associates to combine the funds in a complementary way. As a result we can build a

portfolio that precisely meets our clients’ investment objectives.

Equity Fund 1 Equity Fund 2 Equity Fund 3 Actual Equity Allocation

+ =+

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The initial asset allocation and manager selection phases are just the beginning. At Morningstar

Associates, we spend considerable resources providing ongoing monitoring and evaluation of the portfolio

and the managers in it. On a regular basis, we monitor the strategic allocations to the sub-asset class

categories, including market capitalization, style, and sector weightings. As markets shift and variations in

manager performances affect the allocations, we adjust the allocations at the appropriate time and as

conditions warrant.

We continually evaluate manager quality. When a manager’s quantitative or qualitative evaluation indicates

there are opportunities for better-performing peers to play a role, we consider a manager change. This

ongoing commitment helps ensure that we provide you the highest-quality portfolio recommendations.

Phase 3: Ongoing MonitoringEnsuring that your portfolio remains on track

Our Investment Team

The entire investment process is lead by our team of experienced investment consultants, nearly all

of whom have either an MBA, CFA, PhD, or some combination. They have spent thousands of hours on

manager interviews and have extensive investment management industry experience. They receive

strategic support from Morningstar, Inc.’s Asset Allocation Committee, which meets on a quarterly

basis to review Morningstar, Inc.’s strategic asset allocation policy, and on an annual basis to construct

capital market expectations.

Morningstar Associates, LLC.

Morningstar Associates, LLC is a leading provider of investment management services for institutions and

their clients. We are a registered investment advisor and wholly owned subsidiary of Morningstar, Inc., a

leading global provider of independent investment research and analysis. Through our asset allocation

programs and managed account programs, Morningstar Associates oversees more than $30 billion (as of

December 31, 2005).

For More Information

Call 877-525-3275 Email [email protected]

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MA 0044 Exp Mar07Cons_Sal_PortConst3_073106

225 West Wacker Drive

Chicago Illinois 60606 USA