The magazine of independent research for the world’s financial professionals Q1 2024

What Awaits
As the time to retire approaches, investors need a plan to tackle the looming dangers.
Also in this issue

gSharpening Bond Allocations gThe Decline of Active Management gAnd the latest investing trends from around the world...
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 Q1 2024

4 Contributors
5 Letter From the Editor

Dispatches
6
Letter From the Board
Best and Worst New ETFs

Phillips Curve

8 Crowning Achievement

Ivory Towers
9 Thinking Big

Advisor Insights

14 When Should Advisors Hire?

Sustainability Matters

15 Investing in Climate Adaptation

Global Briefs

17 Americas
23 Greater Europe

Switching Gears
27

For new retirees, crafting a flexible

withdrawal strategy can help provide
a fruitful retirement.

1
 Q1 2024

Strategies Research

34 How to Invest Better With Bonds
38 The Diminishing Role of Active Mutual Funds

Quant U

42 Solving the Retirement Equations, Part IV

Best Ideas

47 Manager: A Different Approach to Value Investing
48 Passive: Cautious but Crafty
49 Equity: An Attractive Transformation

Investors

Morningstar Conversation
50 An Oasis of Bond Opportunities

Undiscovered Manager
56 GoodHaven 2.0

Sector Rap

59 Restaurant Revolution

User Profile

62 Keeping Cool

Data Dashboard
64 Morningstar Global Market Barometer
66 Morningstar Global Valuation Lens
70 Morningstar Global Fund Flows
71 Morningstar Medalists

72 Ten Questions

2
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Contributors
This issue’s Undiscovered Manager (Page 56)
showcases a manager and strategy that have been
featured in these pages before. Drew Carter,
a manager research analyst for Morningstar
Drew Carter Research Services LLC, says that Larry Pitkowsky’s
GoodHaven Fund is worth revisiting after
a complete overhaul. “The dominance of the
so-called Magnificent Seven stocks has provided
a convenient excuse for many fund managers
to underperform in recent years. But Pitkowsky
and GoodHaven have found a way to beat
the S&P 500 over the past four years with a more
diverse array of stocks, both in size and sector,”
says Carter. “The fund’s largest contributor
was Builders FirstSource, a $20 billion industrials
firm, while an $8 billion financials firm and
$30 billion energy company also hit the top five.”
Ivanna Hampton, lead multimedia editor at
Morningstar, interviews consumer equity analyst
Sean Dunlop about how technology might
reshape the restaurant industry (“Restaurant
Ivanna Hampton Revolution,” Page 59). One example: “AI is playing
a bigger role than we might realize in what
we order and when,” Hampton says. “Customer
data is helping restaurants tailor their menus and
promotions to people’s daily routines.”
Hampton regularly interviews Morningstar’s
equity analysts for the Investing Insights podcast.
“They know the companies and sectors that
they cover so well. I get to quiz them on historical
events, their forecasts, and topics in the
news cycle. And they’re game,” she says. “We go
beyond a quick sound bite. I wrap up the
interviews knowing everyone listening gained
new insights.”
New York-based illustrator and graphic designer
Lloyd Miller is a regular Morningstar magazine
contributor. Miller chose a cuckoo clock,
“with its cyclical aspect and interconnected parts,
Lloyd Miller as an appropriate metaphor” for this issue’s
Spotlight on making an investment portfolio last
throughout retirement. “The rising, falling, and
revolving nature of this mechanism—and all under
one roof—suggests the ongoing fluctuations
of the market and overall inflation fears that affect
investors as time ticks on,” Miller says.
4 Morningstar Q1 2024
Morningstar Magazine
Volume 16, Issue 1
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, Don Phillips, Jeffrey Ptak, Katie Rushkewicz
Reichert, Daniel Rohr, Janet Yang Rohr, Jeffrey Stafford,
Timothy Strauts, Lorraine Tan
Contributors Amy C. Arnott, Christine Benz, Brian Bernard, Drew Carter,
Mara Dobrescu, Michael Dobson, Sean Dunlop, Yesenn El-Radhi,
Johanna Englundh, Ivanna Hampton, Roger G. Ibbotson, Ryan Jackson,
Nichola James, Paul D. Kaplan, Charles Keenan, Shannon Kirwin,
Maciej Kowara, Kenneth Lamont, Alec Lucas, Tom Mills, Brian Moriarty,
Matias Möttölä, Leslie Norton, John Rekenthaler, Sheryl Rowling,
Daniel Sotiroff, Larry Swedroe, Tony Thomas, James X. Xiong
Art Director Alex Skoirchet
Designer Paul Zdon
Illustrator Lloyd Miller
Photographers Chris Lane, Matthew Lomanno, Kim Raff, David Zentz
Proofreaders Mary Kate Chambers, Mike Eiler
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
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E03056494
Letter From the Editor
A Flexible Retirement
Recently retired investors have faced massive
challenges right off the bat. An equity bear market
in 2022 paired with double-digit losses by
bonds put a huge dent in the portfolios investors
Jerry Kerns are counting on to fund decades of living
expenses. Meanwhile, a cumulative inflation rate
of 18% since 2020 puts even more pressure
on retirees, whose portfolios now must allow
for the purchase of much more expensive goods
and services. At Morningstar, we often talk
about sequence risk. It’s a given that markets will
drop and that economic risks such as high inflation
will occur. For long-term investors, what’s
important is the timing of such events: They are
much more detrimental to portfolios if they happen
early in the time horizon. Through no fault of
their own, the retirees of 2022 had very bad timing,
and thanks to sequence risk, they experienced
a couple of big setbacks to funding their lifestyles.
But there are potential remedies. Morningstar’s
research shows that retirees willing to adjust their
spending year to year based on market
conditions (good and bad) can flourish over the
long run. Being flexible not only allows for higher
withdrawal rates than a fixed system (such
as the so-called 4% rule), but it also can increase
the chances that retirees won’t outlive their
savings. In “Switching Gears” (Page 27),
researchers Amy Arnott, Christine Benz, and John
Rekenthaler recap their findings and show
how four different flexible strategies fare under
different retirement scenarios. Although each
variable method has its trade-offs, their tests
reveal that flexible strategies effectively handled
the ups and downs of a 30-year retirement.
And thanks to higher yields on bonds and cash,
they found that safe withdrawal rates for
retirees can increase.
Bonds are back on investors’ radar after a
brutal run. Moderating inflation and expectations
that the Federal Reserve will lower interest
rates this year led to a comeback in 2023’s fourth
quarter. To see what might be in store for 2024
and beyond, we invited three veteran bond
managers to participate in this issue’s Morningstar
Conversation (“An Oasis of Bond Opportunities,”
Page 50), moderated by Brian Moriarty,
an associate director on Morningstar’s manager
research team. “For 15 years, we’ve been in the
desert as fixed-income portfolio managers
with incredibly low yields,” Fidelity manager
Ford O’Neil said. “There’s income back in
fixed income!”
Morningstar manager research’s Maciej
Kowara and Alec Lucas are out with some timely
research (“How to Invest Better With Bonds,”
Page 34). They found that optimizing a portfolio for
the Sharpe ratio results in a 5% stock/95%
bond allocation. Acknowledging that that’s not
a realistic allocation for most, the analysts
show how investors can pick their equity allocation
and then Sharpe-optimize the remaining bond
portion for the highest risk/reward ratio possible.
The resulting subsector weightings of the
optimized bond portfolios look very different than
those of a broad fixed-income index.
Careful readers will notice some changes
to the Data Dashboard section (Page 64)
that incorporate feedback from our recent reader
survey. We’ve added more stock picks,
additional index data featuring benchmarks
built around Morningstar research, and
a section highlighting top-rated funds. Thank you
for your input and helping us improve the
magazine. Send your additional suggestions
to jerry.kerns@morningstar.com.
morningstar.com/products/magazine 5
 Dispatches
Best and Worst
New ETFs
A record year brought
the good and the bad.
Phillips Curve LETTER FROM THE BOARD
8 Crowning Achievement Bryan Armour
Ivory Towers
9 Thinking Big By mid-December, asset managers had launched
nearly 500 exchange-traded funds for the
Advisor Insights calendar year, easily breaking the record set in
14 When Should Advisors Hire? 2021, when 461 ETFs were launched. The ETF
universe is more expansive than ever: Investors
Sustainability Matters can choose from 3,487 of them. There have
15 Investing in Climate Adaptation been 5,067 ETFs brought to market since SPDR S&P
500 ETF SPY launched in 1993. This means
Global Briefs 31% of them have since closed.
17 Americas
23 Greater Europe Longtime favorite ETFs continue to control
most of investors’ assets, despite the increasing
number of options available. Half of ETFs’
$7.8 billion in assets is parked in the top 40 ETFs.
The youngest of the top 40 ETFs was launched
in 2013, and all are index funds. Actively managed
ETFs are a major growth trend, but the ETF
market’s broad index-tracking roots remain intact.
New ETFs have little chance of competing with
these strategies directly. Instead, they try to
differentiate themselves by targeting new markets
or by tweaking the classics.
With all this in mind, our ETF research team
analyzed the class of 2023 and voted on the best
and worst new ETF launches.
Best New ETFs
BlackRock Flexible Income ETF BINC and Schwab
High Yield Bond ETF SCYB stand on the shoulders
of giants, ultimately improving ETF investors’
options without creating something original.
Bond ETFs saw a resurgence in 2023, as higher
yields gave investors good reason to replenish
their portfolios with bonds. Taxable-bond
6 Morningstar Q1 2024
ETFs brought in $168 billion of estimated net flows
through November, not far off from U.S.
equity ETFs’ $210 billion, despite a significantly
smaller asset base.
The fact that BlackRock Flexible Income ETF and
Schwab High Yield Bond ETF hold bonds is
the extent of their similarities. They target different
markets. One is actively managed, while the other
tracks an index. BlackRock’s ETF marks the next
stage in the evolution of ETFs, while Schwab’s ETF
proves there’s still room for improvement of
traditional ETFs. What ties these two ETFs together
is that investors benefit from both.
BlackRock Flexible Income ETF
Adoption of actively managed ETFs is accelerating.
A growing willingness by portfolio managers to
reveal their daily holdings and the added flexibility
of custom creations and redemptions have been
crucial to pulling star mutual fund managers into
ETFs. Perhaps no star is bigger than Rick Rieder,
BlackRock’s investment officer of fixed income and
winner of Morningstar’s 2023 Outstanding
Portfolio Manager award.
Investors have flocked to Rieder’s funds, which,
as of July 2023, totaled $144 billion in assets.
Rieder’s teams are known for their broad and deep
analytical resources combined with a well-
honed process, resulting in a High rating for the
People and Process Pillars for Rieder’s top
strategies: BlackRock Total Return MAHQX and
BlackRock Strategic Income Opportunities BSIIX.
This ETF focuses on harder-to-reach fixed-
income sectors. Out of the gates, the portfolio
has targeted a short duration and a solid
yield. Duration can be expected to change with
conditions in the bond market. The ETF has
focused its holdings in global credit, securitized
debt, and emerging-markets sovereign debt.
A 40-basis-point fee offers investors a welcomed
reprieve from the higher fees for investor share
classes of Rieder’s mutual funds.
Schwab High Yield Bond ETF
ETFs are steeped in index-tracking tradition. Their
original use case was to provide broad exposure
to markets at a cheap cost. Core markets have
been commoditized after intense fee competition
among asset managers. Today, some S&P 500
and total stock market ETFs are available at nearly
no cost. Niche markets haven’t experienced
the same level of competition, leaving investors
with a higher bill for venturing away from the most
liquid stocks and bonds.
Vanguard has long played the role of fee agitator.
It would enter a new market by undercutting
incumbents’ fees, forcing them to cut their
expense ratios to compete. This became known
as the Vanguard Effect.
Over the past two years, it hasn’t been Vanguard
playing this role. Instead, bond ETF markets
have been rattled by the “Schwab Effect.” Schwab
added municipal-bond and high-yield bond ETFs
that not only gave investors a new low-cost option
but also led to fee cuts for investors holding
competing ETFs.
Schwab’s approach to product development
has long been to provide low-cost, broad
access to different markets. It wasn’t until 2022
that it moved into more niche bonds, when
Schwab added a muni-bond ETF with a 0.03% fee,
undercutting the lowest-fee ETF by 2 basis
points. In 2023, it launched a high-yield bond ETF
with a 0.10% expense ratio that matched the
lowest-cost high-yield bond ETF on the market,
SPDR Portfolio High Yield Bond ETF SPHY.
State Street didn’t appear to take kindly to
the new competition. SCYB launched on July 11,
and by Aug. 1, State Street had already
cut SPHY’s fee to 0.05%. But Schwab didn’t back
down. On Sept. 25, Schwab responded by
cutting its 2-month-old ETF’s fee to 0.03% from
0.10%. The response by asset managers didn’t stop
there. On Nov. 28, iShares cut the fee for
iShares Broad USD High Yield Corporate Bond ETF
USHY to 0.08% from 0.15%. Two days later,
Xtrackers dropped the fee of Xtrackers USD High
Yield Corporate Bond ETF HYLB by 10 basis
points to 0.05%.
Schwab sparked a fee war in high-yield bond
ETFs that benefited not only new investors
of SCYB but also those holding the other funds.
These fee cuts should save investors over
$10 million this year alone.
Best ETF honorable mentions are: T. Rowe Price
Capital Appreciation Equity ETF TCAF, Dimensional
World Equity ETF DFAW, and iShares J.P. Morgan
Broad USD Emerging Markets Bond ETF BEMB.
Worst New ETFs
Investing is a marathon, but investors can grow
impatient and try to get rich quickly. Many
of the competitors for worst new ETF try to help
investors scratch that gambling itch.
The worst new ETFs—2x Bitcoin Strategy ETF BITX
and YieldMax AI Option Income Strategy ETF
AIYY—tapped into derivatives, a sandbox best
left to the pros to play in. The potential outcomes
for derivatives are not always obvious. And
concentrated risk, leverage, and high fees are all
a recipe for disaster in the long run.
2x Bitcoin Strategy ETF
One of 2022’s worst new ETFs was ProShares
Short Bitcoin Strategy ETF BITI. The reasoning was
that ProShares was playing bookie, trying to
force a referendum on bitcoin by enticing investors
to go long or short. The 2x Bitcoin Strategy
ETF has the potential to be far more destructive.
Bitcoin is highly volatile even without leverage.
BITX takes volatility to the extreme. Since launching
in June 2023, BITX has already experienced a
40% drawdown and rallied to a 70% gain. Investors
may see the large return and think they can
play this ETF right, but timing markets is extremely
difficult. And there’s more to leveraged ETFs
than meets the eye.
These ETFs reset their leverage daily to provide
2 times returns for the next trading day. That
means they must add leverage when bitcoin
moves higher and remove leverage when its price
falls. In choppy markets, that means lots
of buying high and selling low. Over the long term,
performance will look far worse than a continuous
2 times exposure to the price of bitcoin. And
it comes with a prohibitive 1.85% fee. Investors
don’t need to take a stand on bitcoin, but there
are better options if they do.
YieldMax AI Option Income Strategy ETF
Leveraged and inverse single-stock ETFs are a
terrible idea. Betting on single stocks stacks
the odds against long-term success. Adding
leverage or inverse exposure with a high
fee is even worse. Still, investors looking for
a lottery ticket have found their way into
these types of ETFs.
Covered-call strategies are another trend that
has captivated investors. These strategies
start with a long position in something like the
S&P 500, then sell a call option against it,
setting an upside cap on performance while
generating income.
YieldMax merged these two trends into a
single-stock covered-call ETF—a strategy that few
could ever need. In keeping with the trendiness
of the ETF, YieldMax launched this strategy
for many of the trendiest, most volatile stocks
and funds on the market. Think Tesla TSLA,
Nvidia NVDA, and Apple AAPL. Does it make sense
to target some of the most popular stocks? For
YieldMax, of course it does. Are those stocks
the best suited for a covered-call strategy? Perhaps
not. But at least they are among the biggest,
most liquid stocks on the market, making the
strategy easy to execute.
But, on its face, no ETF has targeted more trends
in a single fund than YieldMax AI Option Income
Strategy ETF. Everyone wanted AI exposure
in 2023. The only problem is that AI does not stand
for artificial intelligence in this instance.
AI refers to C3.ai AI, a company working on
artificial intelligence, so at least that’s aligned with
expectations. But it’s a highly unprofitable
small-cap stock with under $300 million in revenue
and a $3 billion market cap. This is not a
great candidate for a single-stock covered-call
strategy, leaving YieldMax’s use of this stock for
this strategy misleading, at best.
Honorable mentions for worst new ETFs are the
Long and Inverse Cramer ETFs LJIM and SJIM and
Roundhill Magnificent Seven ETF MAGS. K
Bryan Armour is director of passive strategies research
for North America with Morningstar Research
Services LLC. He is a member of the editorial board
of Morningstar magazine.
morningstar.com/products/magazine 7
 Dispatches
Crowning Achievement
Good for the many
beats great for the few.
PHILLIPS CURVE
Don Phillips
The lure of brilliant fund managers attracted
investors to mutual funds in the 1980s.
At the time, giants still roamed the industry: Peter
Lynch, Michael Price, and John Neff were
regularly posting index-crushing returns. John
Train’s bestselling book, The Money Masters,
highlighted legends like John Templeton
and T. Rowe Price, who parlayed shrewd insights
into robust returns over decades. It seemed
the fund industry was bursting with amazing
opportunities for intrepid investors willing
to do the research to find fund managers able
to generate great returns.
That promise was never fully realized. Costs
drifted up as distribution expenses became
embedded in stated returns. Political missteps
kept the U.S. fund industry from securing
capital gains treatment that would have made
funds as tax-efficient an investment vehicle
as a diversified holding company such as Warren
Buffett’s Berkshire Hathaway BRK.B. Fund
companies were bought and sold, and managers
frequently jumped ship in fits of hubris.
Ballooning assets were poorly controlled, and
many good strategies became difficult
to execute effectively. In short, what could
go wrong, did.
I was bemoaning this missed opportunity for
greatness recently, when a colleague helpfully
reminded me that while greatness for a
few ardent investors has been rare, good offerings
available to a wide swath of savers and
investors have become much more common—
and that’s certainly a more noble achievement.
Nowhere is this more evident than in
retirement planning and services where investors,
especially in larger company plans, now
8 Morningstar Q1 2024
enjoy broadly diversified, low-cost investment
options and great tools that encourage
better outcomes.
Defined-contribution plans and IRAs in the
1980s often held just a single fund as their equity
exposure. Fidelity Magellan FMAGX was a
particularly popular option. Granted, it was a great
fund under Lynch and Jeff Vinik, but the
performance of any single actively managed
fund will, of course, hit rough patches.
Today, broad-based index funds that produce
consistently competitive results are more widely
deployed. Asset allocation has also been
made simpler with the advent of target-date funds
that not only manage the glide path toward
retirement, but also make the match between
investor and investment horizon clearer. Managed
portfolios, increasingly available through
employer defined-contribution plans, offer a simple,
one-choice path to an intelligently diversified
and professionally overseen investment plan.
Retirement planning has also benefited from the
integration of research from the exciting
field of behavioral finance. Auto enrollment and
automatic contribution step-ups help investors
more fully benefit from these plans. Sadly, the
continuing issue of millions of American
workers still not having access to a quality plan
remains a looming crisis. But for the many
savers who do participate in plans today, the
industry deserves credit for creating a better
experience and improving the chance for
investor success, especially in the accumulation
phase of retirement planning.
Now, the challenge increasingly turns to the
drawdown phase, an essential element of
the ultimate success of these plans. For baby
boomers approaching or now in retirement,
this need is especially critical. As several studies
have shown, boomers as a group have higher
equity exposures than prudent financial planning
standards would recommend. Finding ways
to turn their retirement savings into dependable
income streams may prove to be much-
needed ballast for boomers’ inflated equity
exposures. It would likely be hard to get boomers
to downshift on their own, but managed
accounts or income-stream options via 401(k)
plans stand ready to defuse the risks
this generation is taking by maintaining their
long-standing infatuation with equities.
Finally, there’s a much better understanding
of prudent withdrawal rates, as seen in this issue’s
Spotlight research featured in this magazine
(“Switching Gears,” Page 27). Historically,
when investors retired at a high point in stock or
bond market valuations, they would engage
in higher spending because they were flush with
recent wealth. Today, wise planners recognize
high valuations as a hidden liability and low
ones as a hidden asset for those retirees who are
not simply cashing out, but wisely are investing
for a decade or more in retirement.
Better tools and better research are leading to
better outcomes for fund investors saving
for retirement. A higher probability of a good
outcome for tens of millions of savers may
not make headlines the way a superstar manager
might, but it’s an achievement that those
who work in the industry should take pride in.
Good outcomes for many top great ones
for a few. That’s what makes managing mutual
funds far more admirable than running
hedge funds.
Nowhere has the nobility of mutual funds and
financial planning been better featured
than in helping investors prepare for retirement.
It’s the industry’s crowning achievement
to date. K
Don Phillips is a managing director of Morningstar. He is
a member of the editorial board of Morningstar magazine.
The views expressed here are not necessarily those
of Morningstar.
Thinking Big
Can you safely spend
more early
in retirement?
IVORY TOWERS
John Rekenthaler
Recently, radio talk show host Dave Ramsey
recommended that retirees invest 100% of
their assets in equities, from which they would
withdraw 8% per year of the portfolio’s
starting value, with each year’s expenditures
adjusted for inflation. Thus, if inflation is
3%, the retiree would withdraw $40,000 in year
one from a $500,000 portfolio, $41,200 in
year two, $42,436 in year three, and so forth.
If you listen to Ramsey’s statement, you
will realize two things. First, nobody has ever
been as certain of anything as Ramsey
is about the accuracy of his counsel. (Or he’s
acting—he is a performer, after all.) Second,
he is deeply wrong. His argument relies
on the overwhelmingly false assumption that
stocks will consistently deliver double-
digit returns.
Consequently, a host of “supernerd” researchers
(to use Ramsey’s term for his critics) have
dismantled his suggestion. This article, however,
will take a different angle, by identifying the
conditions under which Ramsey’s advice succeeds.
The failures of his strategy will become quite
apparent. But when does it work?
The obvious way to withdraw aggressively from
an investment portfolio without depleting it
is ... to die early. While generally not regarded as
a desirable solution, expiring quickly does
permit retirees to follow Ramsey’s advice. Even
with Morningstar’s conservative assumptions,
investors can safely withdraw almost 10%
annually, inflation-adjusted, over a 10-year period.
Easy pickings.
While that response sounds glib—and it is—
the underlying point is serious. The only way to
achieve a safe portfolio-withdrawal rate that
is also satisfyingly high is to assume a short time
horizon. Otherwise, something has to give.
Guaranteed income provides security, but nothing
approaching an 8% lifetime withdrawal rate.
And risky portfolios are, well, risky.
History’s Verdict
Let’s view history’s verdict on the viability of
a 100% equity portfolio while funding 8%
inflation-adjusted withdrawals. For each rolling
30-calendar-year period since 1926, I calculated
the annual returns of a portfolio that invested
80% of its assets in the stocks of large U.S.
companies and 20% in small U.S. companies. The
data contains 68 completed 30-year horizons.
E X H I BIT 1 shows the portfolio-survival percentages
for those episodes.
Those unfortunate souls who retired in January
1929 would have been out of money in less
than eight years. Oh, dear. Remember when I
wrote that achieving an inflation-adjusted
8% withdrawal rate for a decade was “easy
pickings”? I omitted the fine print. Doing so calls
for at least a modicum of bonds/cash
to protect against stock market collapses. Of
all possible portfolio strategies, short of
employing leverage, Ramsey’s approach is the
likeliest to lead to immediate ruin.
Yes, you might respond, betting the house on
stocks failed miserably when Herbert Hoover was
president. Fortunately, things have since
changed. When recessions commence, the Federal
Reserve no longer responds by hiking interest
rates while simultaneously permitting banks
to fail. Also, Congress no longer stifles global trade
by enacting steep tariffs. The only lesson to be
drawn from the class of 1929 is the inapplicability
of ancient history to the current era.
It’s true that since the Great Depression ended,
a 100% stock portfolio has almost always
survived for at least 10 years. But on a baker’s
dozen occasions since 1965, retirees adopting
Ramsey’s strategy would have fared not
much better, exhausting their investment pools
before year 15 concluded.
Four of those implosions happened in this
millennium, most recently in 2007, as shown in
EXHIB IT 2 . Today’s economy is different from
1929’s, and so are the federal government’s
policies, but the potential for stock market disaster
remains. Such is the nature of risky investments;
if equities did not hold such dangers, they
would not boast the high potential returns that
an 8% spending rate requires.
The good news: In the 55% of occasions in which
the portfolios survived through year 30, retirees
faced few worries when the period ended. In real
terms, 80% of those portfolios were worth more
after year 30 than when the investor retired. Their
accounts had paid them handsomely for three
decades yet were still flying high. Almost certainly,
they would outlive their owners.
As with the little girl with the curl, when
the portfolios were good, they were very good.
But when they were bad, they were horrid. In
22 of the 68 incidences, representing 32% of the
test cases, the portfolios failed to reach
year 20. Such odds may suit those who retire at
advanced ages, say in their mid-70s, or who
have severe health issues. As I wrote, short time
horizons cure investment ills.
The wager is unlikely to suit most newly minted
retirees, though, since their time horizons are too
EXHIBIT 1
The Track Record Survival of 100%
equity portfolio, 8% real annual
withdrawal rate.
Years
of Survival Incidences
1 to 9 6
10 to 14 13
15 to 19 13
20 to 24 10
25 to 29 3
30+ 55
0% 20 40 60
Source: Morningstar.
morningstar.com/products/magazine 9
 Dispatches

long. For example, a 65-year-old nonsmoking large difference! Indirectly, those results suggest Returns that occur early during retirement
woman with average health has a 25% chance that retiree portfolios fare best when they are much more important than the later arrivals,
of surviving 29 years. Spending aggressively start off strong. as demonstrated in EXHIB IT 4 . It shows the
early on is not appropriate for those in their 60s. portfolio failure rates, over 30 years, for all trials of
In contrast, most of the winning portfolios enjoyed the 8% withdrawal rate during which the
The Key to Failure handsome early returns. The right side of the first year’s return was negative, after considering
$400K
The biggest reason the portfolios cratered was exhibit shows the same calculation, only this time the effect of inflation. It repeats the exercise
slow starts. No portfolio that suffered an measuring the annualized real performance for the cumulative results over the initial two-,
overall real loss during its first five years survived of years 16 – 20. The portfolios that lasted longer three-, four-, and five-year periods.
200years. E X H IB IT 3 shows the median
for 20 than 20 years actually had a lower median
annualized real returns during the initial five years annualized return than the portfolios that ran out The picture tells a grim story. Withdrawing an
of the retirement period for the portfolios that of money by year 20. Later performances inflation-adjusted 8% from an equity portfolio is
did not0 live for 20 years and for those that did. The are largely beside the point. The early results perilous at the best of times but outright
1929
results were, respectively, 11.1% and 0—a very –11.37 are what really matter. destructive for portfolios that start poorly. Such
–200 strategies misfire two thirds of the time if the
first year’s return is negative (again, after
1 3 5 7 8
EXHIBIT 2 Year accounting for inflation). It only gets worse from
there. By year five, there’s no hope. No
Future Flops Real value of 100% equity portfolio, 8% real annual withdrawal rate.
portfolio that suffered real losses through its initial
five years survived the full three decades.
1965 1966 1968 1969 1970 1971 1972 1973
1999 2000 2001 2002 2007
A Flexible Approach: Withdrawal-Rate Cuts
$600K
The question then becomes, can the strategy
be a useful starting point? That is, might retirees
400 be well served by adopting a bold initial
Years withdrawal rate and then adjusting in response
of Survival Incidences
to market circumstances? If equities perform
1 to200
9 6 well, stay on track. If they do not, pull back.
10 to 14 13
0 For this scenario, I evaluated a simple, if
15 to 19 13
unsophisticated, investment policy. Begin with
20–200
to 24 10 an 8% withdrawal rate, per the radio host’s
1 3 5 7 9 11 13 15 recommendation. If the portfolio’s cumulative real
25 to 29 3
Year
return is negative after any of the first five
30+
Source: Morningstar. 55
years, switch to an annual withdrawal rate of
0% 20 40 60 4%. Once at 4%, stay there.
EXHIBIT 3

Early Results Matter Most Median annualized real return %. I designed this arrangement to instruct, not
advise. Halving one’s portfolio-withdrawal
The First Five Years Years 16 to 20 rate forever, based on an arbitrary performance
rule, would be silly. But the exercise should
12 12 provide at least some indication of the power of
11.1 10.6 on-the-fly spending adjustments. Are such
changes effective? Do they meaningfully affect
8 8 7.8 portfolio survival rates? Or do they come too
Median Return %

Median Return %

little, too late?

4 4
0 0 EXHIB IT 5 answers those questions. As the
0
< 20 Years 20+ Years < 20 Years 20+ Years long title and subhead suggest, it’s a bit
Survival Term Survival Term tricky to explain, so bear with me. The top bar
Source: Morningstar. shows the failure rate, over 30 years, for

Negative Real Return Failure %

10 Morningstar Q1 2024
Overall Average 45
 11.1 10.6

8 8 7.8

Median Return %

Median Return %
4 4

EXHIBIT 4 0 0 0
portfolios that used a steady 4% withdrawal rate. 20 Years
Failure<Percentages 8%Years
With an20+ 20 Years
Real Withdrawal <Rate 20+ Years
100% equity portfolio,
(To reiterate, these are the historical figures. Survival Term Survival Term
30-year holding period.
When looking forward, Morningstar calculates
different odds.) It represents the conventional
Negative Real Return Failure %
case. The remaining bars show the failure
rates for portfolios that start with 8% withdrawal Overall Average 45
rates and then retreat to 4% after they suffer First Year Negative Real Return 68
negative real returns.
First Two Years Negative Real Return 88

Incorporating the adjustment fixes the year-one First Three Years Negative Real Return 80
problem. Retirees who spend ambitiously First Four Years Negative Real Return 79
during their initial 12 months but then back down
First Five Years Negative Real Return 100
if that portfolio loses money in real terms are
barely worse off than those who used a 4% Source: Morningstar. 0 20 40 60 80 100
withdrawal rate from the beginning. But the news
sharply worsens if the two-year results
are negative. And from year three onward, EXHIBIT 5

it is unpalatably bad. Failure Percentages With an 8% Real Withdrawal Rate, Adjusting for Slow Starts
100% equity portfolio, starting 8% withdrawal rate, adjusted rate of 4%, 30-year
Too Much Too Soon holding period.
The conclusions are inescapable.
Negative Real
Negative Real Return
Return Failure %
Failure %
gAn 8% real withdrawal rate from an equity Base Case
Case ((4% Throughout)
4% Throughout)
Base 33
portfolio can persist through several decades.
Retirees who are fortunate enough to First-Year Adjustment
First-Year Adjustment 44
ride an early bull market can probably maintain Second-Year Adjustment
Second-Year Adjustment 18
18
such a high spending rate.
Third-Year Adjustment
Third-Year Adjustment 40
40
gBut how to know in advance? Bull markets
appear only in hindsight. Fourth-Year Adjustment
Fourth-Year Adjustment 36
36
gAlthough it’s possible to withdraw flexibly, Fifth-Year Adjustment
Fifth-Year Adjustment 73
73
by scampering to safety if stocks perform poorly,
Source: Morningstar. 00 20
20 40
40 60
60 80
80 100
100
there’s little room for error. In nearly one
observation in five, a mere two years’ worth of
negative investment results doomed the
portfolio, even after the real withdrawal rate EXHIBIT 6

was slashed to 4%. Finding a Sweet Spot 100% equity portfolio, real withdrawal %.

While 8% is a dangerous starting point, some

50
50
retirees might want to bet bigger than 4% for their
-Year
30-Year
30
initial withdrawal rate. 44
44 Failure %
Failure %
40
40 38
38
As EX H IB IT 6 shows, beginning one’s retirement 35
35 -Year
20-Year
20
with a 5% withdrawal rate—and being 30
30 Failure %%
27
27 Failure
willing to adjust downward—is a reasonable
22
22
wager. Perhaps even 6%. Any more than that, 20
20
Rate%%

not so much. K 15
FailureRate

15
12
12
10
10 44 33
Failure

John Rekenthaler is a vice president at Morningstar

Research Services LLC. He is quick to point out that the
00 00
views expressed in Ivory Towers are his own.
8%
8% 7%
7% 6%
6% 5%
5% 4%
4%
Withdrawal Rate
Withdrawal Rate
Source: Morningstar.

morningstar.com/products/magazine 11
Paid advertisement by Nuveen
What plan sponsors
need to know
about lifetime income
The conversation around
guaranteed lifetime income has
been steadily growing since the
SECURE Act of 2019 changed safe
harbor provisions to protect in-plan
annuities. Participants have long
wanted lifetime income built within
their retirement plans, to mirror
the benefits of now essentially
extinct defined benefit plans.
Why guaranteed
lifetime income
Research shows that for participants,
guaranteeing lifetime income in retirement
is a significantly larger concern and could
be used to motivate recruitment and
retention. Seventy percent of participants
surveyed by TIAA expressed a preference
for a company that offers a guaranteed
lifetime income solution in retirement. Even
higher numbers expressed a preference
for income stability over just principal
protection, with 78% of respondents to
an EBRI survey asking for income. These
numbers are not necessarily indicative of a
disconnect between participants and plan
sponsors, but they could be a growing sign
that participants want the next evolution in
their retirement plan.
Participants understand that guaranteed
income has a significant role in securing
their retirement and they are, rightly,
looking to their employer to help them in
that process.
When asked about their views specifically
on guaranteed income, a majority of plan
sponsors see that a guaranteed income
solution can improve the risk/return profile
for participants, and they see a growing
need to explore the available options
for lifetime income given the current
market environment.
Education about the role and benefits of a
lifetime income solution within a retirement
plan is still at a relatively nascent stage.
Those who have an opinion on the matter
are largely in favor, with only around 10% of
respondents disagreeing with the potential
benefits of lifetime income solutions. It is the
role of asset managers as well as advisors and
consultants to help educate plan committees
on the role that guaranteed lifetime income
solutions can provide. The solution isn’t right
for every plan sponsor, but it appears that on
balance, once a sponsor has a firm opinion of
lifetime income, they view it positively.
The how of guaranteed
lifetime income
When it comes to lifetime income solutions
there are both guaranteed and non-
guaranteed products. Systemic withdrawals
are the most common withdrawal
method employed in the current 401(k)
environment, where the participant
determines the amount and frequency of
withdrawals from their retirement account,
until the point the funds are depleted. This
option contains few protections for the
participant, but it is the most flexible and
most liquid of the various payout options.
There are also managed payout options,
in which a managed account investment
manager works to determine regularly
scheduled payouts from the participant’s
assets, with the goal of ensuring that the
assets last through retirement. However,
there are no guarantees with this
type of solution.
We think that an in-plan annuity is the best
way to integrate a lifetime income solution
into a retirement menu. This can be
wrapped into a target date-like structure,
where an allocation to an annuity is built
into the overall glidepath of the retirement
plan. It could also be structured as part of a
range of QDIA-eligible structures.
The benefit of in-plan gives the option,
but not obligation, to convert those assets
into a lifetime income stream at the point
of retirement. Simplicity is key; annuities
can be very complex, and we find it
easiest for these solutions to be adopted
by participants by embedding them into
something that the participants are already
familiar with — such as a target date or
managed account offering.
In-plan annuities wrapped into a fund
structure offers the most seamless
integration for participants as little will
change from their perspective. The genesis
of target date funds was to allocate risk
according to age and time to retirement,
and this metric, while simple, still
reflects the needs of a significant portion
of participants. Wrapping the annuity
allocation into a structure that is broadly
familiar to participants, whether target date
or another type such as a managed account,
eases the transition from viewing a 401(k)
balance as a savings vehicle to a lifetime
income vehicle with a set decumulation
plan. Making this transition as seamless as
possible for the plan participant is the best
way to encourage uptake of the annuity at
the point of retirement and get participants
the lifetime income they need.
Paid advertisement by Nuveen

What’s next?
Education for participants remains critical
for plan sponsors. Recent TIAA data shows
that upward of 80% of new employees use
the default option in their retirement plan,
while longer-tenured employees tend to
more actively manage their investments.
Both types of investors need to be educated
about the annuity option within their
retirement plan menu.
There are also some technical
considerations of different types of
annuities, as they can be relatively
complicated products with different
contract types. Without getting tooin the
weeds, as different annuity types will suit
different plans, the principal types are:
• An immediate fixed annuity, such
as a single premium immediate annuity
(SPIA). These annuities are taken at the
point of retirement, when a participant
signs the annuity contract and hands
over a portion of their assets in return for
lifetime income.
• A qualified longevity annuity
contract, or QLAC. Similar to SPIAs, in
that they are often fixed annuities, that
take a portion of assets and surrender
them in return for guaranteed income.
The major difference is that there is
a delay between the surrendering of
assets, say at retirement, and the start of
payouts, often 10 or 20 years later. This
can significantly increase the payouts
received but it can increase mortality
risk. The assets have to come from a
qualified account or IRA.
• Deferred annuities are used when
a participant deposits into an annuity
contract over time or at some point prior
to retirement. These have two distinct
phases, the accumulation phase, when Myth vs. Reality
the participant is paying into the
annuity, and the payout phase, when Annuities are restrictive,
they are taking the lifetime income. with little to no flexibility.
Some deferred annuities have lockup Annuities offer a range of options
periods or withdrawal limits, while and can be used to diversify a
others have more flexibility and are retirement income plan.
liquid deferred annuities. We prefer
retirement plan options that retain It’s all or nothing with annuities:
liquidity for participants and ensure as they require using total savings.
much flexibility as possible.
Employees can annuitize a portion
• The Guaranteed Lifetime of their savings and leave the rest
Withdrawal Benefit, or GLWB, until they are ready to withdraw them.
is different, as the assets remain
the property of the participant. The Employees lose estate value.
portfolio is redirected into a mix of Employees have multiple options
stocks, bonds and other asset classes with annuities, including joint payout
that then generate the income that options to provide for an estate benefit.
is provided to the participant. The
income is guaranteed by the insurance
company if the level of income from the
portfolio falls below that in the contract. We believe that a guaranteed lifetime
This contract type includes explicit fees income solution is something that plan
paid by the participant to the insurance sponsors should be carefully considering.
company. This has the highest growth The evaluation of different options and
potential and ability to keep pace with whether they are the right solution
inflation, while also offering flexibility for for participants to meet their needs in
the participant. retirement rests on detailed and careful
education and analysis. The cost of the
There are also variables in the underlying
solution is a major consideration, as
contract within each of these types of
is the underlying complexity. Not all
annuity, such as minimum payment
solutions are easy to explain, and many
lengths, survivor benefits, variable or
have different characteristics that can
indexed annuities. Each change to the
change vital components of the annuity.
underlying annuity affects the premiums
The portability of the solution is also a
and payouts accordingly, and each type of
significant consideration, as employees are
solution needs to be carefully evaluated for
increasingly more likely to change jobs,
its suitability.
while the overall support afforded by the
It takes time to examine a plan menu to solutions provider to participants should be
evolve the options to include a guaranteed robust to educate and support them in their
lifetime income solution. retirement journey.

For more information, please visit us at nuveen.com/lifetimeincome

Any guarantees are backed by the claims-paying ability of the
issuing company.
The views and opinions expressed are for informational and educational
purposes only as of the date of production/writing and may change
without notice at any time based on numerous factors, such as market
or other conditions, legal and regulatory developments, additional
risks and uncertainties and may not come to pass. This material may
contain “forward-looking” information that is not purely historical in
nature. Such information may include, among other things, projections,
forecasts, estimates of market returns, and proposed or expected
portfolio composition. Any changes to assumptions that may have been
made in preparing this material could have a material impact on the
information presented herein by way of example. Past performance
is no guarantee of future results. Investing involves risk; principal
loss is possible.
This material is not intended to be a recommendation or investment
advice, does not constitute a solicitation to buy, sell or hold a security or
an investment strategy, and is not provided in a fiduciary capacity. The
information provided does not take into account the specific objectives
or circumstances of any particular investor, or suggest any specific
course of action. Investment decisions should be made based on an
investor’s objectives and circumstances and in consultation with his or
her financial professionals.
Please note that this information should not replace a client’s
consultation with a tax professional regarding their tax situation.
Nuveen is not a tax advisor. Clients should consult their professional
advisors before making any tax or investment decisions.
Nuveen, LLC provides investment solutions through its investment
specialists. GAR-3267551PG-O1123X 1091101
 Dispatches
When Should
Advisors Hire?
Taking on staff seems
costly, but it can lead
to growth.
ADVISOR INSIGHTS
Sheryl Rowling
I recently received a question from an advisor:
“My daughter has been working as a financial
advisor for a large company since graduating from
college five years ago. She has been quite
successful, and even I’m impressed with her
growing expertise. Now that she’s earned her chops,
we have been talking about bringing her in
to my solo practice to both create a succession plan
and update the firm’s vision moving forward.
I’m concerned about pulling the trigger because
my income will be affected. I also struggle with
the best way to structure her equity participation.”
This is really three questions:
1 Should I hire someone now?
2 Should I hire my daughter?
3 How do I approach sharing equity?
Let’s address each question.
Should I Hire Someone Now?
Before addressing who should be hired, you
must first determine whether it’s the right
time to hire and what role the new hire should fill.
With solo firms, I generally favor adding an
employee if for no other reason than for backup.
What if the advisor becomes ill or disabled,
wants to take a vacation from internet connectivity,
passes away? From a financial standpoint,
this could destroy the value of the business.
Worse, it could leave clients in the lurch.
As much as being a sole practitioner avoids the
hassles of being an employer, it’s not the
best way to function in the long run.
14 Morningstar Q1 2024
So, if it’s the right time to hire, how can you
justify and afford the expense? Obviously, growth
is required to be able to absorb the cost of
an employee. But growth is required for every
firm. Why? Because stability is impossible.
If your firm is not growing, it’s decaying. Think
about it. No matter how loyal your clients
are, you will lose some over time—to moves,
marriage or divorce, assumption of assets
by a trustee, death, or some other unanticipated
event. Without new clients, the business
will decline. The bottom line is that growth
should pay for the cost of an employee.
Moving from a solo practitioner to a multiperson
firm can actually help bring growth. That
the firm no longer relies on only one person can
encourage more clients to make referrals and
can convert more prospects to clients.
Although it would seem less costly to bring
someone on in an administrative role,
I think the solo practitioner’s first hire should be
professional. This provides valid backup to
the primary advisor and builds a foundation for
further growth. My recommendation would
be to hire someone who:
gHas at least three to five years of experience.
gHolds a professional designation, such as
a certified financial planner, personal financial
specialist, or chartered financial analyst.
gIs willing to pitch in on nonprofessional tasks
that are often required at a small firm.
Should I Hire My Daughter?
Now that you’ve decided to hire someone, does
it make sense to hire your daughter?
Based on your description of her education and
experience, she seems to meet the basic
criteria for a first hire. Beyond that, as with any
employee, you need to critically consider
whether she has the right personality, work ethic,
and culture fit to perform well in your firm.
Because she’s your daughter, you also need to
evaluate whether a boss-employee relationship
can be successful. Could your personal
relationship be at risk? Do you both have the
ability to separate work roles from family roles?
What if it doesn’t work out? Are your spouses/
significant others supportive? And, at
a basic level, does your daughter want to
work with you?
How to best use an additional employee could
be an entire series of articles. But deciding
when and whom to hire is an important first step
in ensuring the continuity of your practice.
How Do I Approach Sharing Equity?
Unless you’re looking at a merger or sale to
another firm, committing to or even discussing
an equity-sharing agreement before you’ve
worked together is premature. Generally, equity
should be considered once:
gYou’ve worked with an employee for a while.
gThe employee has become integral to the firm.
gThe employee has proved capable of bringing
in new clients.
gThe employee has expressed an interest in
becoming an owner.
g You’ve become comfortable with sharing
ownership with the employee—or anyone!
Finally, before discussing equity sharing, it’s a
good idea to work with a consultant familiar with
structuring deals. Most forms of ownership
transfer should come with a financial commitment.
This might not be critical when dealing with your
daughter. However, in my experience, a financial
buy-in cements the level of commitment.
Hiring decisions should not be taken lightly. Yet
because practicing solo can leave the advisor
and clients at risk, I recommend moving forward as
soon as practically possible. K
Sheryl Rowling, CPA, is an editorial director at Morningstar.
The views expressed here are not necessarily those of
Morningstar.
Investing in Climate
Adaptation
These companies
stand to benefit from
a warming climate.
SUSTAINABILITY MATTERS
Leslie Norton
For all of society’s efforts to curb global warming—
including the recently concluded COP28
United Nations climate summit—temperatures
will continue to rise for at least another
century. Global temperature is on track to rise by
2.5 degrees Celsius to 4.5 degrees Celsius by
2100. After the hottest year on record, we’re
likely to see continued fallout, including increased
risks of wildfires, droughts, floods, and what
scientists call “disruptive inundation.”
These certainties don’t mean we stop trying to
cut emissions. But they do mean we need
to adapt to the warming climate—which creates
opportunities for investors. Climate adaptation
is the industry built around creating resilience in
our infrastructure as the planet warms.
3 Major Climate Adaptation Themes
Home Depot HD and Lowe’s LOW are oft-cited
beneficiaries of climate adaptation, on the
thesis that people must rebuild their homes after
an event such as a hurricane. But there are
even better examples and themes.
HVAC
More air-conditioning systems will be needed to
keep buildings comfortable in areas that didn’t
previously need them, and longer summers means
that replacement rates for existing AC units will
rise. Those needs will increase as cloud computing
and artificial intelligence require large server
farms with intense cooling needs. Companies that
could benefit include Trane Technologies TT,
Johnson Controls International JCI, Watsco WSO,
Lennox International LII, and Daikin Industries DKILF.
Water
Droughts and water scarcity are rising. New
Orleans recently declared a state of emergency
after saltwater flowed into the drought-
stricken Mississippi River, threatening the city’s
drinking water. More capital will be spent
on water treatment, pumps, and pipes. Possible
beneficiaries: Xylem XYL, Primo Water PRMW,
Zurn Elkay Water Solutions ZWS, Pentair PNR,
Core & Main CNM, Mueller Water Products MWA,
and American Water Works AWK.
Engineering
Governments and industries need to make
infrastructure more resilient. As every port in the
world faces rising seas, governments will need
to step up their disaster warning and flood defenses.
Companies that could benefit include Aecom ACM,
Tetra Tech TTEK, Stantec STN, and Arcadis ARCVF.
How Big Is the Climate Adaptation Market?
Rising temperatures could cut into economic
growth, but spending on climate adaptation
measures can offset that. The World Economic
Forum sizes up the market at $2 trillion by 2026.
That estimate is too small, says Chris Goolgasian,
director of climate research at Wellington
Management. “It will be in [multiples of] 10, 20, 30
trillions of dollars,” Goolgasian says. Consider
the $750 billion Inflation Reduction Act, the
landmark 2022 law promoting renewable energy.
Spending was initially proposed at well over
$1 trillion. “A big section of the cut was adaptation
spending,” Goolgasian says.
Goolgasian expects to see new legislative
initiatives from many different jurisdictions for
such things as protecting food infrastructure,
coastal dredging, and building and infrastructure
hardening. In 2022, for example, Florida
passed the Home Hardening Sales Tax Exemption
to help Floridians reinforce their homes with
such things as hurricane-resistant glass. Toronto is
offering subsidies to homeowners to protect their
homes against basement flooding.
Other Climate Adaptation Beneficiaries
Building Materials
Tony Tursich, a portfolio manager at Calamos
Investments who specializes in sustainable
equities, likes Kingspan KGSPY, an Irish building-
materials company that has made innovations
in insulated panels and high-insulation roofing
that incorporates photovoltaics. “It’s exposed to
long-term secular growth,” Tursich says. Kingspan
also harvests and manages rainwater and is
auditing the city of Sydney’s rainwater harvesting.
Tursich also likes Saint Gobain CODYY, which
makes fire- and impact-resistant glass.
Efficiency Experts
Tursich is a fan of Prologis PLD, the REIT that
leases warehouse space to customers like
Amazon.com AMZN. Prologis is the second-largest
corporate producer of solar energy, which
runs on warehouse roofs and helps customers
be more efficient and reduce energy use.
Power Generation
U.S. power demand growth has stagnated
because of efficiency gains in appliances
and lighting. That will change as heating and
cooling needs rise and electric vehicles gain
traction. “We’re moving back to trend,”
says Matt Breidert, portfolio manager at Ecofin.
Breidert is a fan of Constellation Energy CEG,
which operates the largest fleet of nuclear power
plants in the United States.
Green Bonds
These are bonds that raise money for climate-
related projects. “Climate adaptation is becoming
an integral part of mitigation,” says David
Zahn, head of sustainable fixed income at Franklin
Templeton. According to the United Nations,
adaptation costs in developing countries could
reach $300 billion every year by 2030.
One U.S. example owned in Franklin Municipal
Green Bond ETF FLMB is a 5% Alameda,
California, bond maturing in 2048 that raised
$17.5 million for embankments, a seawall,
and other improvements to protect the district
against a sea level rise of seven feet.
“Global warming is going to happen,” says Zahn.
“You can argue what the cause is. Ocean levels will
rise, and we need to adjust.” K
Leslie Norton is editorial director for sustainability
with Morningstar.
morningstar.com/products/magazine 15
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 Dispatches

Global Briefs
TRENDS

The Big Shortfall: Investors in Thematic ETFs Show Terrible Timing

Global assets in thematic funds—designed to
harness secular growth themes ranging
from artificial intelligence to aging populations—
have more than doubled since 2018. However,
investor trading habits over the past five years
have destroyed considerable value.
While thematic funds averaged a 7.3% annualized
total return over the five-year period through
June 30, 2023, the typical investor return in these
funds was only 2.4%—an investment gap of
4.9 percentage points. The volatile return profiles
of many thematic funds, coupled with low- or
no-commission trading, can encourage the worst
type of investor behavior. Investors in broad
thematic funds fared best. These funds tend to be
more diversified and less volatile than funds
focused more narrowly on technology, physical
world, or social themes.
Return gaps were far wider in exchange-traded
funds than in mutual funds. ETFs tend to be more
concentrated, resulting in higher volatility, and
their intraday trading capabilities lend themselves
to tactical usage. The five-year gaps recorded
by open-end mutual funds are considerably lower
than those posted by their thematic ETF peers.
This is most striking in the case of technology- and
physical-world-themed funds, where ETFs have
an investment gap 500 to 600 basis points higher
than their traditional mutual fund peers.
Kenneth Lamont, CAIA, is a senior analyst at Morningstar
Manager Research.
Matias Möttölä, CFA, is a director at Morningstar
Manager Research.

5-Year Total Returns, Investor Returns, and Return Gap by Investment Type

Fund 5-Year Investor 5-Year Total

Theme Investment Type Count Return % Return % Return Gap
Broad Thematic* Open-End Fund 257 6.6 7.7 –1.1
Physical World Exchange-Traded Fund 39 2.3 11.8 –9.5
Open-End Fund 373 6.9 10.1 –3.3
Social Exchange-Traded Fund 22 –2.8 0.1 –3.0
Open-End Fund 386 1.9 4.4 –2.5
Technology Exchange-Traded Fund 84 –2.3 5.4 –7.6
Open-End Fund 442 5.3 7.7 –2.5
*There were no broad thematic ETFs with a five-year history as of the date of the study. –4% 0 4 8 12
Source: Morningstar Direct. Data as of June 30, 2023.

Dodge & Cox Still A recent report alleging unethical trading at Dodge
& Cox overstates lapses at the firm. ProPublica,
Merits a High Parent a nonprofit investigative journalism outlet, said
that Dodge & Cox’s chief investment officer, David
Rating Hoeft, had traded certain stocks around the same
time as its funds.
AMERICAS
Both ProPublica and Dodge & Cox note that the
United States
trades cleared Dodge & Cox’s compliance
procedures and personal trading policies. And it
isn’t unusual for investment firms to allow
employees—even investment professionals—
to invest outside the firm’s funds in their
personal accounts. Dodge & Cox says that such
freedom is necessary to attract the best
investors, adding that having “skin in the game”
gives its investment staff greater incentives
to make good calls while more closely aligning
themselves with clients.
Even so, allowing fund managers to trade
personally in individual stocks runs risks. A
manager of a multibillion-dollar mutual fund could
get into a stock before his fund begins buying

morningstar.com/products/magazine 17
 Dispatches
it and sell before the fund exits, thereby
benefiting in both situations from his knowledge
of his fund’s plans.
But ProPublica’s data doesn’t clearly show that
Hoeft engaged in such abuses. Using Hoeft’s
tax records, ProPublica could pinpoint when Hoeft
bought or sold a stock, but Dodge & Cox’s
mutual funds report their holdings quarterly and
such reports do not disclose when the funds
traded those holdings. At most, we know
Hoeft personally traded some stocks around the
same time as his firm’s funds.
Dodge & Cox insists that Hoeft’s trades met
the standards of the company’s code of
ethics. According to the firm, Hoeft sought and
obtained approval for his activities.
Employees cannot trade stocks that any of
the firm’s strategies are formally considering
buying. A compliance team monitors all
employees’ trading and can flag issues or take
disciplinary action—neither of which occurred
in the instances noted by ProPublica.
Given Dodge & Cox’s compliance policies
and investment ethos, it’s unlikely that Hoeft’s
trading was unethical. Many investors who
“front-run” stocks do so for a quick profit, but
Hoeft held the stocks featured in the exposé for
longer periods. In the two stocks cited by
ProPublica, VMware (since acquired by Broadcom
AVGO) and NetApp NTAP, Hoeft held his
investments for at least two to three years before
beginning to sell them. These trades were
consistent with the firm’s long-term investment
mindset; indeed, they easily surpassed
a firmwide prohibition on taking short-term profits,
defined as gains realized within 60 days
of purchase.
It’s a stretch to call Hoeft’s trading front-running.
For example, Hoeft and Dodge & Cox, in
an interview with Morningstar, admitted Hoeft
bought VMware before the funds but said
he did not break the firm’s ethics policy. Hoeft
began researching the stock, and it was
put on the firm’s restricted list; he pitched it to
one of the firm’s investment committees,
which initially passed on the idea; this resulted
in the stock’s removal from the restricted
18 Morningstar Q1 2024
list, and Hoeft subsequently bought the stock
in his own account after getting permission
from the firm. Hoeft later reproposed the
idea to the investment committee, disclosing to
colleagues at the time that he owned the
stock. The second pitch was successful,
and Dodge & Cox began buying VMware shares
for its portfolios.
There is no reason to change Dodge & Cox’s
High Parent rating or its strategies’ Morningstar
Medalist Ratings.
Tony Thomas is associate director of equity strategies for
Morningstar Research Services LLC.
Staying Invested Beats
Timing the Market
Don’t try to time the market. This advice has been
passed down often by successful investors
like Benjamin Graham, Warren Buffett, Jack Bogle,
and Peter Lynch through the decades.
But has this mantra held up in recent years? After
all, investors boast access to more and more timely
TRENDS
What We (Un)learned in 2023
In Star Wars: The Empire Strikes Back, Yoda
tells Luke Skywalker, “You must unlearn
what you have learned.” Investors would do well
to heed the Jedi master’s exhortation. The
past year was filled with unforeseen events and
common assumptions overturned.
When 2023 began, economists were debating
whether the United States would experience a
hard or soft landing with inflation raging and
the yield curve inverted. Yet, by the third quarter,
information than ever and they can trade at
practically no cost, all while markets have heaved
to and fro.
Furthermore, Morningstar equity analysts’
fair value estimates show some ability
to predict the market. Morningstar’s coverage list
includes nearly 700 stocks listed in the United
States. While that number has fluctuated
over time, the coverage history goes back to
July 2002.
We used a market-cap-weighted aggregate to
determine whether the market was deemed over-,
under-, or fairly valued each month since
then. When we examined the three years that
followed each month, we found the median return
of the market was higher when the market
was undervalued (that is, aggregate price/fair
value estimate ratio of less than 1.0), and
lower—even negative at times—when viewed as
overvalued (aggregate price/fair value estimate
ratio greater than 1.0).
The price/fair value ratio got one key thing
very right: It correctly signaled that undervaluation
paved the way to positive future returns.
Indeed, there was only one month in this study
in which the market looked undervalued
and the following three years’ performance
was negative: December 2007. Moreover,
it correctly foresaw periods in which returns
were likelier to be negative.
gross domestic product was expanding by 5%.
Equities rebounded impressively, and Japan
came to life. Tech-related growth stocks resumed
market leadership. Meanwhile, investors
lured into fixed income by high yields and the
promise of falling rates were met with
borrowing costs that promised to stay “higher for
longer”—until a powerful November rally.
Dan Lefkovitz is a strategist for Morningstar Indexes.
 EXHIBIT 1

But could that strength be translated into Overvalued Markets Were Followed by Lower 3-Year Returns
a successful market-timing strategy?
120
To address that question, we calculated the
returns of two portfolios, built up over
time through regular income. The first, a Steady 80
Equity approach, put all income to work

3-Year Total Return %

in the Morningstar US Market Index, no matter 40
the valuation. The second, Valuation Aware,
siphoned incoming funds to that index
or to cash accounts depending on stock market 0
valuation; it also “swept” cash into equities –40
when the market looked undervalued. 0.5 0.75 1.00 1.25 1.50
(Neither portfolio sold shares at any point; the Starting Price/Fair Value Estimate Ratio
allocation to either cash or equities in the Source: Morningstar. Data: Rolling 3-year periods starting July 1, 2002, through Aug. 31, 2020.

Valuation Aware strategy affected incremental

income only.)
EXHIBIT 2

As shown in E X H I B I T 2 , buying and holding Steady Equity Investment Outpaces Valuation Aware Market Timing
generated better returns over the past
21 years, albeit by a narrow margin of around
0.76% per year. $1.0M
Steady Equity
0.89
Did it matter when we started the clock? The 0.8
short answer is no: The Steady Equity strategy’s Valuation Aware
outperformance was mostly indifferent to 0.6 0.81
when we began the study over the past 21 years,
Portfolio Balance

although starting with a market that was 0.4

overvalued shrank the outperformance margin
a bit (about 8% versus 9.9%, on average). 0.2
0
The only starting period in which the Valuation 06/30/2002 06/30/2008 06/30/2014 08/31/2023
Aware strategy outperformed the Steady Source: Morningstar. Data from July 1, 2002, through Aug. 31, 2023.

Higher Interest Rates Aren’t Necessarily Bad for Growth Stocks

$16K Growth stocks are more sensitive to interest
Morningstar US rates than value stocks. That’s the narrative. But
Large-Mid Broad in 2023, growth bounced back despite
14 Growth several rate hikes. In the U.S., the “Magnificent
$13,704
Seven”—Apple AAPL, Amazon.com AMZN,
12 Morningstar US Alphabet GOOG, Nvidia NVDA, Meta Platforms
Large-Mid Broad META, Microsoft MSFT, and Tesla TSLA—captured
Value an outsize share of equity gains. Many of
10 $11,041 these mega-cap growth stocks are perceived
8 beneficiaries of the theme consuming investors:
12/31/2022 04/30/2023 08/31/2023 12/12/2023 artificial intelligence.
Source: Morningstar Direct. Data from Jan. 1, 2023, through Dec. 12, 2023.

19
 Dispatches
Equity investment was between August 2020 and
February 2022 (again, measuring performance
through August 2023). This is likely partly
because our analysts viewed the U.S. market as
overvalued at this time and partly because
it’s over a relatively short period that’s comfortably
within the three-year window in which
the price/fair value ratio has shown some
predictive ability.
Buying shares when they’re undervalued and
holding back when they’re overpriced may seem
like it should outperform a valuation-blind
equity investing strategy. However, it appears the
Valuation Aware strategy’s underperformance
boiled down to mainly two issues.
What held the Valuation Aware strategy back?
Cash drag. Though the strategy earned
higher average returns when the equity screens
indicated the market was undervalued, this
was more than offset by the upside the strategy
missed out on when those same signals
showed the market was rich. In other words,
because stocks tend to go up over very
long periods, it pays to be fully invested, even if
occasionally going to cash might have taken
some of the edge off at times.
Second, while extreme market over- or
undervaluation has led to sharp under- or
outperformance, these situations are
exceedingly rare. In the vast majority (79%)
Higher Interest Rates Aren’t Necessarily Good for Banks
$14K
12
10
8 painful markdowns of long-term U.S. Treasuries
6 and agency mortgage-backed securities.
12/31/2022 04/30/2023
Source: Morningstar Direct. Data from Jan. 1, 2023, through Dec. 12, 2023.
20
of months over the past 21 years, the market
has been within 10% of fair value. A Valuation
Aware strategy simply didn’t have enough
opportunities to make up lost ground versus
a Steady Equity portfolio that was able
to strongly compound capital in nearly all
market environments.
Adam Fleck is head of ESG research for
Morningstar Sustainalytics.
How Home Bias Affects
Performance
AMERICAS
Canada
A recent Morningstar study reviewed the
portfolios of more than 3,000 Canada-domiciled
mutual funds and found home bias across
the board. Granted, global equity funds
reduced their holdings in Canadian equities by
3.4 percentage points in the 10 years ended
September 2023, while global fixed-income funds’
average Canada stake fell by 5.1 percentage
points. Yet, a significant portion of funds
in global categories still held disproportionate
Morningstar
US Market
$12,257
Morningstar US
Banks-Regional
$8,528
08/31/2023 12/12/2023
stakes in Canada relative to corresponding
global indexes.
Global equity funds on average held 8.3% in
Canadian equities as of September 2023,
nearly 3 times the Morningstar Global Markets
Index’s 2.9% stake. (The overweight was
particularly pronounced among global equity funds
of funds, which averaged a 16.8% stake in
Canadian equities, versus 4.0% for conventional
funds that own stocks directly.) Global
fixed-income funds averaged 17.3% in Canadian
fixed income, about 6 times the Morningstar
Global Core Bond Index’s stake.
A bias toward Canadian stocks was a hindrance
over the past decade. The Morningstar
Canada Index lagged the Morningstar Global
Markets Index by 3.4 percentage points
annualized from September 2013 to September
2023. A $10,000 investment in the global
markets benchmark over that time would have
earned $7,500 more than the same investment
in the Canada benchmark.
However, a tilt toward Canada hasn’t always been
a disadvantage. In the previous 10-year period
from October 2003 to September 2013, the
Morningstar Canada Index outperformed its global
counterpart by 2.8 percentage points annualized.
The Morningstar Canada Index also beat the
Morningstar Global Markets Index in more than
half of the 244 rolling five-year periods from
The Morningstar US Banks-Regional Index tells
the story of a troubled industry that saw
the collapse of Silicon Valley Bank and made
First Republic the biggest U.S. bank failure
since 2008. Aren’t higher rates supposed to be
good for banks? The Fed’s steep rate hikes
did widen the spread between deposit rates and
lending rates. However, banks suffered
 EXHIBIT 1

July 1998 to September 2023, primarily those that Canadian Equities Haven’t Always Lagged Global Markets
began before October 2013.
30
A home bias hasn’t been as significant for Morningstar
fixed-income portfolios—so long as nondomestic Global GR CAD
bonds are hedged. That condition is crucial, 20 7.55

Annualized 5-Year Return %

and many funds do hedge their foreign-currency
Morningstar
exposure back to the Canadian dollar to Canada GR CAD
remove the influence of currency fluctuations. 10
7.28
The rolling five-year returns of the Morningstar
Canada Core Bond Index track relatively 0
closely to the Morningstar Global Core
Bond Index Hedged to CAD, while the unhedged –10
Morningstar Global Core Bond Index has 06/30/2003 06/30/2009 06/30/2015 09/30/2023
diverged significantly. Source: Morningstar Direct. Data from July 1, 1998, through Sept. 30, 2023.

Geographic exposure matters significantly in an

investor’s portfolio when it comes to equity EXHIBIT 2

strategies. Canada struggled against the world, Canadian Bonds Track Global Bonds Hedged to Canadian Dollars
and especially the U.S., over the last decade.
Investors would be wise to evaluate their
10
biases and make sure the decisions they make are
Morningstar Canada
rooted not in comfort but in sound rationale. Core Bond GR CAD
–0.02
Annualized 5-Year Return %

Michael Dobson is an associate manager research analyst 5

with Morningstar Canada. Morningstar Global Core
Bond GR Hedged CAD
–0.21
0 Morningstar Global Core
Bond GR CAD
–1.32
–5
12/31/2004 12/31/2011 09/30/2023
Source: Morningstar Direct. Data from Jan. 1, 2000, through Sept. 30, 2023.

Economic Growth and Recovery Don’t Always Boost Small Caps

$13K Small caps are perceived to be economically
Morningstar sensitive, rallying in recoveries. Yet, U.S.
US Market small caps lagged in 2023, even amid robust
12 $12,257 growth, just as they did in the 2021 recovery.
Morningstar US Sector biases help explain small caps’
11 Small Cap woes. The small-cap universe is relatively light
$11,288 on technology, the best-performing
equity sector. Heavy exposure to financials,
10 real estate, and materials dragged.
9
12/31/2022 04/30/2023 08/31/2023 12/12/2023
Source: Morningstar Direct. Data from Jan. 1, 2023, through Dec. 12, 2023.

21
 Dispatches
Venezuela Bonds Stage
a Comeback
AMERICAS
Venezuela
Careful observers of Morningstar’s hard-
currency emerging-markets bond categories
might have noticed an unusual trend in
the fourth quarter: Some funds shot to the top
of their category performance rankings.
An example is Luxembourg-domiciled Ashmore
Emerging Markets Total Return, which had
trailed more than 85% of its category peers year
to date as recently as September but leaped
into its category’s top quintile in October.
Other funds, like Candriam Bonds Emerging
Markets or Allianz Emerging Markets Sovereign
Bond, also recorded a significant uptick
in performance.
Common to many of October’s highflyers are
stakes in the defaulted debt of Venezuela
and its state-owned oil company, Petróleos de
Venezuela, S.A., or PDVSA. While the bonds
remain in default, several recent events
have boosted their prices. These include the end
of U.S. sanctions on secondary trading of
the bonds, a New York judge’s decision to extend
the validity of the debt contracts, and signals
from index provider J.P. Morgan that the issues
Low Valuations Alone Can’t Lift Equities Outside the U.S.
$14K
12
10
8 to prompt a leadership rotation to equities
12/31/2022 04/30/2023
Source: Morningstar Direct. Data from Jan. 1, 2023, through Dec. 12, 2023.
22
could soon reenter its widely used emerging-
markets debt indexes.
Many fund managers holding Venezuelan or
PDVSA debt built those positions between
2014 and 2017, when high inflation and political
unrest sent yields on Venezuela’s bonds
skyrocketing. At the time, some still believed the
sovereign’s foreign reserves stockpile and
its access to external financing were enough to
keep it paying its debts. Those hopes faded
in 2017, however, when the U.S. government,
citing alleged human rights abuses by
Venezuelan President Nicolás Maduro, issued
a raft of sanctions against the country,
including an effective ban on new Venezuelan
external debt issuance.
Between 2017 and 2019, interest payments
on all Venezuelan and PDVSA bonds ceased.
In 2019, the U.S. government extended its
sanctions to prohibit any U.S. persons (including
any entity doing business in the U.S.) from
purchasing the bonds on the secondary market.
While some fund companies tried to divest
their Venezuelan bonds to non-U.S. entities, the
potential buyer base turned out to be too
small to be viable, leaving fund managers stuck
with the securities.
The Biden administration’s Oct. 18 reversal of
the secondary-trading ban unleashed pent-up
demand. It came shortly after a New York
Morningstar Japan
GR JPY
$12,709
Morningstar US Market
$12,257
Morningstar Global
ex-US GR
$11,081
08/31/2023 12/12/2023
judge’s decision in August to extend the validity of
already defaulted Venezuelan and PDVSA debt for
several years, keeping the door open for a
possible restructuring of bonds that have already
passed their maturity dates.
The vast majority of Venezuela and PDVSA
bonds continue to trade for pennies on the dollar,
reflecting the fact that payments to creditors,
if they happen at all, are likely years away.
A Venezuelan sovereign issue, maturing in 2037,
and a PDVSA bond with a maturity date in
August 2023, for example, were trading for less
than $0.10 on the dollar in June 2023; these
rose in price to just $0.14 and $0.16, respectively,
by the end of October. As long as the U.S.
government’s restrictions on primary debt issuance
remain in place, Venezuela and PDVSA are cut
off from restructuring their debt. For now,
therefore, today’s major buyers of the bonds are
likely hedge funds with deep reserves of patience
and the resources to go through a complex
International Monetary Fund renegotiation when
the time comes.
Despite their windfall gains in recent months,
funds significantly exposed to Venezuelan
government bonds and PDVSA debt have yet to
make investors whole for losses incurred
after the bonds defaulted in 2017. Ashmore
Emerging Markets Total Return, for example,
which held as much as 9.2% of assets in
Venezuelan bonds in December 2016, still ranks in
U.S. equities have soared in recent years, and
most other markets have simply not kept
up. Dollar strength is not the whole story. U.S.
companies overall have superior earnings
growth, higher returns on capital, and greater
innovation. Corporate Japan, however,
has undertaken real structural reform, helping
fuel an equity market rally in 2023. Japan
shows that lower valuations alone aren’t enough
outside the U.S.
the global emerging-markets bond Morningstar
Category’s bottom decile over the trailing
five years.
Many of the funds with the largest exposures to
Venezuelan government bonds share a
preference for other frontier-markets debt, at the
expense of stakes in more-liquid emerging
markets. When combined with successful
bottom-up country selection, this bias proved
extremely beneficial in 2023. Candriam Bonds
Emerging Markets was also overweight
in the outperforming Dominican Republic and
El Salvador markets. Additionally, some
funds benefited from a spectacular rally in Sri
Lanka government bonds, where debt-
restructuring efforts and potential financial
support from the IMF raised hopes of recovery.
Investments in frontier and distressed markets
can be exceptionally time-consuming. Activities
like participating in creditor consortiums and
engaging in complex negotiations with issuers
require substantial analytical and legal firepower.
So, before choosing a fund that leans heavily
on this space, investors should seek fund
managers with the skills and resources that are
well matched for the task at hand.
Mara Dobrescu, CFA, is a director, manager research,
at Morningstar EMEA.
Shannon Kirwin is an associate director, manager research,
at Morningstar EMEA.
Bonds Don’t Always Diversify Equities—and Fixed Income Isn’t a Monolith
$13K
12
11
10
9
12/31/2022 04/30/2023
Source: Morningstar Direct. Data from Jan. 1, 2023, through Dec. 12, 2023.
Caution Hindered
Multi-Asset Funds in
2023
GREATER EUROPE
United Kingdom
For U.K. multi-asset funds, 2023 was much kinder
than 2022 in an absolute sense, with several
allocation categories eking out modest positive
returns in the first 10 months of the year, compared
with around 10% losses across the board in 2022.
But in 2023, managers struggled to keep up
with the Morningstar allocation category indexes.
While fund performance should be judged over
longer periods, it is worth a look at what’s been
shaping these shorter-term deviations. As equity
markets moved higher while bond returns were
muted, managers’ reduced weightings to equities,
combined with a narrow concentration of returns
in the equity market, were challenges last year.
Rising interest rates, recession fears, and a
dramatic selloff in bonds prompted managers in
aggregate to make a notable shift in 2022,
reducing equities in favor of bonds. At a category
average level, managers began to reduce
their equity allocations in early 2022 and have
since remained underweight relative to
their category index. For example, in the GBP
Morningstar US Market
$12,257
Morningstar LSTA US Leveraged Loan
$11,208
Morningstar US High-Yield Bond
$11,028
Morningstar US Core Bond
$10,281
12/12/2023
allocation 40% – 60% equity category, home to a
typical “balanced” fund and benchmarked
against a 50% equity/50% fixed-income and cash
index, net equity exposure stood at 44% at
the end of October 2023, down from over 50% at
the start of 2022. Over the same time frame,
exposure to bonds increased from around 30% to
over 40%, with both corporate and government-
bond allocations increasing.
EX HI BI T 1shows the excess returns of the GBP
allocation fund categories versus their relevant
category index for 2023 through October. Only the
most cautious 0 – 20% equity category managed to
beat its index. The more aggressive categories
lagged, likely because an underweight to equities
had a greater opportunity cost. Equity selection
also had a large impact.
In 2023, the GBP flexible allocation category
lagged the furthest behind its Morningstar
benchmark, the Morningstar UK Moderate Target
Allocation Index, likely explained by the category’s
low average level of net equity exposure.
Net equity exposure was 41.5% at the start of 2022,
but decreased to 25% at the start of 2023 and
remained around that level. This low level
of equity risk represented cautious positioning by
managers. Many funds in this category have
capital preservation objectives, which causes
managers to reduce their exposure to risky assets
when they perceive heightened risk and
uncertainty to minimize the potential for losses.
In November, the U.S. bond market enjoyed its
best month since 1985; optimism around
interest-rate cuts in 2024 lifted the Morningstar
US Core Bond Index into positive territory. No
one complains about positive correlations between
stocks and bonds when both asset classes rise.
Credit-sensitive securities, such as high-yield
corporates and leveraged loans, thrived in 2023’s
strong economy; these instruments have
tended to be more equitylike in their behavior.
23
 Dispatches

EXHIBIT 1

Most GBP Allocation Categories Lagged Their Benchmark Through October

Europe Challenges
Morningstar Category Excess Return Tesla’s Anti-Union
GBP Allocation 0–20% Equity
GBP Allocation 20–40% Equity –1.2
0.6
Model
GBP Allocation 40–60% Equity –2.1 GREATER EUROPE

European Union
GBP Allocation 60–80% Equity –2.4
GBP Allocation 80%+ Equity –3.2
GBP Flexible Allocation –3.4 When Swedish mechanics sought union talks with
Tesla TSLA, the carmaker stuck to its usual
–4% –3 –2 –1 0 1
line and turned them down. With a workforce of
Source: Morningstar Direct. Data from Jan. 1, 2023, through Oct. 31, 2023.
120,000 globally, Tesla has consistently resisted
unionization, threatening workers with retaliation.
But while past attempts to unionize at Tesla
EXHIBIT 2
came to nothing, a monthlong strike in Sweden
Equities Drove Performance in 2023 has hobbled the electric car maker’s distribution
Performance Breakdown of Morningstar UK Moderate Target Allocation Index in the country, as workers even outside
the automotive sector refuse to support Tesla’s
operations. And the strike went international
5
0.4 Asset Class in early December, when Danish dockworkers
represented by 3F, Denmark’s largest union, said
0.1 2.0 Equities they would no longer help transport Tesla
Total Return Contribution %

0 vehicles to Sweden. Automotive unions in other

–0.6 Bonds
–2.9 countries are watching closely.

–5
–10 –6.7
2022
Source: Morningstar Direct. Data from Jan. 1, 2023, through Oct. 31, 2023.
E X H I B IT 2 shows the respective contributions
of equities, bonds, and cash to the total
return of the Morningstar UK Moderate Target
Allocation Index in 2022 and 2023. This
index consists of 50% equity/50% bonds and
cash. The exhibit shows that bonds
detracted far less in 2023 than they did in 2022,
but they were still a drag on performance.
Equities did most of the heavy lifting, while
higher interest rates also meant a better
assist from cash in 2023. A simplistic takeaway
is that an overweight to equities would
have provided multi-asset managers with a
performance advantage in 2022 and
2023, although the composition of their bond
Cash
YTD 2023
and equity portfolios might look different to
an index.
Another difficulty for managers in 2023 was the
narrow concentration of equity returns, caused
by the artificial-intelligence-fueled outperformance
of U.S. mega-cap tech stocks. At a stylistic
level, global growth equities returned 11.3%
through October 2023 versus a gain of only 0.8%
for global value equities in GBP terms, a
sharp reversal from 2022. This underlines the
importance of equity selection.
Tom Mills is a senior analyst, multi-asset and alternatives,
with Morningstar Manager Research.
The strike started in late October, after Sweden’s
IF Metall union had tried to get Tesla to accept
collective bargaining for years. Tesla’s refusal to
negotiate with its Swedish mechanics “represents
a substantial threat to the Nordic country’s
labor model,” IF Metall says. Soon after, several
trade unions took industrial action in solidarity
with the mechanics, refusing to perform
labor that aids the automaker until an agreement
is reached. The strike now involves mechanics,
electricians, builders, dockworkers, postal
workers, and painters.
Despite this coordinated action among different
unions in Sweden—something that is
technically illegal in many other European
countries and the U.S.—Tesla initially found ways
around the strikes and continued to roll out
new Teslas to Swedish buyers.
But when the Union of Service and Communication
Employees, or Seko, announced its solidarity
measures, things heated up for the electric
car manufacturer. Seko’s strike involved a blockade

24 Morningstar Q1 2024
against the delivery and collection of shipments,
letters, packages, and pallets made by PostNord
(Sweden’s postal service) and CityMail to all
of Tesla’s facilities in Sweden. In other words, new
Teslas can’t even get Swedish license plates.
Tesla’s CEO and largest individual shareholder,
Elon Musk, took to social-media platform X,
which he owns, to denounce the blockade against
mail deliveries as “insane.” The automaker filed
two separate lawsuits against the Swedish
Transport Agency and PostNord. While one court
favored Tesla, another rejected it for so-called
interim security measures. No final verdict
has been presented as of early December, and
Teslas are still missing their license plates.
The battle between Tesla and the unions has
sparked a polarized debate in Sweden.
Independent economist Claes Hemberg argues
that the trade union IF Metall has lost the
plot in its fight against Tesla.
“I don’t think it is the union’s role to chase
companies out of Sweden. I think they have
misunderstood their role and have identity
problems,” he told financial daily Dagens Industri.
Meanwhile, AMF, one of Sweden’s biggest
occupational pension companies with SEK 755
billion under management, has sent a letter
to Tesla’s American board demanding that it
“adopt to the customs of the country.” AMF
is one of the largest Swedish institutional owners
of Tesla, with shares worth around $337 million
at the start of December, according to Morningstar
Direct data.
Despite its union battle, Tesla had the second-
highest sales in Sweden in November, with
1,236 new Tesla Model Y registrations. For the year
through November, the Model Y dominated the
new-car market, scoring 3,675 more registrations
than the country’s second-most popular model,
the Volvo XC40 compact SUV.
Swedes may love Teslas, but the company’s
annual sales there are dwarfed by those in the
U.S., China, and Germany. That said, the
current union standoff could prove a bellwether
for its labor relations globally.
Success for the Swedish unions would put
pressure on Tesla in other markets where unions
have been fighting the same battle for years.
On the other hand, if Tesla remains steadfast,
the Swedish unions are likely to intensify efforts to
drive Tesla out of the country. Morningstar
analyst Seth Goldstein is optimistic it won’t come
to that: “I’d imagine Tesla is negotiating with its
union in Sweden to come to a resolution, and
I would expect the two sides will eventually reach
an agreement. As a result, I don’t see a huge
impact to Tesla.”
Johanna Englundh is an editor for Morningstar in Sweden.
Sovereign Ratings
Withstand Political
Uncertainty
GREATER EUROPE
Netherlands
The snap elections in the Netherlands in November
led to a surprise victory for the far-right Freedom
Party, or PVV, and are likely to be followed by
lengthy and difficult negotiations on the formation
of a coalition government. In Morningstar DBRS’
view, the landslide election outcome has increased
policy uncertainties in various areas, including
foreign affairs, climate policies, and immigration.
The PVV received by far the most seats in
parliament but would need to form a coalition
government with other parties to obtain a
parliamentary majority. The PVV’s preferred
coalition partners likely include the center-right
People’s Party for Freedom and Democracy,
or VVD, of outgoing Prime Minister Mark Rutte
and the newly founded centrist New Social
Contract, or NSC. However, if the latter two parties
refuse to partner with the PVV, they could
also form a four-party coalition government with
the joint list of the Green and the Labour
parties (GL/PvdA) and the liberal D66. In view of
marked programmatic differences across
major parties, it is currently difficult to assess
which of these diverging coalition scenarios is
more likely.
While most recent polls had predicted a neck-to-
neck race, the PVV secured significantly
more parliamentary seats than other major parties,
winning 37 out of 150 seats in the House of
Representatives, the main legislative body. This
puts the party well ahead of the GL/PvdA (25
seats) and the VVD (24 seats). The NSC, which was
founded in August 2023 and led the election
polls for several weeks, secured 20 seats. In
contrast, the pro-farmer BBB, which had won the
provincial elections in March 2023, landed
only at seven seats. The PVV benefited from public
discontent about higher consumer prices, a
housing crisis, and rising numbers of refugees.
The most likely coalition scenarios are a center-to-
far-right government under the leadership of
the PVV or, alternatively, a four-party government
of more centrist parties. However, finding
common ground for a center-to-far-right coalition
government between the PVV, the VVD, and the
NSC is likely to be complicated by several
contentious positions in the PVV’s election
manifesto. These include holding a referendum on
European Union membership, a reversal of climate
policies, and a ban on mosques. At the same time,
bridging differences in a potential four-party
coalition among the GL/PvdA, VVD, NSC, and BBB
is also likely to be challenging given different
views on the nitrogen crisis and migration policies.
While we expect policy uncertainty to be elevated
over the next months, the Morningstar DBRS
AAA sovereign ratings on the Kingdom of the
Netherlands continue to be supported by
important credit strengths. These include high
institutional quality, a highly productive
and competitive economy, moderate government
debt levels, and a strong external position.
Yesenn El-Radhi is vice president, global sovereign ratings,
at Morningstar DBRS.
morningstar.com/products/magazine 25
 Spotlight

State of Retirement Income

Switching Gears
For new retirees, crafting
a flexible withdrawal
strategy can help provide
a fruitful retirement.
RETIREMENT after 30 years. This safe withdrawal rate is more
Amy C. Arnott, Christine Benz, and generous than the numbers we cited in the
John Rekenthaler previous two years of the study. As yields on bonds
and cash have increased, the prospects for
portfolio returns—and in turn the amounts that
The headline numbers from the Morningstar new retirees can safely withdraw from those
State of Retirement Income 2023 study were portfolios—have continued to edge up since we
positive.1 We estimate that new retirees can afford last covered the topic in 2022.
to withdraw as much as 4% as an initial rate
from their investment portfolio, assuming But it’s not all sunshine and roses for retirement
a 90% probability of still having funds remaining income. Recent retirees haven’t had an easy

1 The full paper is available at https://www.morningstar.com/lp/the-state-of-retirement-income.

morningstar.com/products/magazine 27
 Spotlight: State of Retirement Income
$50K
47.26
45 45.58
42.82
EXHIBIT 1 EXHIBIT 2
40 40.00
time of it lately. When stock and bond prices both Costly Consumption The price of Larger Nest Egg High inflation means
plummeted in 2022, many retirees saw big essential goods is now significantly retirees need larger portfolios to fund
dents in their portfolio values. Making matters 35
higher than it was just a few years ago. their spending.
worse, higher inflation has forced many retirees to 30
take bigger withdrawals to meet their spending 2020 2021 2022 2023
needs as their portfolio values have shrunk. Growth in Size of Required Retirement
Growth in Cost of $40,000 Consumption Basket Investment Portfolio
This double whammy so early in retirement can
have a cascading effect on the long-term $50K $1.2M
health of investment portfolios. It also highlights 1.18
47.26 1.14
the benefits of adopting a flexible withdrawal 1.07
45 45.58
strategy instead of using a fixed plan. 1.0
42.82 1.00

The Challenge of Inflation 40 40.00

At the end of 2023, inflation appeared to be 0.8
moderating. The November inflation report showed 35
a year-over-year increase of 3.2%, which is 30 0.6
still above the Federal Reserve’s 2% target but 2020 2021 2022 2023 2020 2021 2022 2023
well below the 9.1% peak in June 2022.
Source: Morningstar. Data as of Sept. 30, 2023. Source: Morningstar. Data as of Sept. 30, 2023.

However, even if inflation continues to ease,

$1.2M
it still creates significant challenges for 1.18
1.14 $300K
recent retirees. This is because past inflation To illustrate this, we can use the maximum adjusting their withdrawals for the effect of three
1.07
typically creates a permanent increase in 4% safe withdrawal rate as a starting point for inflationary scenarios: 256.83
1.0 1.00 238.89
the baseline cost of required spending. The rate calculating the required size of a retirement
200
of inflation may slow (disinflation), but price nest egg. The 4% figure is equivalent to 1 10% inflation in year one followed by 3% annual
declines (deflation) are rare. In fact, the withdrawing 1/25th of the starting portfolio value inflation until the end of the assumed 30-year
0.8
U.S. has not experienced a sustained period of each year, so we can estimate a required retirement horizon.
price deflation since 1954, when high inflation portfolio value by multiplying the annual spending 100
0.6
amid the post-Korean War recession led the amount by 25. At the beginning of 2021, this 2 3% annual inflation in years one through 14,
2020 2021 2022 2023
Federal Reserve to raise interest rates, resulting in math worked out to a required portfolio value of 10% inflation
0 in year 15, followed by a return to
weaker demand for products and services. just over $1 million for someone planning on 3% annual inflation throughinyear
High Inflation Year301. High Inflation in Ye
annual spending of $40,000. But with the increase
Thanks to elevated inflation rates in recent years, in costs, it now takes nearly $1.2 million 3 3% annual inflation in years one through 29
$300K
the cost of essential goods such as food, in portfolio value to support the same spending followed by 10% inflation in year 30.
286.37
clothing, shelter, and gasoline is higher than it level that used to require $1 million ( EXHIB IT 2 ). 256.83
was a few years ago. An annual “consumption 238.89 As this admittedly simplified illustration shows,
basket” priced at $40,000 at the end of 2020 would 200
A common concern among prospective retirees the 50%
timing of inflation matters significantly for
cost about $47,300 in 2023 ( E X H I BI T 1 ). is “sequence risk”: the possibility of a bear retirement outcomes ( EXHIB IT 3 ). The retiree who
40
market either just before they retire or shortly experienced higher inflation early in retirement
This upward price trend does not present a after.100
Suffering severe investment losses finished with a 7% lower balance than the
30
problem for retirees who rely on Social Security while coming out of the gate can hamper the retiree who encountered it midway through
as the sole source of retirement funding; their entire retirement
0 strategy. The same principle retirement and almost 17% less than the retiree
20
checks include an annual cost-of-living adjustment applies to inflationary shocks. Inflation
High Inflation in Year 1 that High Inflation indidn’t
who Year encounter
15 high
Highinflation until
Inflation in Year 30
to keep pace with inflation. But for people who arrives early in retirement years elevates the final year of retirement. Note that these 12.1 11
10
use portfolio withdrawals to cover additional future spending, whereas inflation further along differences
0 occurred
5.9 even though
5.6 the assumed
5.9
expenses, it can create a significant challenge. in retirement has a more muted impact. inflation rate was the same across the three
>15% 10 to 5 to 0 to 0t
Indeed, the nearly 18% cumulative inflation scenarios, at 3.2%. 15% <10% 5% –5
rate since the end of 2020 means that those who To illustrate, we ran a test (originally introduced
have not yet retired must save considerably 50%’s paper) assuming retirees earned no
in 2022 Sequence-of-Returns Risk 50.0
more to match the purchasing power modeled in market return, while withdrawing 1.5% each year As discussed above, portfolio losses occurring
the first version of this paper, published in 2021. of an 40
initial $1 million retirement balance, right before or shortly after retirement increase the

30
28 Morningstar Q1 2024
20
18.3 18.2
Pros and Cons of Dynamic Spending Methods
Approach Pros
Fixed Real gDelivers steady “paycheck equivalent”
(Base Case) throughout retirement.
gLowest cash flow volatility of any method.
gHighest ending portfolio value.
Forgo Inflation gCuts in real spending, while modest,
Adjustment are cumulative and allow for meaningfully
higher starting withdrawal rates.
gTypically results in healthy ending
portfolio value.
Required gSupports the highest starting safe
Minimum withdrawal rates across most allocations.
Distribution gMay save time since retirees still need to
calculate RMD amounts and take
distributions for RMDs even if they follow
another method.
Guardrails gSupports the highest starting safe
withdrawal rates across most allocations.
gLifetime withdrawal rates are also
substantially higher than other methods.
Actual gResults in second-highest ending
Spending portfolio value.
gDelivers higher paychecks early in
retirement when retirees are likely to spend
the most.
gVery low cash flow volatility.
Cons
gDoesn’t maximize lifetime withdrawal rates.
gMay leave too much money on the
table for retirees who don’t want to leave
a legacy to heirs.
gDelivers lower lifetime withdrawal rates
than most other methods.
gLeads to the highest cash flow volatility
of any method.
gEnding portfolio values are lower than most
other methods.
gMore complicated than other methods.
gResults in far higher cash flow volatility than
most other methods.
gTypically leads to lower ending portfolio
value than most other methods.
gDoesn’t maximize lifetime withdrawal rates.
Best For
Retirees who value a predictable income
stream and want to maximize the ending
portfolio value as a bequest.
Retirees who seek a paycheck-equivalent
approach that allows for slightly higher
starting withdrawal percentage than the
basic system of fixed real withdrawals.
Retirees with shorter-than-average life
expectancies or those who can cover most
of their fixed living expenses from
nonportfolio income sources such as Social
Security or a pension.
Retirees who prioritize maximizing spending
over leaving a bequest to family or charity.
Retirees who want to spend more in the
early years of retirement and are looking for
a high degree of cash flow predictability.

chances of portfolio exhaustion, for two reasons.
First, they delay the stock and bond gains needed
to maintain and enlarge retirement funds over
time. Second, they can force retirees to sell assets
to support their spending at inopportune
times—when stocks and bonds boast more
attractive expected returns.
Sequence risk has been on full display in recent
years. Because a portfolio balanced between
stocks and bonds lost 15.5% of its value in 2022, a
person who retired at the end of 2021 with a
$1 million portfolio with 50% stocks and 50% bonds
and used our recommended withdrawal rate of
3.3% would have finished the year with a
portfolio value of about $811,000. While the equity
market partially rebounded in 2023, the portfolio
would still be well below its starting level.
Market results for calendar 2022 were slightly
worse than the bear-market scenario we tested in
2022’s version of the paper: a 15% loss in the
first year of retirement. Using the same approach
of running 1,000 trials in which the market
followed a random walk, we found that the retiree
had a 50% chance of running out of money by the
end of year 30 if the 50% stock/50% bond
portfolio lost at least 15% in year one ( EXHIBIT 4 ).
Making matters worse, that test was based
on an assumed inflation rate of 2.2% per year. If
inflation remains above that level, the odds of
success would be even lower.
Put another way, the retiree who lost 15% or
more in the first year of retirement was more than
6 times as likely to outlive their savings by
year 30 as the retiree who earned a positive return.
Of course, that finding assumes that the retiree
who encounters big losses in year one of

morningstar.com/products/magazine 29
 $50K
Spotlight: State of Retirement Income
47.26
45 45.58
42.82
$50K
40 40.00
47.26
retirement
45 sticks with a system of fixed real in weak market
45.58environments and perhaps higher retirees who aim to maximize consumption
35
withdrawals without adjusting spending. Variable paydays in very strong ones—typically (which may encompass charitable giving
42.82
withdrawal
30 strategies can support significantly allows for higher withdrawal rates. Flexible and lifetime gifts to loved ones) during their own
40 40.00
higher spending rates.
2020 2021 strategies help prevent retirees from overspending
2022 2023 lifetimes, flexible strategies allow for spending
in periods of market weakness while giving them increases when market performance is strong.
How 35Dynamic Withdrawal Strategies Can Help a raise in stronger markets. Moreover, for nearly all retirees, portfolio
we30did in 2022’s paper, we tested a variety
As$1.2M withdrawals will compose just a portion of the
of flexible withdrawal
2020systems. An approach 2021 Adjusting withdrawal
2022 1.18
rates based on portfolio
2023 household’s cash flow needs: Income from Social
1.14
that involves changing withdrawal amounts1.07 from performance can also help ensure that Security, a pension, or an annuity will supply
year to
1.0year—taking lower withdrawals retirees consume their portfolios efficiently. For some or even most of the household’s spending.
1.00
$1.2M As a result, changes in portfolio spending
1.18
1.14 imposed by a flexible system will affect only a
0.8
EXHIBIT 3 1.07 portion of the retiree’s cash flows.
1.0
Importance Timing The effects of high inflation on portfolios vary depending on
of 1.00
0.6 Variable strategies do entail trade-offs—
when it occurs during retirement. specifically, the tension between a higher lifetime
2020 2021 2022 2023
0.8 withdrawal rate afforded by periodic withdrawal
Balance of Retirement Assets at End of Year 30 Assuming Three Inflation Paths ($1 Million Starting adjustments and the volatility those adjustments
Balance, 0% Market Return, 1.5% Initial Withdrawal Rate, 90% Success Rate)
0.6 create in the retiree’s cash flows, which may
$300K 2020 2021 2022 2023 also subject retirees to swings in their standards
286.37 of living. Consequently, some retirees may find
256.83 flexible schemes unacceptable.
238.89
200
$300K For example, taking a fixed percentage withdrawal
286.37 (say, 4% of the portfolio balance per year)
256.83 entirely solves the problem of running out of
238.89
100 money, but it does so at the expense of
200
the retiree’s standard of living being buffeted by
0 changes in the value of the portfolio. Also,
High Inflation in Year 1 High Inflation in Year 15 High Inflation in Year 30 should the markets perform badly, the withdrawal
100
Source: Morningstar. Data as of Sept. 30, 2023. amount could end up being trivially low.

0 At the opposite extreme, the fixed real withdrawal

High Inflation in Year 1 High Inflation in Year 15 High Inflation in Year 30 system nicely addresses a retiree’s desire
EXHIBIT 4
to have stable portfolio cash flows, much like a
Sequence Large losses in the first year of retirement can devastate portfolios.
Bad50% 50.0 paycheck in retirement. But taking fixed real
withdrawals can be inefficient because it does not
40
Percentage Likelihood of Outliving Assets by Year 30 of Retirement Based on Portfolio Return in Year 1 link consumption to portfolio values.
50%
30 50.0
If the starting withdrawal is too low and the
portfolio outperforms expectations, the retiree will
40
20
18.3 18.2 leave behind a large sum, which may not be
12.1 11.1 a goal. If, on the other hand, the initial withdrawal
30
10
0 5.9 5.6 5.9 is too high, the retiree will consume too much
20 too early and risk running out prematurely
>15% 10 to 5 to 0 to 0 to <–5%
18.3 to <–10% to <–15%
18.2 or having to engage in dramatic belt-tightening
15% <10% 5% –5% –10% –15%
12.1 11.1 later in life.
10
0 5.9 5.6 5.9
>15% 10 to 5 to 0 to 0 to <–5% to <–10% to <–15% To help identify how flexible strategies balance
15% <10% 5% –5% –10% –15% lifetime income with considerations of quality of
Source: Morningstar. Data as of Sept. 30, 2023. life and the volatility of cash flows, we tested some

30 Morningstar Q1 2024
 of the most widely used flexible strategies,
benchmarking them against a system of fixed
real withdrawals. The four methods are:
1 Forgo Inflation Adjustments After Annual
Portfolio Loss
This method, advocated by (among others) T. Rowe
Price, begins with the base case of fixed real
withdrawals throughout a 30-year horizon.
However, to preserve assets after down markets,
the retiree skips the inflation adjustment
for the year after a year in which the portfolio has
declined in value. The cuts in real spending,
while small, are cumulative.
2 Take Required Minimum Distributions
This is the framework that underpins required
minimum distributions from tax-deferred accounts
like IRAs. It incorporates two key variables:
remaining life expectancy and remaining portfolio
value. In its simplest form, the RMD method
is portfolio value divided by life expectancy. For
life expectancy, we used the IRS’ Single
Life Expectancy table and assumed a 30-year
retirement horizon, from ages 65 to 94. (We
employed the updated RMD calculations that went
into effect in 2022.) This method is designed to
ensure that a retiree will never deplete the
portfolio because the withdrawal amount is always
a percentage of the remaining balance. However,
while changes in life expectancy are gradual,
the remaining portfolio value can change
significantly from year to year, adding substantial
volatility to cash flows.
3 Build Guardrails
Originally developed by financial planner Jonathan
Guyton and computer scientist William Klinger,
the guardrails method sets an initial withdrawal
percentage, then adjusts subsequent withdrawals
annually based on portfolio performance and
the previous withdrawal percentage. The
guardrails attempt to deliver sufficient—but not
overly high—raises in upward-trending markets
while adjusting downward after market losses.
In upward-trending markets, in which the
portfolio performs well and the new withdrawal
percentage (adjusted for inflation) falls below
2 Banerjee, S. 2012. “Expenditure Patterns of Older Americans, 2001−2009,” EBRI Issue Brief, No. 368, February.
The Role of Guaranteed Income
In addition to the dynamic withdrawal strategies,
retirees can also support their retirement
spending by using guaranteed income sources,
such as Social Security, annuities, and Treasury
Inflation-Protected Securities.
Retirees can maximize the value of Social Security
by waiting to claim full benefits until the official
full retirement age (currently 67 for people born in
1960 or after); delaying filing until age 70 to
receive even higher monthly payments; or
postponing Social Security while also waiting to
tap into the retirement portfolio.
Fixed annuities (either immediate or deferred)
are another way of generating a guaranteed
income stream (which mainly consists of a return
of the initial capital amount purchased over
time). Because they spread out mortality risk
across a wide pool of policyholders, fixed
annuities continue to deliver monthly payments
throughout a retiree’s life span.
A TIPS ladder, which is a self-liquidating portfolio
created to support spending over a specific
20% of its initial level, the withdrawal increases by
the inflation adjustment plus another 10%.
The guardrails apply during down markets, too.
Specifically, the retiree cuts spending by 10%
if the new withdrawal rate (adjusted for inflation)
is 20% above its initial level.
4 Incorporate Spending Declines in Line With
Historical Data
New for 2023, we also tested a strategy that
incorporates the average decline in spending that
occurs over the retirement lifecycle. In past
studies, we incorporated this spending pattern by
assuming that the hypothetical retirees did not
adjust their annual withdrawals by the full amount
time horizon, can also be an attractive way to
generate guaranteed income. Because both
principal values and yields of TIPS are adjusted for
changes in inflation, they not only provide
a steady income stream but also a built-in hedge
against unexpected inflation. Creating a TIPS
ladder involves buying TIPS with a range
of maturities over the entire spending period
(30 years, in this case), and then using the
proceeds of the bonds as they mature (as well as
their ongoing coupon payments) to cover
spending needs over time.
Current yields on TIPS are more attractive than
they’ve been in the past, making the TIPS
ladder strategy particularly compelling. We
estimate that as of Sept. 30, 2023, a 30-year TIPS
ladder would support a 4.6% withdrawal
rate. That’s not only higher than most of the other
strategies we tested, but also 100% guaranteed.
On the downside, if the retiree uses the TIPS
proceeds for spending, there’s no potential for
residual balances, in contrast with the portfolio-
spending strategies that we’ve discussed.
of inflation but instead by 1 percentage point
less than the annual inflation rate. In 2023’s study,
we further refined this method by incorporating
more specific patterns observable in retiree
spending at various life stages. Research from the
Employee Benefit Research Institute demonstrates
that inflation-adjusted household spending has
historically fallen by 19% from age 65 to 75,
34% from age 65 to 85, and 52% from age 65
to 95.2 We adjusted the annual spending numbers
to match up with these longer-term declines.
To reflect this, this method assumes that real
retirement spending declines by 1.9 percentage
points per year between age 65 and 75;
1.5 percentage points per year between
morningstar.com/products/magazine 31
 Spotlight: State of Retirement Income
EXHIBIT 5
Spending Methods Summary How the different withdrawal strategies performed
across four metrics.
40% Equity/60% Bond Portfolio, 30 Years, and 90% Success Rates
Starting Safe
Method Withdrawal Rate %
Base Case 4.0
Forgo Inflation Adjustment 4.4
RMD 4.4
Guardrails 5.2
Actual Spending 5.0
Source: Morningstar. Data as of Sept. 30, 2023.
75 and 85; and 1.8 percentage points per year
between 85 and 95.
Assessing the Strategies
For each strategy, we used stochastic (Monte
Carlo) modeling to test how successful withdrawal
systems—meaning that a given system
ensured that a retiree did not run out of money
over a 30-year horizon—fared on a few key
metrics. We defined success as not running out
of money in 90% of the random trials. We
employed a 40% equity/60% fixed-income portfolio
but also looked at other asset allocations.
Each method entails its own set of trade-offs. We
compare the methods based on four metrics:
starting safe withdrawal rates, lifetime portfolio
withdrawal rates, year-30 cash flow standard
deviation, and median ending value at year 30. The
base case uses fixed real withdrawals. E X H I BI T 5
depicts how each method fared on each metric,
assuming 40% stock/60% bond portfolios, a
30-year spending horizon, and a 90% success rate.
The spending method that delivers the best
outcome is noted in bold. We’ll analyze the results
of each metric.
Starting Safe Withdrawal Rate
Each flexible spending method supports a higher
initial safe withdrawal rate than the 4%
in the fixed real withdrawal method (base case).
But the guardrails method supports the
highest starting safe withdrawal rates not only
for the 40/60 portfolio but also across most
32 Morningstar Q1 2024
Lifetime Year 30 Cash Flow Median Year 30 Ending
Withdrawal Rate % Standard Deviation % Value ($ Millions)
4.0 0 1.5
4.1 5.4 1.4
5.4 43.7 0.2
4.8 29.4 0.8
3.9 0 1.4
asset allocations. This reflects the nature
of the approach, which can support higher initial
withdrawals by making potentially significant
year-to-year adjustments to dollar withdrawals,
by throttling spending down at inopportune times.
For the other methods, starting safe withdrawal
rates are generally highest with equity allocations
ranging from 20% to 40% and lowest in less-
diversified allocations like 100% stocks.
Lifetime Withdrawal Rate
Most flexible spending approaches boast a higher
lifetime withdrawal rate than the fixed real
withdrawal method, across the asset-allocation
spectrum. The RMD and guardrails methods
support the highest lifetime withdrawal rates,
while forgoing an inflation adjustment in the year
after a portfolio loss also offers slightly higher
levels of lifetime income than the baseline.
Notably, equity-heavy allocations under the
guardrails and RMD methods support higher
lifetime withdrawal rates than bond-heavy
allocations. That’s because the portfolios with
higher equity allocations provided larger
“raises” in annual withdrawals after good years,
thereby enlarging lifetime withdrawal amounts.
As always, there are trade-offs: The increases
in spending reduce the portfolios’ ending values.
Year 30 Cash Flow Standard Deviation
With this measure, the trade-offs demanded by
the RMD and guardrails methods become apparent.
Both approaches have far greater variability
in their annual withdrawal amounts. Thus,
retirees who are attracted to these methods’ high
withdrawal rates must also reckon with
the substantial uncertainty they can impose. By
contrast, the forgoing inflation and actual
spending methods entail relatively little year-to-
year spending change, making them more
useful to retirees who prize stability.
Median Ending Value at Year 30
The base case of taking fixed real withdrawals
creates some of the highest median balances
at year 30. In other words, retirees using
such a strategy may well underspend during their
lifetimes. That attribute depresses potential
spending but may appeal to bequest-minded
retirees. Among the flexible withdrawal methods,
the actual spending method and the forgoing
inflation method produced the highest year 30
values, on average. At the other extreme,
the RMD method resulted in the lowest ending
values. This result is because it spends down most
of the retirement capital by design. The
guardrails approach splits the difference between
a more aggressive, freer-spending method
like RMD and thriftier methods that curtail, but
never increase, spending.
Conclusion
A bear market in the early years of retirement can
greatly reduce an investment portfolio’s ability
to fund a full retirement. High inflation that
arrives early in retirement elevates future spending,
causing retirees to withdraw more from their
portfolios than planned. In 2022, new retirees
experienced both conditions. Flexible withdrawal
strategies allow retirees to respond to such
conditions and increase the chances that their
investment portfolio lasts. The right level of
flexibility will depend on the individual's situation,
including the extent to which fixed expenses are
covered by nonportfolio income sources. K
Amy C. Arnott is a portfolio strategist at Morningstar
Research Services LLC.
Christine Benz is director of personal finance and
retirement planning at Morningstar Research Services LLC.
John Rekenthaler is a vice president at Morningstar
Research Services LLC.
Digging Into the Research: An Analysis of Safe Withdrawal Rates
As we did in 2022’s retirement income study, we
employed a base case to test safe starting
withdrawal rates in 2023.
Specifically, we assumed a new retiree with a
30-year anticipated time horizon who would
like to secure a 90% probability of not outliving
their money. We assumed that the retiree was
using a fixed real withdrawal system, which
involves setting the starting withdrawal amount
and then taking inflation adjustments to that
dollar amount each year thereafter, as opposed
to a flexible system discussed earlier.
We held these key inputs steady from 2022,
but the overall assumptions for portfolio
returns rose based on the capital markets
assumptions put together by our colleagues in
Morningstar Investment Management.
The anticipated 30-year returns for stocks were
slightly lower in 2023’s research compared
with the previous year, with projected returns for
an all-equity portfolio edging down to 9.41% from
9.88% in 2022. At the same time, though,
expected fixed-income returns (including cash)
moved up to 4.81% from 4.44% in 2022. More
temperate inflation assumptions were another
positive. Our 30-year inflation forecast eased down
to 2.42% from 2.84% in 2022.
With two out of the three main assumptions
trending in a positive direction, our
research suggests that people heading into
retirement today can reasonably use a higher
starting withdrawal rate than indicated
in 2022.
As shown in the exhibit below, we estimate
that a new retiree planning for a 30-year
horizon can safely withdraw as much as 4% of
the portfolio’s value as a starting withdrawal
rate for a portfolio with a 40% equity weighting.
Because of the more attractive yields
available on fixed-income securities, we found
the same figure applies to portfolios with
equity weightings as low as 20%.
Investors might expect that safe withdrawal
rates would increase with higher equity
weightings, but that’s not necessarily the case.
Our return assumptions still expect that
stocks will deliver significantly better long-term
returns than bonds and cash.
As a result, equity-heavy portfolios typically
ended up with more money left over at the end of
the 30-year period. But stocks also court
significantly higher levels of volatility, which makes
the outcomes for all of the withdrawal rates
tested inherently less certain.
In addition, we targeted a success rate of 90%,
which is relatively high. This also tended to
tilt the scales in favor of the less volatile assets
of bonds and cash.
For retirees with time horizons both shorter
and longer than 30 years, portfolios with
equity weightings of 20% to 40% also generally
supported higher withdrawal rates than more
equity-heavy portfolios.
As shown in the exhibit, retirees with shorter time
horizons can safely withdraw significantly
more than the 30-year baseline assumption, but
safe withdrawal rates ratcheted down at
a more modest pace for retirees with longer
time horizons.

Projected Starting Safe Withdrawal Rate %, by Asset Allocation and Time Horizon (90% Success Rate)

Equity Weighting (%) 10 Years 15 Years 20 Years 25 Years 30 Years 35 Years 40 Years

100 8.3 5.8 4.6 3.8 3.3 3.1 2.9

90 8.6 6.0 4.7 4.0 3.5 3.2 3.0
80 8.9 6.2 4.8 4.1 3.7 3.3 3.2
70 9.2 6.4 5.1 4.3 3.8 3.5 3.2
Portfolios with equity weightings
60 of 20% to 40% supported 9.4 6.5 5.2 4.4 3.9 3.5 3.3
higher withdrawal rates than
50 more equity-heavy portfolios.
9.6 6.7 5.4 4.5 3.9 3.6 3.4
40 9.8 6.8 5.4 4.5 4.0 3.6 3.4
30 9.9 6.9 5.5 4.6 4.0 3.6 3.4
20 10.0 6.9 5.5 4.5 4.0 3.6 3.3
10 9.9 6.9 5.4 4.4 3.9 3.4 3.2
0 9.7 6.7 4.2 4.3 3.6 3.2 2.9
Source: Morningstar. Data as of Sept. 30, 2023.

33
 Strategies
How to Invest Better With Bonds
Sharpening fixed-income portfolio
allocations can improve results.
Research SHARPE
38 The Diminishing Role of Active Maciej Kowara and Alec Lucas
Mutual Funds
Quant U The emergence of Modern Portfolio Theory
42 Solving the Retirement Equations, Part IV in the 1950s revolutionized investing. Instead of
viewing stock or bond picks in isolation,
Best Ideas practitioners can now consider the direction and
47 Manager: A Different Approach to extent to which security prices in a portfolio
Value Investing change in relation to each other, or their
48 Passive: Cautious but Crafty covariances and correlations. And they can aim to
49 Equity: An Attractive Transformation maximize the portfolio’s return while minimizing
its risk, defined as price volatility.
The Sharpe ratio—originally called the reward/
variability ratio but renamed for its creator,
Nobel laureate William F. Sharpe—has become
a key metric for assessing funds’ or asset
classes’ past or future performance. The ratio is
an annualized number that incorporates both
opportunity cost and risk. The numerator is
the average of the monthly return of each security
or portfolio in excess of a risk-free rate measure,
such as the three-month Treasury bill yield,
while the denominator is the standard deviation
of that excess return. True to its original name,
the metric gauges an investment’s reward relative
to its volatility, whether that investment is a
stock or bond fund.
Although the higher the better, constructing an
optimal portfolio is not just a matter of choosing
the top asset classes in terms of Sharpe ratio.
Covariances and correlations matter across asset
classes, too. Thus, the Sharpe-optimal portfolio
is the one whose mix of asset classes maximizes
excess return relative to its standard deviation.
1 Asness, C.S., Frazzini, A., & Pedersen, L.H. 2012. “Leverage Aversion and Risk Parity.” Financial Analysts Journal, Vol. 68, No. 1, P. 47.
34 Morningstar Q1 2024
Given Modern Portfolio Theory’s long-standing
influence and the Sharpe ratio’s prominence,
one might assume that Sharpe-optimal portfolios
are the norm, but that’s not the case. Using
Stocks, Bonds, Bills, and Inflation return data on
intermediate U.S. government bonds and
U.S. large-cap stocks since 1926 and optimizing
for Sharpe ratio leads not to the standard
60% stock/40% bond portfolio but to a 21% stock/
79% bond allocation.
The contemporary bond market’s diversity allows
for an even smaller equity stake. Drawing on
Morningstar Indexes data since 2000 and sticking
to major U.S.-dollar-denominated asset classes,
optimizing for Sharpe ratio results in a 5%
stock allocation, far smaller than is typical in all
but the most conservative portfolios, and a bond
allocation whose subsector weightings look
quite different from the broad fixed-income market.
Academic theory suggests that investors who
want to increase portfolio returns beyond
what a 5% stock allocation would produce should
employ financial leverage.1 But that’s hard
to implement in practice and courts considerable
risk if extreme market events exceed expectations.
So, to provide those investors with an
actionable alternative, we have instead opted to
use set minimum equity allocation percentages as
starting points (20%, 40%, 60%, and so on)
and then to Sharpe-optimize the rest of each
portfolio around that constraint.
Capital allocators, financial advisors, and
sophisticated investors who wish to implement
Sharpe-optimized portfolios will find examples
 in this article based on exchange-traded funds.
Even if one does not adopt any of the
models presented here, keeping in mind how
Sharpe-optimized portfolios differ from
what’s typical could help practitioners make
better asset-allocation decisions.
Optimizer Results
Our study includes seven asset classes. The
Morningstar US Market Index holds about
1,500 stocks and accounts for 97% of the U.S.
equity market’s capitalization. The Morningstar
US Corporate Bond Index, Morningstar US
High-Yield Bond Index, Morningstar US Mortgage-
Backed Securities Index, and Morningstar
US Treasury Bond Index are all broad measures of
their respective domestic asset classes. The
Morningstar Emerging Markets Composite Bond
Index gauges fixed-rate, investment-grade,
and high-yield sovereign and corporate bonds
issued by emerging-markets entities but only those
denominated in U.S. dollars. Rebranded since
Morningstar acquired Leveraged Commentary &
Data from S&P Global in mid-2022, the Morningstar
LSTA US Leveraged Loan Index measures
U.S.-dollar-denominated bank loans that have
been syndicated in the United States, though
issuers can be located anywhere.
Core Plus Bond Index. Within the Sharpe-optimized
portfolio, the investment-grade corporate
market is not represented, even though it accounts
for one fifth of the index. The optimizer seems
to have taken its credit-risk exposure from stocks,
the modest stakes in high-yield and emerging-
markets bonds, and most of all from low-volatility
leveraged loans, or bank loans.
Indeed, the Sharpe-optimized portfolio’s
leveraged loan weighting is 30% compared with
zero for the Morningstar US Core Plus Bond
Index benchmark (which excludes this more than
$1 trillion asset class as a matter of index
construction). It also helped that bank loans are
much less correlated with Treasuries than
investment-grade corporates.
The optimizer made Treasuries, mortgages, and
bank loans the workhorses of its portfolio. That’s
because for the whole period, Treasuries had
a negative correlation with bank loans and a weak
one with agency mortgages. Meanwhile, the
correlations between Treasuries and high-yield and
emerging-markets debt were low.
EXHIBIT 1
Bank loans have risks to bear in mind. They aren’t
regulated in the same way as stocks and bonds,
and trades can take longer to settle. Holding
loans through a fund mitigates those longer
settlement times, but longer settlement times can
also make the asset class vulnerable to market
shocks. The bank loan space has also evolved and
is less staid than it was during the earlier years
of our dataset.
Although the future will not repeat the past,
our use of resampled historical data to
build Sharpe-optimized portfolios assumes that
key aspects of asset-class relationships will
persist. Bank loans may not remain negatively
correlated with Treasuries, but they are
not likely to be highly correlated either. It is also
unlikely that investment-grade corporates’
positive correlation with Treasuries, mortgages,
and so on will cease. The correlations between
Treasuries and high yield on the one hand
and Treasuries and emerging-markets debt on
the other have been weak or nonexistent
for most of their respective histories, which
could continue.

The Sharpe-Optimized Portfolio Not only is the allocation of the most optimized
shows the Sharpe-optimized portfolio
E X H I B IT 1
that results from our resampled data without portfolio 5% equity/95% bond, but also the portfolio’s bond portion is distinctive.
requiring a set minimum equity allocation as a
Sharpe-Optimal Morningstar US Core
starting point.2 Unlike the prototypical 60% Portfolio Weighting Plus Bond Index
stock/40% bond portfolio, optimizing for excess Asset Class % Weighting % +/–
return relative to its standard deviation across Morningstar US Market Index 5.0 0.0 5.0
the seven asset classes of our study leads
Morningstar US Corporate Bond Index 0.0 21.0 –21.0
to a 5% stock/95% bond portfolio. Severe equity
market downturns since 2000, including Morningstar US High-Yield Bond Index 3.0 4.8 –1.8
2000–02, 2007–09, and in early 2020, dimmed Morningstar US Mortgage-Backed Securities Index 26.0 26.6 –0.6
the attractiveness of a stock allocation from the
Morningstar US Treasury Bond Index 30.0 40.3 –10.3
standpoint of the Sharpe ratio.
Morningstar Emerging Markets Composite Bond Index 6.0 1.1 4.9
The Sharpe-optimized portfolio’s bond portion Morningstar LSTA US Leveraged Loan Index 30.0 0.0 30.0
is also distinctive. E X H I B I T 1 shows how Source: Morningstar Direct; Intercontinental Exchange. Data as of Sept. 30, 2023. The Morningstar US Core Plus Bond and Morningstar Emerging Markets
Composite Bond Indexes shared in common 78 investment-grade, USD-denominated emerging markets corporate bonds and 146 quasi and foreign government
the portfolio’s weightings compare with those bonds, which together accounted for 1.11% of the Core Plus index and 17.55% of the Emerging Markets index, respectively. The 78 corporate bonds
of the high-yield-inclusive Morningstar US also appeared in the Morningstar US Corporate Bond Index, where they had a 1.39% weighting, versus a 4.29% weighting in the Emerging Markets index.

2 To assess this data through September 2023, we used the statistical technique of resampling, which involved drawing random samples to account for the uncertainty and variability of financial
markets while also limiting sensitivity to any given starting or end point. In our case, from the more than 23-year period in question, we created 10,000 separate samples of 180 months
(15 years), with replacement, and have averaged the optimal allocations based on those samples. We used Python’s SciPy package to set up the optimizer, which constrained all optimizations
to be long-only (thus no shorting) and to add up to 100%.

morningstar.com/products/magazine 35
 Strategies

EXHIBIT 2

Higher Return Potential Investors who want to increase their equity exposure can set their equity minimum and optimize the
portfolio’s bond allocation.

Sharpe-Optimized Portfolios With Required Minimum Equity Allocations, 0% to 90%

Required Minimum Equity Allocation (%)

Asset Class 0 10 20 30 40 50 60 70 80 90

Morningstar US Market Index 5 11 20 30 40 50 60 70 80 90

Morningstar US Corporate Bond Index 0 0 1 2 2 2 2 2 1 1
Morningstar US High-Yield Bond Index 3 2 2 2 3 3 3 3 2 1
Morningstar US Mortgage-Backed Securities Index 26 21 14 8 5 3 2 1 1 0
Morningstar US Treasury Bond Index 30 34 35 31 25 18 12 8 5 2
Morningstar Emerging Markets Composite Bond Index 6 6 8 11 13 14 13 11 8 4
Morningstar LSTA US Leveraged Loan Index 30 26 20 16 12 10 8 5 3 2
Source: Morningstar Direct; authors’ calculation. Data as of Sept. 30, 2023. Weights are rounded to the nearest whole number such that each portfolio allocation adds up to 100%.

One aspect of the future that may differ is the
pricing of risk. Since 2000, the monthly average
return of 13-week Treasury bills at auction, a
common proxy for the risk-free rate in the U.S.,
went through two prolonged stretches of returning
very little.3 Only recently did the opportunity
cost for investing return.
With interest rates at levels not seen in more
than 15 years, a bond-heavy portfolio that
is attuned to fixed-income sector correlations
has a good chance of delivering solid results,
particularly for conservative investors.
Scaling Up Equity Allocations
Investors who want to increase return potential
while sticking with a bond-heavy portfolio
could use financial leverage to do so, but this
approach is hard to execute and can be
risky. It typically involves buying futures and
rolling over those futures contracts as they expire,
which can generate significant tax costs.
Users must also monitor margin calls, which
can be more frequent and bigger than consensus
expectations. In addition, some of the asset
classes we consider in our analysis don’t have
futures markets, which limits strategies that
use them for leverage, like AQR risk-parity funds.
Most investors who want to increase return
potential instead will opt for more equity exposure.
While that may lead to a suboptimal experience
from the standpoint of the Sharpe ratio, it
can help them meet their real-world goals, and the
Sharpe ratio can still be useful in optimizing the
bond portion of the portfolio once a minimum
equity percentage has been determined. EXHIB IT 2
shows the Sharpe-optimized bond weightings
accompanying equity allocations ranging from 0%
to 90%, in increments of 10 percentage points.
Each bond portion also differs from the broad
fixed-income market and typical “one-stop” bond
funds as represented by core-plus or multisector
strategies. The bond sector weightings evolve,
however, as the equity allocation increases.
Corporate bonds, for example, go from no role to
a modest one. Allocations to mortgage-backed
securities, Treasuries, and leveraged loans remain
robust throughout, though the Treasury stake
increases as the mortgage-backed securities
weighting fades at higher equity levels because of
Treasuries’ negative correlation with stocks.
The emerging-markets-debt allocation increases
to double digits at equity weightings between
30% and 70%, and at a 60% stock weighting is the
highest bond exposure in the portfolio.
A Sharpe ratio trade-off occurs with the evolution
of these stock and bond sector weightings,
though. The Sharpe ratio declines as a portfolio’s
required equity allocation increases. A portfolio
without an equity requirement has an annualized
Sharpe ratio of 1. At a 60% required equity stake,
it drops to 0.54 and at 90% to 0.43.
Implementation
Although the data fed to an optimizer limits its
output, even with resampling, the allocations
shown in EXHIB IT 2 may serve as guideposts for
investors who want to improve the fixed-
income allocation within their portfolios. To that
end, we show how to implement these Sharpe-
optimized portfolios using the following
seven ETFs: Vanguard Total Stock Market ETF VTI,
SPDR Portfolio Corporate Bond ETF SPBO, SPDR
Bloomberg High Yield Bond ETF JNK, SPDR iShares
MBS ETF MBB, iShares US Treasury Bond ETF
GOVT, iShares JP Morgan USD Emerging Markets
Bond ETF EMB, Invesco Senior Loan ETF BKLN.
We selected each ETF based on modest costs
relative to other options, an early inception date so
we could illustrate real-world portfolio performance
over the longest possible period, and investment
suitability. Although none of the ETFs aims

3 From November 2008 through October 2016 and again from March 2020 through February 2022, the monthly average return of 13-week Treasury bills at auction was 1 basis point.

36 Morningstar Q1 2024
to replicate the Morningstar index for its asset point they either matched or were about in line approaches to the bond portion of U.S.-focused
class, its tracking error with that index from March 1, with their stock/bond equivalents. portfolios. Optimizing for the Sharpe ratio
2012 (the first full month in which all the ETFs leads to bond sector weightings that differ from
existed) through September 2023 is less than 100 As E X HIB IT 3 shows, the Sharpe ratios of our the broad fixed-income market and that evolve
basis points annualized for five of the seven. ETF portfolios increased with equity weighting as the equity allocation increases. Implementation
rather than decreased as they did using the of these Sharpe-optimized portfolios using ETFs
Performance Morningstar indexes. But Vanguard Total Stock has produced competitive real-world performance
The suitability of the ETFs to provide portfolio Market’s 0.78 Sharpe ratio over the period in over more than a decade.
exposures approximating the investment question versus Vanguard Total Bond Market’s
universes of our seven Morningstar indexes shows 0.03 explains most of that difference. Also, Investors who opt not to implement these
through in long-term, real-world performance. our Sharpe-optimized portfolios’ results are based portfolios may still want to consider whether the
on that one 10-plus-year period, whereas our results here should alter aspects of their approach
E X H I B IT 3 displays the absolute and risk-adjusted study with Morningstar indexes uses resampled to portfolio construction. Big allocations to
results of 10 Sharpe-optimized portfolios data and thus draws on multiple iterations investment-grade bonds, for example, might seem
with required minimum equity weightings of 0% of 15-year periods created from an almost 24-year difficult to justify based on their correlations
to 90% in increments of 10 percentage points. stretch of monthly returns. Furthermore, the with other asset classes, while leveraged loans
The plus/minus columns compare that ETFs used to implement the Sharpe-optimized and mortgage-backed securities should play a
performance to the results of an equivalent stock/ portfolios are imperfect representations of greater role in most portfolios. K
bond mix using Vanguard Total Stock Market their respective Morningstar indexes. Even if
ETF and Vanguard Total Bond Market ETF BND. different from what we might have expected, our Maciej Kowara, Ph.D., is a strategist, fixed-income
strategies, at Morningstar Research Services LLC.
For example, the 0% Required Equity portfolio, Sharpe-optimized portfolios proved competitive.
which had a 5% equity weighting, though it could Alec Lucas, Ph.D., is director, fixed-income strategies,
have had none, beat a 5%/90% blend of Vanguard Conclusion at Morningstar Research Services LLC.
Total Stock Market and Vanguard Total Bond Drawing on Morningstar Indexes data since 2000,
Market in every respect. Its 2.13% annualized gain this article has sought to refine allocation
from March 2012 through September 2023
was 48 basis points more, its 3.73% standard
deviation was 72 basis points lower, and its 0.30
EXHIBIT 3
Sharpe ratio doubled its rival’s. Since the
Sharpe-optimized portfolios also use Vanguard Competitive Results The Sharpe-optimized portfolios more than held their own
Total Stock Market ETF for their equity weighting, against equivalent stock/bond allocations using Vanguard Total Stock Market ETF
what the plus/minus columns highlight is the and Vanguard Total Bond Market ETF.
difference between bond portfolio performance.
Standard
Sharpe-Optimized Portfolio Return % +/– Deviation % +/– Sharpe Ratio % +/–
Given that the optimizer becomes more constrained
as the required minimum equity weighting 0% Required Equity 2.13 0.48 3.73 –0.72 0.30 0.15
increases, the Sharpe-optimized portfolios’ results 10% Required Equity 2.71 0.38 4.14 –0.52 0.41 0.12
are quite competitive. Their annualized return
20% Required Equity 3.68 0.31 5.07 –0.14 0.53 0.07
beat each equivalent stock/bond mix. The degree
of that outperformance declined from 48 basis 30% Required Equity 4.81 0.31 6.33 0.25 0.61 0.03
points to 31 basis points as the required minimum 40% Required Equity 5.93 0.31 7.68 0.55 0.65 0.00
equity weighting moved from 0% to 20%; it then 50% Required Equity 7.04 0.32 9.02 0.74 0.68 –0.02
stayed around 30 basis points up to 60% before
60% Required Equity 8.12 0.30 10.29 0.79 0.71 –0.02
declining again with each incremental equity
increase. The standard deviation of the bond-heavy 70% Required Equity 9.13 0.24 11.48 0.72 0.73 –0.02
Sharpe-optimized portfolios was lower, but 80% Required Equity 10.11 0.15 12.57 0.51 0.75 –0.01
as the required equity weighting moved beyond
90% Required Equity 11.11 0.10 13.67 0.29 0.76 –0.01
20%, the Sharpe-optimized portfolios became more
Source: Morningstar Direct. Figures are annualized and net of fees from March 1, 2012, through Sept. 30, 2023, with annual portfolio rebalancing back to
volatile. The Sharpe ratios of the optimized the target asset class weightings shown in Exhibits 3. Thus, the stock allocations for the Sharpe-Optimized 0% and 10% required equity portfolios are 5%
and 11%, respectively, while the 20% to 90% required equity portfolios have stock allocations matching their names. Each +/– column shows the difference
portfolios, though, continued to be superior up for the preceding metric between the Sharpe-Optimized portfolio and an equivalent stock/bond allocation to Vanguard Total Stock Market ETF and
to a 40% required equity weighting, at which Vanguard Total Bond Market ETF.

morningstar.com/products/magazine 37
 Strategies
The Diminishing Role of Active
Mutual Funds
Active offerings are in a downward spiral
of underperformance and outflows.
ACTIVE
James X. Xiong, Thomas M. Idzorek, and
Roger G. Ibbotson
The U.S. active equity mutual fund industry
has changed dramatically over the past 30 years,
with persistent underperformance and net
outflows accompanied by decreasing expense
ratios. The lower expense ratios did not seem to
meaningfully improve net returns for investors
and did not halt the trend of net outflows. In
this article, we summarize a longer study (Xiong,
Idzorek, and Ibbotson, 2023) on how both the
performance and flows of U.S. active equity mutual
funds have evolved over the past 30 years and
extrapolate from the past to forecast a continuing
diminished role for these funds.
The great migration from active mutual funds into
passive funds started around 2006. Since then,
we calculate that the cumulative net outflows for
U.S. active equity mutual funds were about
$2.2 trillion. In contrast, index equity mutual funds
and exchange-traded funds together have
enjoyed $1.48 trillion of cumulative net inflows
during the same period.
Bad relative after-fee performance likely
contributed to the net outflows. Consistent with
the “arithmetic of active management” (Sharpe,
1991), Fama and French (2010) find that in
aggregate, active mutual funds realize net returns
that underperform capital asset pricing model,
three-factor, and four-factor benchmarks by
expense ratios from 1984 to 2006. The reported
analyses on net returns suggest that very few fund
managers have enough skill to cover costs.
38 Morningstar Q1 2024
The migration of assets from active to passive and
corresponding fund flows may in fact influence
the performance of active mutual funds.
Lou (2012) presents the flow-induced price
pressure hypothesis (or flow-driven return effect)
and shows that flow-induced trading has
little to do with stock-picking ability, but it can
cause significant price pressure.
In our study, we quantify the impact of fund flows
on performance and address four questions:
1 First, what is the performance (gross and net
alphas) of active and passive funds in the most
recent 15-plus year period?
2 Second, how does the performance of small-AUM
active mutual funds compare to large-AUM active
mutual funds over the past 30 years?
3 Third, how does the fund flow influence
performance for active mutual funds?
4 Fourth, what is the future of active mutual funds?
The first three answers are empirical, while the
fourth involves extrapolating from the empirical
observations into the future.
The Performance of Active Mutual Funds
and Passive Funds
The performances of the three fund universes
(active mutual funds, index mutual funds,
and ETFs) are summarized in EXHIB IT 1 . Gross or
net returns are aggregated (either asset-weighted
or equal-weighted) for each of the three fund
universes in each month. Asset-weighted
is simply weighted on assets under management.
Panel A contains the results from January 1991
to December 2005 (the first period), and Panel B
contains the results from January 2006 to
September 2021 (the second period). ETFs only
have performance results in the second
period. Each of the two panels is then subdivided,
with the top section containing the results
based on gross returns and the bottom section
containing results based on net returns. All
numbers in EXHIB IT 1 are annualized.
Alpha is defined as a fund’s return over its
Morningstar-assigned benchmark return (such as
the Russell 1000 Growth Index). We reported
similar performance results for the other three
alpha measures that are based on various factor
models. Equal-weighted gross alpha for active
mutual funds is significantly positive and
higher than index funds in the first period, but
not in the second period.
The performance of active mutual funds is
comparable to index funds on asset-weighted
gross returns for both time periods. Active
mutual funds outperformed index funds
by annualized 23 basis points and 7 basis points
on geometric means during the first and
second periods, respectively. However,
equal-weighted active fund gross returns showed
significant deterioration in the second period.
Continuing with gross geometric mean
returns, active mutual funds outperformed index
funds by 113 basis points annualized
during the first period, but they underperformed
index funds by an annualized 17 basis points
during the second period.
The results for the first period in Panel A of
EXHIB IT 1 are consistent with those reported in the
literature, especially Fama and French (2010).
In contrast, Panel B of EXHIB IT 1 shows that
the equal-weighted performance for active mutual
funds in the second period is worse than in the
first period. In other words, small-AUM active
funds tend to outperform large-AUM active funds
in the first period, but not in the second period.
The Flow Trend for Active Mutual Funds
It is well documented that fund flows respond to
past performance. In the absence of adequate
skill, higher fees make it inevitable that aggregate
net returns will be worse; thus, outflows would
seem nearly unavoidable.
 EXHIBIT 1

shows the active market share, defined

E X H I B IT 2 Performance of Three Fund Universes Summary statistics for aggregated active
as the ratio of active AUM to total (active plus mutual funds, index mutual funds, and ETFs for gross and net returns.
passive) AUM, over the past 30 years. We combine
index funds and ETFs into passive funds.
Panel A: First Period (January 1991 –December 2005) Geometric Standard
At the far left of E X H IB IT 2 , in 1991, active AUM Mean (%) Deviation (%) Alpha (%)*
represented 97% of the total U.S. fund Gross Returns Asset-Weighted Active 12.07 14.25 0.44
market. Interestingly and perhaps ironically, Index 11.84 14.08 –0.16
Sharpe’s “arithmetic of active management,”
Equal-Weighted Active 13.60 14.54 1.05
which makes it very clear that after fees and in
aggregate active management is a losing Index 12.47 14.27 0.01
proposition, was published in 1991. As shown in Net Returns Asset-Weighted Active 11.03 14.34 –0.47
E X H I B IT 2 , the percentage of total AUM in
Index 11.55 14.07 –0.40
active mutual funds has been in steady decline,
dropping to 46% as of September 2021. Equal-Weighted Active 12.20 14.52 –0.20
Index 11.84 14.30 –0.47
shows the cumulative dollar flows
E X H I B IT 3
into active mutual funds, index funds, and ETFs.
The flows for active mutual funds have been Panel B: Second Period (January 2006 –September 2021) Geometric Standard
negative since around 2006, while the flows for Mean (%) Deviation (%) Alpha (%)*

index funds and ETFs have been positive Gross Returns Asset-Weighted Active 10.58 15.73 –0.10
for most of the time. As mentioned earlier, the Index 10.51 15.51 0.04
cumulative net outflows for active mutual
ETFs 10.39 15.54 0.03
funds were $2.2 trillion from January 2006 to
September 2021. In contrast, the cumulative Equal-Weighted Active 10.36 16.37 –0.12
net inflows during the same period for Index 10.53 16.19 0.10
index mutual funds and ETFs were $380 billion ETFs 10.11 16.39 0.05
and $1.1 trillion, respectively.
Net Returns Asset-Weighted Active 9.72 15.73 –0.89

The Performance of Small-AUM Active Index 10.32 15.50 –0.13

Mutual Funds
E X H I B IT 4 plots the cumulative alpha differences
between the small-AUM and large-AUM
active mutual funds. Small-AUM funds
outperformed large-AUM funds in the first period,
but they slightly underperformed in the second
period. Clearly, the excess performance that
small-AUM funds enjoyed over the first period
disappeared over the second period.
shows the rolling 12-month average
E X H I B IT 5
percentage flows for the small-AUM and
large-AUM active mutual funds over the 30-year
period. It shows a negative trend for both
fund AUM groups. The slope of the percentage
flow for small-AUM funds is about 2.5 times
the slope for the large-AUM funds, indicating a
much faster drop of percentage flow for small-
AUM funds. Small-AUM funds have higher average
percentage flows (3.75%) than large-AUM
funds (0.54%) in the first period. In contrast, the
ETFs 10.23 15.55 –0.12
Equal-Weighted Active 9.22 16.36 –1.17
Index 9.98 16.18 –0.39
ETFs 9.77 16.40 –0.28
*Alphas in bold numbers are significant at the 5% level.
Source: Morningstar. Data as of September 2021.
average percentage flow for small-AUM funds associated with the deteriorated performance
(0.74%) is not far away from that of large-AUM of the small-AUM funds.
funds (negative 0.33%) in the second period.
Large-AUM funds are much larger than small-AUM We argue that the flow-driven return effect,
funds, so they tend to have smaller magnitudes documented in Lou (2012), can be one
of percentage flows. of the factors that drove small-AUM funds to
outperform large-AUM funds in the first
Impact of Flow on Active Fund Performance period. Flow-driven return effect means that
E X H I BIT 4 raises an interesting question: Why flows in and out of funds influence performance.
did the performance of small-AUM funds It has little to do with skill, and it is more
deteriorate in the second period? EXHIB IT S 4 & 5 related to liquidity and trading costs. Extrapolating
suggest that consistently reduced flows are from Lou (2012), when funds experience

morningstar.com/products/magazine 39
 Strategies

50

Active Share
46

EXHIBIT 2 EXHIBIT 3 0
The Great Migration The percentage Divergent Flows The
01/1991 asset flows
01/2002 into active mutual funds have been negative since
09/2021
of total AUM in active mutual funds has around 2006, while the flows into index funds and ETFs have continued to rise.
been in steady decline.
Cumulative Net Dollar Flows Into Active and Passive Funds
Ratio of Total Active AUM to Total Active Plus
Passive AUM $2T
Passive (Index
Funds + ETFs)
100% 1 1.88

Cumulative Fund Flow

0
50
Active Share

46
–1 Active Funds
0 –2 –1.25
01/1991 01/2002 09/2021 01/1991 01/2002 01/2013 09/2021
Source: Morningstar. Data as of Sept. 30, 2021. Source: Morningstar. Data as of Sept. 30, 2021.

immediate large outflows, liquidity is low and the performance of the active fund industry by EXHIB IT 6 shows the forecast active market share,
Cumulative Outperformance

1.50
trading$2T
costs can be high, which can drag negative 0.43% over the past 30 years. This is or the ratio of active AUM to total AUM. The
Passive (Index Small-Large
down the performance, or alphas. Conversely, economically meaningful and is comparable to the active market share is forecast to drop to 17% from
of Small-AUM Funds

Funds + ETFs) AUM

large inflows can create price pressure in the expensive ratio difference (about 0.70%) between 46% after 15 years. The assumption for future
1.41
1 1.88
stocks held in common by these funds. Therefore, 1.25index funds. The negative flow impact
active and market returns does not change the active share
Cumulative Fund Flow

steady inflows can lift performance, while of negative 0.10% alpha in the second period is forecast much because it has the same impact on
0
steady outflows can drag down performance expected to continue and is probably large enough both active funds and passive funds.
1.00
for active mutual funds. for the active fund industry to fall into a vicious
01/1991 01/2002 01/2013 09/2021
–1 circle. Bad net performance leads to outflows, We don’t believe active mutual funds will
Active Funds
Our research shows that flows have an important which lead to further negative performance
–1.25 due disappear completely. They will probably remain
–2
impact on the performance of individual active to flow8impact and more outflows. prevalent in 401(k) plans for the foreseeable future
Rolling 12-Mo. Avg. % Flow

01/1991
mutual funds. 01/2002
Flows have a monotonic relation 01/2013 09/2021 because 401(k) recordkeepers struggleSmall-
to handle
AUM
with performance. Inflows and outflows contribute Forecasting Active Market Share ETFs (Rekenthaler, 2021). It has been Quintile
argued
to the over- and underperformance of individual Given the4 net outflows during the more recent that at some point as the ratio of active
0.13AUM to
active funds. We estimated that the flows 15-plus years, is the active mutual fund industry total AUM drops, the market will become less
Large-AUM
helped small-AUM funds outperform large-AUM likely to0 remain large? To forecast the active efficient, leading to exploitable alpha opportunities,
Cumulative Outperformance

1.50 Quintile
funds by at least 0.44% in the first period. market share for the next 15 years, we simply use and encourage money to flow to active managers.
–0.34
–4
information on returns and flows fromSmall-Large
the This argument will be tested soon.
of Small-AUM Funds

We further estimated the aggregated flow impact 12/1991 12/2001

AUM
second period. More specifically, the monthly 12/2011 09/2021
1.41
for the active
1.25 mutual funds industry. As mentioned geometric mean net returns are 0.78%, 0.82%, and Conclusion
earlier, the average monthly percentage flow 0.82% for active funds, index funds, and ETFs, The year 2006 marked a significant change for
1.0 PROJECTION
for aggregated active mutual funds is 0.65% (net respectively. The monthly geometric mean the U.S. active equity mutual funds industry. Since
Active Mutual Fund Share

inflow) in1.00
the first period and drops to negative percentage flows are negative 0.33%, 0.28%, and then, active mutual funds have experienced
01/1991in the second period. Given
0.33% (net outflow) 01/2002
the 0.70% for active01/2013
funds, index09/2021
funds, and ETFs, continuous net outflows, while index funds and
flow impact of 0.50 (first period) and 0.29 (second respectively.
0.5 The equation to calculate AUM at the ETFs have experienced continuous net inflows.
period) for large-AUM funds, the flow impact end of month 180 for active or passive funds is: Active Mutual
8 Fund Share
Rolling 12-Mo. Avg. % Flow

on annualized alpha is positive 0.33% for the first The asset-weighted performance of active
Small- AUM 0.17
period and negative 0.10% for the second AUM =0AUM0 (1 + r + f ) (3)
180
mutual funds remains similar over time, but the
Quintile
period,4which leads to a change of negative 0.43% 01/1991 01/2003 01/2015 12/2027 10/2036
equal-weighted performance has deteriorated
0.13
alpha across the two periods. In other words, the where r is the monthly geometric mean return and during the past 15 years. Before 2006, small-
negative flow trend has had an impact on f is the monthly geometric mean flow.Large-AUM AUM active mutual funds had outperformed
0 Quintile
–4 –0.34
40 Morningstar
12/1991 Q1 2024 12/2001 12/2011 09/2021
 0 Funds + ETFs)

A
100%
1 01/1991 01/2002 09/2021 1.88

Fund Flow
0
50

Active Share
46

Cumulative
EXHIBIT 4 –1 Active Funds
large-AUM active mutual funds. Some of these $2T0
Performance of Small Funds The excess performance that small-AUM funds –1.25
–2 Passive (Index
small-AUM fund managers were deemed to enjoyed 01/1991
over the first
01/1991 period disappeared
01/2002 09/2021 over the second period.
01/2002 01/2013 09/2021 Funds + ETFs)
be skilled, but their outperformance was partly 1 1.88
driven by more inflows.
Cumulative Excess Gross Alpha of the Small-AUM Quintile Over the Large-AUM Quintile for Active

Cumulative Fund Flow

Mutual Funds
Flows have an impact on the performance of 0
individual active mutual funds. At the aggregated

Fund FlowOutperformance
1.50
level for the active funds industry, the flow $2T
–1 Active Funds
Passive (Index
impact on annualized alpha was 0.33% for the first Small-Large
–1.25 + ETFs)

of Small-AUM Funds
–2 Funds
AUM
period and negative 0.10% for the second 1 01/1991 1.88
01/2002 01/2013 09/2021 1.41
period, which led to a negative change of 0.43% 1.25

Flow CumulativeCumulative
in alphas across the two periods. The negative
0
flow-induced impact of negative 0.10% on alpha
1.00
in the second period is expected to continue,
01/1991 01/2002 01/2013 09/2021
and it is probably large enough for the active fund Active Funds –1
Outperformance

1.50 Data as of Sept. 30, 2021.

Source: Morningstar.
industry to fall into a vicious circle. –1.25 –2
Small-Large
of Small-AUM Funds

01/2002 01/2013 09/2021 AUM 8 01/1991

Finally, the fee difference of about 70 basis points EXHIBIT 5
Small-AUM
1.41
between active and index funds may shrink, Falling1.25
Flows Both small and large funds saw negative flow trends, but small
-Mo. Avg. %

Quintile
Cumulative

but it probably won’t disappear, continuing to drag 4

funds’ slope was steeper. 0.13
down the net performance and drive the
1.00 Large-AUM
persistent outflows from active mutual funds. If
Rolling 12
Outperformance

1.50
Rolling0 12 -Month Average Percentage Flows Into Small-AUM and Large-AUM Quintile Active
Quintile
the flows for active mutual funds, index funds, 01/1991 01/2002 01/2013 09/2021
Mutual Funds –0.34
Small-Large
and ETFs for the next 15 years are the same –4
of Small-AUM Funds

as the past 15 years, active market share will likely 12/1991 12/2001 12/2011 09/2021 AUM
8 1.41
Avg. % Flow

drop to 17%. K 1.25

Small-AUM
Cumulative

1.04
Quintile
James X. Xiong, Ph.D, CFA, is head of scientific investment PROJECTION
Share

1.00 0.13
research at Morningstar Investment Management.
12-Mo.

01/1991 01/2002 01/2013 09/2021 Large-AUM

RollingFund

Thomas M. Idzorek, CFA, is chief investment officer,

0 Quintile
Workplace, at Morningstar Investment Management.
Mutual

0.5
–4 –0.34
Roger G. Ibbotson, Ph.D, is chairman at Zebra Capital Active Mutual
8
% Flow

Management and professor in practice emeritus at the Yale 12/1991 12/2001 12/2011 09/2021 Fund Share
Active

School of Management. Source: Morningstar. Data as of Sept. 30, 2021. Small-

0.17 AUM
0 Quintile
12-Mo. Avg.

4 01/1991 01/2003 01/2015 12/2027 10/2036 0.13

1.0 PROJECTION
Fund Share

References EXHIBIT 6
Large-AUM
Fama, E.F. & French, K.R. 2010. “Luck Versus Skill in the Continued
0 Decline We forecast that the market share of active mutual funds will
Quintile
Active Mutual Fund Share Active MutualRolling

Cross-Section of Mutual Fund Returns.” Journal of Finance.

fall to
–4 17% in 15 years. –0.34
Vol. 65, No. 5, PP. 1915–1947.
0.5 12/1991 12/2001 12/2011 09/2021 Active Mutual
Lou, D. 2012. “A Flow-Based Explanation for Return
Predictability.” The Review of Financial Studies. Vol. 25,
Forecast Ratio of Active Mutual Fund AUM to Total AUM Fund Share
No. 12, PP. 3457–3489. 0 0.17
1.0 PROJECTION
Rekenthaler, J. 2021. “Farewell, Mutual Funds.” 01/1991 01/2003 01/2015 12/2027 10/2036
Morningstar.com. Sept. 2.

Sharpe, W.F. 1991. “The Arithmetic of Active Management.”

Financial Analysts Journal, Vol. 47, No. 1, PP. 7–9. 0.5
Active Mutual
Xiong, J., Idzorek, T.M., & Ibbotson, R.G. 2023. “The
Fund Share
Diminishing Role of Active Mutual Funds: Flows
0 0.17
and Returns.” Journal of Investment Management. Vol. 21,
No. 4, PP. 32–52. 01/1991 01/2003 01/2015 12/2027 10/2036
Source: Morningstar. Data as of Sept. 30, 2021.

morningstar.com/products/magazine 41
 Strategies

Solving the Retirement Equations, Part IV where t is the realized return in year t on the
underlying portfolio of risky assets.

From annuity payouts to consumption To show how an IVA works, I took the 500
Monte Carlo trials on the 50/50 stock/bond mix
levels, Milevsky has the formulas. that I use in Part III of this series (in the
Q4 2023 issue) to illustrate self-annuitization to
represent here the underlying risky portfolio
of an IVA. In this illustration, I go out 90 years.
EXHIB IT 1 shows the evolution of various
percentiles of the payout.
W0
QUANT U
P0 =
Paul D. Kaplan A(a, 0, h) Value of a Financial Legacy (Solomon S. Huebner,
1882 – 1964) n
a –a
where: max
qta The 7 Most Important Equations, Equation 6
This is the fourth and final installment of Quant U A( a, 0, h) = ∑( 1 + h)
t Solomon S. Huebner, whom Milevsky attributes f=
t=1
in which I discuss the equations presented P0 = the initial payout (time 0) the equation I discuss in this section, was a
by Moshe Milevsky of York University’s Schulich W0 = the amount of wealth invested in major figure in the life insurance industry. Milevsky P
1 + Rt
School of Business in Toronto in two of the
Pt = Pt –1IVA writes that in the early 20th century, the life
his books: h 1 + h= the assumed interest rate insurance industry had a terrible reputation. In the
A(a,0, h) =a the price of a fixed annuity that 1920s, ’30s, and ’40s, Huebner was the person P(
q o
1 The 7 Most Important Equations for Your q1a + t = t a+1
pays $1 for life for a person of age a, most responsible for rehabilitating that reputation.
q
Retirement (Wiley, 2012) t with no guaranteed period, with He was also a great advocate for life insurance.
2 Life Annuities: An Optimal Product for 1 – discount q1a + t rate h. This is the price of D(
Retirement Income (CFA Institute Research LI1taB =
the IVAB. I am going to express the Huebner equation
1+ r
Foundation, 2013) in a bit of a different way than Milevsky by tying it
From the a equation
max–a
qva–+tt for the aprice of an immediate directly to term life insurance. With term life
The equations in these two books answer LI a
B
Pfixed
0
t
=
= ∑ W
annuity( that
0
1+ r )
Iv present
+t
– t LI1v – in
t BPart II of this series insurance, each year you pay a term life premium P(
(in the A(
Q3a,20230, h)issue), we have:
v= t
specific questions in retirement-income planning that keeps the insurance in place for the following
and the pricing of insurance instruments. W0 pay the premium each year so
year. You must n
pva–+tt = qva–+tat– 1 ––a qvqa–+att P0 =
In this installment, I discuss four equations, each long asA(youa, 0,want
h) to keep the policy in effect.
max
c

of which answers a different question.

A( a, 0, h) = ∑ t

( 1 + h)
t
However, the premium rises each year because the
q
f=
t=1
a –a–1
max
p a+ t
probability of a dying
–a
qtthe
a following year also rises.
∑
max
v–t
Payout of an Immediate Variable Annuity
LItaB =
where:1 + R ( 1 + r ) v – t
B A( a, 0, h) = ∑ ( 1 + h)
t
P
Life Annuities, Equations 11a, 11b Pt =
v = t +1t
Pt –1 To calculate t=1 what a fair premium would be, the =
1+ h
I discussed immediate variable annuities, or IVAs, amax = the highest ln(q1a +possible
t
) + – age (set to 115) first step is to calculate the probability of
ln(c ) = probability 1+ R P(
in the Q3 2022 issue of Quant U, so this section qta t + 1) – ln(c
q =
a tthe of someone age a Pdying
= in onet year,Pt –1 given that you are alive in year t.
t o Pc
is somewhat of a review. An IVA is an annuity q1a + t = t a+1 surviving t or more years
1 + h by:
This is given
qt
that continues to make payouts until the investor μ– rf
1 qta+1
dies. But unlike a fixed annuity, payments Usinga
– 2q1a + t ( FGompertz
= the 1truncated + H) model that I describe q1a + t = Dc(
LI1t B = B qta
vary over time depending on the performance of in Part I of this 1 + series
r (Q2 2023) for a 25-year-old
an underlying portfolio of risky assets. The woman and an assumed interest rate of 4%, 1 – q1a + t
payouts of an IVA also depend on its assumed I calculate
a –a
max
the qprice
a+ t
of thea IVA , A( 25, 0, 0.04 ), to be LI1 a
t B =as before, qtBis the probability of someone
Where, a Dm
interest rate.
LIt B =
a
∑
P0 =.37. Assuming
$22
W0 v – t
(1+ r ) that
LI1v –+ tt B
v – t the investment in the IVA
1+ r
age a surviving t or more years. Hence, q1a+ t
P(
v =. t
A(a, 0, h)
( W0 ) is $100,000, the initial payout (P0 ) is $4,469. means asomeone
–a
max
qva–+oftt age a +a +t tsurviving at least one
The equations that Milevsky presents focus on
p = q
a+ t
v–t
– qq
a + atmax – a
v– t –1
a +a t
v –t t
LI a
= ∑
t B year. Note that
more
(1+ r )
LI1v – t Ba to be the person’s
v – t I define
nDm
c
the calculation of the payouts of an IVA in The
A( a,second
0, h) =equation gives subsequent payouts age at time 0, so their age is a+t in year t.
∑
v= t
q
t f=
real time. (As usual, my notation is a bit different as follows: t=1 ( 1 + h)
than Milevsky’s but is consistent with that of
a –a–1
max
pva–+tt pva–year
In
+t
= t,qvthe
a+ t
– qva–+tt of the person dying in year ∆
– t – 1probability

previous issues of this series.) The first equation

LItaB = ∑ Rt ( 1 + r )
1v+= t +1
v–t B
t

t + 1 is 1 – q1 . The premium for term life insurance

a+ t PP
Pt = Pt –1 =
gives the initial payment: 1+ h in year at is:–a–1
max
pva–+tt
ln(q1a + t ) + – LItaB = ∑ (1+ r )
v–t B DV
P(
ln(ct + 1) – ln(ca t) =
v = t +1
q o
42 Morningstar Q1 2024 q1a + t = t a+1 Pc
qt ln(qa+ t
)+ –
1
1 μ– rf ln(ct + 1) – ln(ct ) =
 –j –n

1 + Rt
P=
c
q ∑
j =1
(
+ 1+ q
y
) (1 + ) y f
q

Pt = Pt –1
1+ h n
f– j – qT

q a
P ( y; c, T ) =
c
q ∑ (1 + ) + (1 + ) y
q
y
q
t +1 o j =1
q1a + t =
q a
f– j – qT
( ) (1 + ) ( )
t c
n j –f y y
EXHIBIT 1 ∑ j =1 q q q + T 1+ q
( )
LI1taB =
1 – q1a + t
B Percentiles of Payout of an IVA for a 25-Year-Old DWoman
y; c, T =
With AIR P=( y;4%
c, T, )50/50
1+ r Stock/Bond Portfolio
amax – a
qva–+tt
where:
LItaB = ∑ (1+ r )
a+ t
v – t LI1v – t B $10K
P ( y; c, T ) = P y; c, ( n
q ) (1 + ) y f
q
v= t W0 95th Percentile
LI1 ta = the term life premium of someone age a P0 = f– j 9.22
f– j
A( a, 0, h)

pva–+tt = qva–+intt– year
1
– qtva–per
+ t dollar of coverage (the 1
t c
(1 + ) y
q
= c
(1 + )90 Percentile
y
q th
is to indicate that the insurance is for 8 q q
P ( y; c, T ) P ( y; c, ) (7.64
1+ )
amax – a n y f
a – aone year.) qa
q q
max –1
pva–+tt A( a, 0, h) = ∑ t

( 1 + h)
t
75th Percentile
B
LIt B =
a = ∑ the size of theBbequest being insured
+ r ) v – t rate
t=1
(1 + ) y
–j
6.05
r =v = t +1the( 1discount 6 = c
q
q
1 + Rt P ( y; c, ) n
q 50th Percentile
Using the same truncated ln(q1a + t Gompertz
) + – model as Pt = Pt –1 4.71
ln(ct +1) – ln(ct ) = 1+ h
before, with a discount rate of 2% and a bequest
size of $100,000, I find the term life premium
4 a
q
Pc ( y ) = 1
y (1 + ) y f
q 25th Percentile
3.55
o
Wμ–0 rf woman to be $6.93. E X H I BI T 2
q1a + t = t a+1
Pfor a 25
1 -year-old qt
0 =
shows A( howa, 0,this
h)
2
(F + H)
premium increases as she gets
Dc ( y ) = 1
y (1 + ) – y
q
f
q 10th Percentile
Annual Payout

21 – q a+ t 2.77
older, starting off very low but rising at 1 n = qT
LI1taB = B
an increasing a –a
rate. qShould
max a the person live to a very 1+ r P ( y; c, T ) 5th Percentile
A(a, 0, h) =
old age, the premium ∑ +
t

( 1 h) approaches
t the size 0
Dm (y; c, T ) =
f = n– qT P ( y; c, T ) 2.44
t=1 amax – a
.
of the bequest, as it becomes inevitable that she qa+ t
will die soon.
LI B = t
a
∑ 0 v–t
( 1
Year + r )
a+ t
v – t LI1v – t B
30 60 c n
P= q ∑
–j
+ 1 +
y
90
–n
1+ q
y f
( ) ( )
1 + Rt v= t D ( y; c, T ) q

Pt = Pt –1 T) =
Dm (y; c,j =1 y
1 + h equation gives the economic value
Source: Author’s calculations.
1+ q
The Huebner pva–+tt = qva–+tt– 1 – qva–+tt
n
f– j – qT
today of lifea insurance maintained from now
q
P ( y; c, T ) = q
∆P
y c
1+ q + 1+ q ∑( y
) ( )
quntil = t a+1
a + t the uncertain time of death. If you are the
o ≈ – Dm ∆y j =1
1 q amax – a – 1 P
$100K pa+ t
$100K f– j
of y – qT
beneficiary,t this is its value to you. Mathematically,
this is the 1W mortality-adjusted present value of
LItaB = ∑ (1+ r )
v–t
v–t B when they began to rise
rising and
n again.
j –f c The periodsy
∑ j =1 q q 1 + q + T 1 +96.32
D
( )( q ) ( )
–0 q1a + t v = t+1 D ( y;falling
c, T ) =interest rates roughly correspond
P0 =
LI1 a
= life premiums: 80.78 DV 01 = P = P DPm( y; c, T )
thet Bterm B
•
y
A( a, 0,
1 +h)r 75 to periods75 of rising1 +andq falling inflation. If bond
Proper Spending Rate ln(q(Irving
) + Fisher,
– 1867–1947), 1
a+ t
investors form their inflation expectations based
ln(ct + 1) – ln(ct ) = n = qT
Menahem Yaari, b. 1935 ) on recent 50inflation (so-called adaptive expectations),
Annual Premium

amax – aamax – a a + t a
q q 50
∑ (∑1 + r( 1) + h) LI1
LItaB 0,=h) =
A(a,
v–t t
v–t t
a+ t
v–t B The 7 Most Important Equations, Equation 4 P
then the ( y; c, T )
f =historical
= P
n– qT record
y; c, n
(
1 +
P ( y; c,isTconsistent
q )
y f
q with the )( )
v = t t=1
μ– rf C (y; c, T ) =
Irving 1Fisher Fisher Identity.” P ( y; c, T )
= 25 (F + H) 25 n
–j –n
Milevsky describes Irving Fisher of Yale as
( ∑)
c
( ( ) )( )
f– j f– j y f
Value

2 y
P = 1q+ y + 1 + 1q + y 1 + q
a+ t
=1 +q R for– aq25-year-old woman who is
p example, a+ t a+ t 0 0 q q
PFor “the greatest economic scholar of the first half of gCreation c of anj =1 inflation cindex. By creating an
v–t
= v– t –1
Pt –1 v–t
q = q
90 60+ y f 85
t
planning 1 +ahlegacy of $100,000, the value 0 30 60
the 20th century.” Among his many contributions:
Year
inflation P
C ( index,
( y; 0c, T )
y; c, TYear ) Fisher
= nmade ( )( ) 30
P his n
y; c,theories
f– j
q 1 about q
– qT
the
a –a–1
is $30,449. E X H I BpIvaT–+t3t shows how the value of the
max

∑
impactPof ( y;inflation ∑( ) ( )
c
c, T ) = practical.
q –j +
1 q
y
+ 1 q+
y

LItaB = qta+1
qlegacy
1
a+ t
= evolves
qt
v = t +1a
( 1toward
B
+ r ) v – tthe size of the bequest. .
gThe distinction between nominal and real o interest c n (( ) () ) ( )
y
1f –+j q f –j =1j – 1
=q ∑q j =1 qin the qmoney1 supply
c + q
y
f– j–2

rates. While nominal interest rates are what gLinking growth to f–inflation.
( ) ( )( ) (
j – qT

Another interpretation of the Huebner equation $80K in fixed-income markets, what matters
we observe Fisher’sD (work
P Py;( y;c, c,qn∑T j)n=1 jq–f qc 1 + qy + T 1 + qy
y; c, Ton ) =money and inflation laid
)
1 – q1a + t ln(q1a + t ) + –
ln(c
LI1 a
)it–isln(c
t tB+1 =
is that = B
thet ) lump-sum cost of guaranteeing economically are real interest rates, that is, the groundwork1 for Milton qT – 2P ( y; c, Inflexibility
– Friedman’s T )monetarist
1+ r
a bequest. To write the equation in a way that interest60rates after we have accounted for expected P ( y
T ) T
= +
school cof macroeconomics
+
1
y( () ( ) )
q 1 + 1 q
y fy
+ q and the rational
High
makes that a – aμ–evident,
qrvfa–+tt definea +the probability inflation. Fisher wrote an equation to express this: expectations school’s P ( y; c, T )models of money and
1 y f 1.63
max
Annual Consumption

oftadying
LI ∑
B= = in v–2t years
(1+ r )
( F +for
v–t
H
LI1)v –person
a t
t
B who is age a+ t real interest rate = nominal interest rate—
40
Pc( y;
D
inflation.
∆P
y )c,=Tmy
(See 1
( ( ) )(
)y =1article, y
P+ qy; c,–“Is
Dm ∆y + 12 Phenomenon?”
nf
qq 1 +
Inflation
2
q Always )and
as follows: v= t
expected inflation. So, for example, if a bond’s Everywhere ≈ a–Monetary C ( ∆y ) Mid
P 0.04
nominal interest rate is 5%, but expected inflation (Quant U, Q4 2022 f–).j f– j

pva–+tt = qva–+tt– 1 – qva–+tt 20

is 4%, investors in the bond are getting only 1%
+( y
Dc m (y;1 c, Tq ) = ) P ( y;
c
c, T ) 1 + q
y

Low
( )
q P=( y;q c, T )
. in real terms.
0 Fisher’s equation holds up empirically. Wt P=( y;
gFormulated c,t +T )Ft of how
a Hmodel P rational (
y; c, q 01 + q make
n investors y f
)( )
The Huebner
a – a – 1equation
max
pva–+tt can be written As I wrote in0 “Yield to Inflation” (Quant30U, Q1 intertemporal60 trade-offs. As Milevsky 90 says, Fisher
LI a
∑
ast Bthe=mortality-adjusted
(1+ r )
v – t Bpresent value of 2023), “Yields rose
Year from the 1950s until reaching “was the first to
Dm (y; c, 1T+ =q (tell
) y D ( y; c, T )
us
–j
how) y
to properly accumulate
v = t +1
death probabilities: their peak in 1981, and then fell until recently =Wt qc =our
and spend (1 + nestr) (W t1–1+–qIn
egg.” ct–1this,
) Fisher was

ln(q1a + t ) + – T
(
P y; c, qn )
∑ P(1≈+–r)Dmc∆y
∆ –t
ln(ct +1) – ln(ct ) = t–1 = W0
t =P0
Pc ( y ) = y1 1 + q
morningstar.com/products/magazine ( y f
) 43
 10th10Percentile
th
Percentile

Annual Payout
Annual Payout
2 2 Strategies 2.772.77

5th 5Percentile
th
Percentile
2.442.44
0 0
0 0 30 30 60 60 90 90
EXHIBIT 2 Year
Year EXHIBIT 3

Term Life Premiums for a 25-Year-Old Value of $100,000 Bequest for idea that it is better to receive something now
Woman With $100,000 Bequest a 25-Year-Old Woman than to have to wait for it. Therefore, it
is sometimes known as an investor’s degree
of impatience.
$100K
$100K $100K
$100K
96.32
96.32
4 . Milevsky describes this parameter as longevity
80.78
80.78
75 75 75 75 risk aversion, but I prefer interpreting it as
inflexibility with respect to consumption over time.
In other words, it measures how much the investor
Annual Premium
Annual Premium

50 50 50 50
dislikes fluctuations in consumption over time.
25 25 25 25 In EXHIB IT 4 , I illustrate the impact of this
Value
Value
parameter by plotting consumption over time for a
0 0 0 0
25-year-old woman with three different levels of
0 0 30 30 60 60 90 90 0 0 30 30 60 60 85 85
labeled Low (1.33), Mid (2), and High (4).
Year
Year Year
Year
Source: Author’s calculations. Source: Author’s calculations.
For the first 55 years (until age 80), with a low
level of inflexibility, the planned level of
$80K
$80K consumption is fairly flat. After age 80, planned
decades ahead of his time in that other great The left-hand side is the percentage change in
Inflexibility
Inflexibility consumption falls rapidly as survival probabilities
economists
60 60 such as Friedman, Franco Modigliani, annual consumption from year t to year t + 1 fall rapidly.
High
High
and Paul Samuelson would further develop Fisher’s in logarithmic form. Below, I discuss each
1.63 of the
1.63
Annual Consumption
Annual Consumption

ideas. Their work is now known as lifecycle finance. four parameters on the right-hand side: Stocks vs. Cash Allocation (Paul Samuelson,
40 40 MidMid
These economists were awarded the Nobel Prize 1915–2009)
0.04
0.04
for their work. In this section, I will discuss Fisher’s 1 ln(q1a + t ). This is the natural logarithm of The 7 Most Important Equations, Equation 5
20 20 and Samuelson’s in the next.
contribution the survival probabilities of a personLowof
Lowage a + t. Paul Samuelson
W 0 0
P0 = 0 0 0 Survival probabilities figure into the consumption It is hard to image an economist who was more
A(a,
Sometimes,0 00,Fisher’s
h) great contributions
30 30to calculation
60 60 because when planning90 90 influential than Samuelson. His 1941 Harvard
economics and finance are overshadowed by his
Year
Year consumption, it makes sense to take into account doctoraln =dissertation,
qT Foundations of Economic
a –a
one great blunder. qJust
maxa
before the crash of that the further the investor looks out into Analysis, placed economics on a solid mathematical
A(a, 0, h) =
1929, he declared ∑ t

that
( 1 + h) “stocks
t
are at a permanently the future, the less unlikely it is that the investor footing.f =Numerous
n– qT undergraduates have been
t=1
high plateau.” will be alive to enjoy consumption. This introduced to Keynesian
n
– jmacroeconomics–n andf
1+ R leads to consumption planned for the distant P = q
c
∑
j =1
+ 1 +
neoclassical microeconomics by his textbook, q
y
( 1 +) (
y
q first )
Pt = Equationt Pt –1
The future being less than consumption planned for introduced in 1946, Economics: An Introductory
1+ h
As is the case with other equations that I discuss the near future. However, if the investor Analysis. When I took n
introductory f– j classes–in qT

in this series,
qta+1 the person credited with the were to annuitize their wealth, they would be able P ( y; c, T ) = qc
macro- and microeconomics ∑( y
1 + qin 1977 ) (
+ 1and
y
+ q 1978, my )
o j =1
qequation
a+ t
= did
1 qta not write it down as an equation but to create a lifetime stream of income and professors assigned the 10th edition of Samuelson’s
f– j – qT
rather described the relationship in words. consumption without having to consider their textbook. To this day,∑ economics
D ( y; c, T ) =
n
j =1 q
j –f c
( )(
is taught
q 1+ q
y
)
+ using
T 1+ q
y
( )
Someone else 1 – qwould
a+ t
come along later and express survival probabilities. In this case, the term later editions.
LI1taB =
1
B P ( y; c, T )
the idea mathematically.
1+ r This is the case with ln(q1a + t ) would drop out of the equation.
the equation I present here attributed to Fisher. Samuelson was a spokesman for the Keynesian
a –a
Fisher expressed
max
qva–+his
t
idea in words in 1930, 2 . This is the logarithmic form of the real rate school of macroeconomics.n He debated his
LI t B =
a
∑
and 35 years( 1later,
+r)
t a+ t
– t LI1v – t BYaari, also of Yale,
vMenahem of return on investments, r. It is given by ln(1 + r). friend Milton Friedman (
P ( y; c, T ) = P y; c, q 1 + q
y f
)(
of the monetarist school. )
v= t
gave in the mathematical form that I now discuss. I emphasize the real rate of return in keeping He was an advisor to Presidents John F.
f– j f– j

pva–+tt = qva–+tt– 1 – qva–+tt

The Fisher/Yaari equation tells us by what
with Fisher’s point that returns must be adjusted
for inflation to be meaningful. In the following
Kennedy and
c
to follow
(1 +Lyndon
the
y
q )
Keynesian =
B. Johnson,
c
1 +advising
approach
q
to
y

handling
( them
)
q q
percentage we should change our consumption
a –a–1
examples, I set r = 2%, so = 1.98%
P ( y; c, T )
recessions by increasing government (
P y; c, qn 1spending.
+q
y f
)( )
each year, basedpvon
a+ t
– t four parameters. The
max

LItaB =
equationv = tis:
∑ ( 1 + r )
v–t B
3 . This is the logarithmic form of the real The Equation (
1+ q
y
–j
)
+1
= qc

ln(q a+ t
)+ –
subjective discount rate, . It is given by ln(1 + ).
I set = 1.5%, so = 1.49%. The real subjective
(
Samuelson’sP interests n
y; c, q )
went beyond macro-
and microeconomics, narrowly defined. He also
1
ln(ct +1) – ln(ct ) = discount rate is based on the economic did important work iny financial economics. In
( )
f
Pc ( y ) = y1 1 + q

1 μ– rf
44 = Morningstar (F + H)
2 Q1 2024 Dc ( y ) = 1
y (1 + ) – y
q
f
q
 A(a, 0, h) = ∑ t f = 50
n– qT

Annual Premium
t=1
( 1 + h) 50
n
–j –n

1 + Rt 25
P=
25 ∑
c
q
j =1
(
+ 1+ q
y
) (1 + ) y f
q

Pt = Pt –1

Value
1+ h 0 0 n
f– j – qT

q a
0 30 60 90 P ( y; c, T0) =
c
q ∑ (130+ ) + (160+ ) y
q
y
q
85
t +1
EXHIBIT 4 Year o Year j =1
q1a + t =
particular,qbuilding off the work of Fisher, he made
a
Consumption Over Time for a 25-Year-Old Woman With Threen Levels of Inflexibility
f– j – qT
( ) (1 + ) ( )
t
j –f c y y
advances in lifecycle finance that are part of ∑ j =1 q q q + T 1+ q
1 – qa+ t D ( y; c, T ) =
theaBfield
LI1 = to this 1day. BHe also debunked the notion P ( y; c, T )
t
1+ r $80K
of “time diversification,” which is the idea that the
longer your time horizon, the less risk there Inflexibility
a –a
max
q a+ t
60
is ain
LIt B =
investing in stocks;LI1
∑
time horizon,
v – t

)
v–t
+ r higher
( 1the
therefore,
a+ t
v–t B
the longer your
your asset allocation
P ( y; c, T ) = P y; c, ( n
q )(1 + ) High
1.63
y f
q

Annual Consumption
v= t

should be in stocks. 40
(1 + )Mid
f– j f– j

p = q
a+ t
v–t
a+ t
v– t –1
–q a+ t
v–t c
(1 + ) y
q
= c 0.04
y
q

Samuelson showed that risk does not q q

P ( y; c, T ) P ( y; c, ) (Low
1+ )
n y f
20 q q
changea with – a – 1the time horizon. Therefore, an
max
pva–+tt 0
investor
LI t B =
a
∑ should also vallocate
W0 ( 1 + r ) – t
B the same 0
0 30 (1 + ) q
y
–j

Pfraction
0
= v of total
= t +1 wealth to stocks at all times = 60 c
q
90
(the balanceA( a, 0,being h) invested in cash). This brings Year P ( y; c, ) n
q
us to the Samuelson ln(q a+ t
equation
1
) + as
– presented Source: Author’s calculations.
n = qT
ln(c ) – ln(c a )– a=
t +1 t q a

( y f
)
max
by Milevsky:
A(a, 0, h) = ∑ ( 1 +
t

h)
t
EXHIBIT 5
P ( y) = 1 1 + q
fc = n– qTy
t=1
μ– rf An Illustration of the Value of Human Capital, Financial Wealth,
1 y – j f andy Total Wealth
n

PDc =( y ) q=∑y (1 + q ) –+q(1 + q ) (1 + q )

= 2
(F + H) c 1
–n
y f

1 + Rt Over a Lifetime j =1
Pt = Pt –1
1+ h
where: P n( y; c, Ty) f– j – qT

q a
$3M Pm( y;(y;c,c,T )T =) = q
D c
∑( +
P ( y; 1c, T )q ) + (1 + ) y
q
t +1 o j =1 Total Wealth
.
q1a + t == dollars
q of total wealth invested in stocks
a
0.02
f– j – qT
( )( ) ( )
t c
j –f y y
(the balance being invested in cash) ∑D ( y; c, T ) 1 +
n
+ T 1+ q q
2 j =1 q q
– q1a + t of average relative risk
= the1coefficient Dm( y;(y;c,c,T T) )==
D Human
y
LI1taB = B 1+ P ( y; c, Capital
T)
q
aversion 1+ r 0.02
µ = the expected return on stocks ∆P
a –a
qva–+tt rate (the 1 ≈ – Dm ∆y Financial
r = the risk-free
max
return on cash) P
LIf taB = ∑ a+ t
v – t LI1v – t B
P ( y; c, T ) = P y; c, ( n
)(1 + ) Wealth
y f
Wealth

q q
= the standard
( +
1 r ) deviation of stock returns
v= t
0 0
F = financial wealth D
0 30 DV6001 = yP f– j y = P Dm 90y f– j •

Ha + t = human capital (the present value of future

pv – t = qva–+tt– 1 – qva–+tt Year c
(
1+ q 1 + q
= qc
) 1+ q ( )
wages and benefits) q
P ( y; c, T ) ( )( )
y f
Source: Author’s calculations. P y; c, qn 1 + q
a –a–1
Note
max

that there is pva–no

+t
t time element in this equation. P– j ( y; c, T )
LIt B =
a
∑
It shouldv = hold
v–t B
1 +allr )times. Also note how
(at $1.5M C (y; c, T1)+=qy ( )
t +1
= q c P ( y; c, T )
the dollars invested in stocks vary with three
key variables: ln(q1a + t ) + –
So, if Samuelson is right about time diversification,
why do investors reduce the percentage
Human capital,
(
P y; c, qbeing
)
n the present value of future

wages and benefits (such as Social Security in

Risk Aversion
Dollars Invested In Stocks

ln(ct +1) – ln(ct ) = 1.0 to stocks in their investment portfolios Low

allocation the U.SC.),( y;isc,very
T ) =muchy like an asset. As
( )
f EXHIBIT 5
Pc ( y ) = y1 1 + q 0.01
1 It varies inversely with the coefficient of relative as they approach retirement? 1 This is where shows, human capital decreases over time as the
f – j – 2Mid

=
1 μ–
risk aversion ( r).f
2
(F + H)
lifecycle finance comes into play.
0.5
cash flows
c nthat
q ∑ j =1 1q
Dc ( y ) period.
and shorter
( () ( ) ) (
f –it
j discounts
f– j–1

= y 1 +Inq the yq f1
occur
+ q over
– meantime,
q
y a shorter
0.01
financial
)
P ( y; c, T )
2 It is increasing in the ratio of the expected excess According to lifecycle theory, as developed by wealth increases during a person’s working High years,
return on stocks to the riskiness of stocks. Samuelson 0 and other Nobel laureates, investors do as they save toward their
(
P y;y c, T retirement;
– qT –) 2 0then, it
not make their
0 consumption and investment
30 + 60 as (it
1
Dm T(y; Tc,+T q) = 1 + q
decreases is spent )(
P ( y; c, T ) 90 retirement.
down during )
. decisions based
Year solely on financial wealth. Rather, Adding financial P ( y;wealth
c, T ) and human capital
they make these decisions on the basis of total to get total
∆ P wealth, we
D+( y; can see that total wealth
1 c, T ) 2
3 It is increasing in total wealth (F + H). wealth, which includes human capital. typically (y;≈ c,– TDm) ∆y
DPm declines =over 2 Cy(investor’s
the ∆y ) lifetime.
1+ q
100
Risk Aversion
∆P
age of Financial Wealth

Wt =≈ –HDt +m ∆y
Ft
P is invested in risk assets, so overLow
1 Exhibit 5 is a stylized chart without investment risk, designed to demonstrate overall trends in wealth. In reality, the portfolio of financial wealth time, there are
fluctuations in its value. The discounted cash flows in the calculation of human75
capital can also be subject to fluctuations, so that human capital can be subject to fluctuations over87.24time.
D
W = =(1 +P r) (Wyt –1 –= cPt–1 )Dm
DVt 01 • Mid
50 1+ q 58.16
morningstar.com/products/magazine 45
T
–t
∑ (1 + r) ct–1 = W0 High
s
 Strategies

E X H I B I T 6 shows the dollar allocations to stocks
based on the Samuelson equation for three
levels of risk aversion: Low ( = 1.33 ), Mid ( = 2 ),
and High ( = 3 ). It shows how the higher the
level of risk aversion, all other things being equal,
the lower the dollar allocation to stocks.
$3M the desired dollar allocation to stocks,
To achieve
the investor can only allocate to stocks in the
financial wealth account. This is usually expressed
as the percentage
2 of financial wealth in stocks.
When the investor is young, their wealth is
$3M
predominantly in human capital, which is usually
1 Financial
Wealth
treated as being like fixed income. So, even if
financial wealth were 100% stocks, total wealth
would be largely fixed income. In this way, a young
investor has a high level of risk capacity in that
they can invest their financial wealth heavily
in stocks while still maintaining a moderate level
of risk in their total wealth.
Before retirement, over time, as human capital
Total Wealth
0.02 their risk
decreases and financial wealth increases,
capacity declines, and they allocate less
Humanand
less to stocks to maintain a constant Capital
percentage
0.02
allocation to stocks in their total wealth.
Total Wealth
0.02
Wealth
The systematic decrease in the percentage
allocation to stocks in financial wealth that arises
out of taking human capital into account is
one way of motivating an asset-allocation glide
path. A glide path can be achieved either
by an investor shifting between equity and
fixed-income funds over time or by purchasing
a target-date fund. However, a target-date
fund is a one-size-fits-all solution, so the
glide path that it follows may not be suitable
for a given investor.
Simply applying the Samuelson equation
as it is may not be practical. The equation may
say that the investor should put more

2 0Human
0 dollars in stocks than there are dollars of financial
EXHIBIT 6 Capital wealth, so that the percentage stock allocation
0 30 60 90 0.02
Dollar Allocations
Year to Stocks Based on Samuelson’s Equation for Three Levels is greater than 100%. Unless the investor
of Risk1Aversion: Low, Mid, and High Financial is willing to use leverage, this is not practical.
Wealth
Wealth

Therefore, when applying the Samuelson

0 0
$1.5M equation, it may be necessary to limit the stock
0 30 60 90 allocation to 100%.
Year Risk Aversion
StocksInvested In Stocks

Low Another constraint that could be placed on the

1.0
0.01 percentage stock allocation is that it never
$1.5M Mid increases over time. The reason for this constraint
0.01 is that it may not be acceptable to the investor
0.5 Risk Aversion
to increase the percentage stock allocation. In
High
Low
Dollars Invested InDollars

1.0 EXHIB IT 7 , I plot the percentage of financial wealth

0 00.01
in stocks over time for the three levels of risk
0 30 60 90 Mid aversion that I use in EXHIB IT 6 . I calculated these
Year 0.01
0.5 glide paths by using the Samuelson equation,
Source: Author’s calculations.
High subject to the two constraints. As expected,
0 0 the higher the risk tolerance, the lower the equity
EXHIBIT 7 100
0 30 60 90 Risk Aversion percentages for each year.
of Financial Wealth

Glide PathsYear for

Different Levels of Risk Aversion From Samuelson Equation
Low Conclusion
With Constraints
75 87.24 In this four-part series, I covered 11 equations
Mid that Moshe Milevsky identified as important
50
100 58.16 for either planning for retirement or for being
Risk Aversion
Wealth

High retired. These equations are the product of some

Percentage

Low
of the best minds in history, and in some
in Stocks

25
75 29.08
87.24
Percentage of Financial

cases, as Milevsky’s excellent writing shows, there

0 Mid is an interesting story behind them. Hopefully,
50 0 30 60 90 58.16
this review of these equations will prove useful
Year
High in practice. K
in Stocks

25 29.08
Paul D. Kaplan, Ph.D., CFA, recently retired as director
0
of research at Morningstar Canada.
0 30 60 90
Year
Source: Author’s calculations.

46 Morningstar Q1 2024
A Different Approach to Value Investing
Avantis U.S. Large Cap Value ETF seeks low prices relative
to profitability.
BEST IDEAS: MANAGER

Daniel Sotiroff Avantis U.S. Large Cap Value ETF AVLV

This article is adapted from the fund’s Morningstar Global Fund Report dated Stats 12/31/2023
Jan. 4, 2024. Morningstar Medalist Rating Morningstar Category Expense Ratio
„ Large Value 0.15%
Avantis U.S. Large Cap Value ETF AVLV pursues stocks trading at lower
Total Assets 1-Year Return 1-Yr % Rank in Cat
multiples relative to their profitability. It’s an attractive combination $2.1 Billion 17.37% 17
of risk factors that should lead to better risk-adjusted performance than the
Russell 1000 Value Index. Morningstar Pillars 12/31/2023
Process People Parent
Avantis’ managers select stocks from the top 90% of the U.S. market by market Above Average Above Average Average
cap, excluding REITs and utilities. (The former are held in a separate real estate
fund, while the latter have less upside potential owing to industry regulations.) Growth of 10K 12/31/2023
They sort this large cohort by price/book ratio, adjusted to remove goodwill, and
a cash-based measure of profitability. The portfolio holds the top 25% of stocks $14K
Avantis U.S. Large
based on the combination of those two risk factors, preferring names that Cap Value ETF
trade at lower multiples with greater profitability. The managers initially weight 12 $12,186
these stocks by market cap before assigning market-cap multipliers to scale Morningstar US
their weightings. Those trading at a lower price/book with greater profitability Large Value
10 $12,055
receive larger multipliers than those with opposite characteristics.
8
The portfolio’s average profitability, as measured by return on invested capital, 09/30/2021 06/30/2022 03/31/2023
has consistently landed above the Russell 1000 Value Index, as has its
average price/book ratio. These two characteristics are often closely related, Morningstar Style Box 09/30/2023 Risk Profile 12/31/2023

as greater profitability commands higher price multiples. Value Blend Growth Snapshot as Mstar US
of most recent Period Fund % Lg Val %
Large

portfolio.
The portfolio can hold growth stocks if their profits justify their relatively 1-Yr Return 17.37 11.82
steeper multiples. Apple AAPL has landed among the fund’s 10 largest holdings
Mid

1-Yr Standard Deviation 17.15 12.75

since inception. Overall, the portfolio retains an emphasis on relatively
1-Yr Sharpe Ratio 0.71 0.53
cheaper companies. The fund had a sizable 17% stake in the energy sector at
Small

the end of October 2023, but its strong emphasis on profitability should steer 1-Yr Max Drawdown –10.76 –9.69
it away from these stocks should their profits decline.
Top 5 Sectors 12/31/2023
Avantis launched the exchange-traded fund in September 2021, and the mutual
■ Fund ❙ Category Average
fund version followed in June 2022. Both have delivered strong index-relative
p Industrials 11.37 16.60
performance over their short lives. The ETF beat the Russell 1000 Value
Index by 3.2 percentage points annualized from its inception through November t Consumer Cyclical 6.66 16.48

2023. Avantis charges 0.15% for both, an expense ratio far lower than many o Energy 9.17 15.22
Morningstar Category peers. K y Financial Services 14.25 18.83

Daniel Sotiroff is a senior manager research analyst for Morningstar Research Services LLC. i Communication Services 5.93 11.06
0% 5 10 15 20

morningstar.com/products/magazine 47
 Strategies

Cautious but Crafty

Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF has
a leg up on the market.
BEST IDEAS: PASSIVE

Ryan Jackson Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF GSLC
This article is adapted from the ETF’s Morningstar Global Fund Report dated Stats 12/31/2023
Dec. 20, 2023. Morningstar Medalist Rating Morningstar Category Expense Ratio
„ Large Blend 0.09%
Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF GSLC takes small,
Total Assets 5-Yr Annlzd Return 5-Yr % Rank in Cat
calculated risks that should give it a leg up on the broad market. Sound $11.3 Billion 15.02% 42
diversification and a low fee add to its appeal.
Morningstar Pillars 12/31/2023
This index strategy spans most of the U.S. large-cap market and favors stocks Process People Parent
with strong value, quality, momentum, and low-volatility traits—four factors Above Average Average Average
that are worth pursuing. The first three have historically been associated
with market-beating returns, while low-volatility stocks reduce portfolio risk. Growth of 10K 12/31/2023
Factor payoffs tend to ebb and flow on different cadences, so combining them
should improve risk-adjusted returns no matter the environment. $14K
Morningstar US
Large Core
This portfolio combines four sleeves that each focus on a different factor— 12 $13,123
a conservative but sensible strategy. Within each factor sleeve, the index
Goldman Sachs
tilts stocks from their market-cap weight based on the strength of their factor ActiveBeta U.S.
10 Large Cap Equity
exposures. Combining the four sleeves at the portfolio level dilutes
$12,932
overall factor exposure because there’s little overlap between them, and 8
different stocks’ factor traits frequently offset. That said, the “mixing” 01/31/2021 01/31/2022 01/31/2023
multifactor approach helps curb turnover and the associated transaction costs.
Morningstar Style Box 09/30/2023 Morningstar Ratings 12/31/2023

The fund looks similar enough to the broad market that its mild tilts add Value Blend Growth Snapshot as Mstar Mstar Mstar
meaningful value. Roughly 76% of this portfolio overlapped with the S&P 500 of most recent Period Return Risk Rating
Large

index as of November 2023, and it posted a paltry 1.3% tracking error portfolio. QQQ
3-Yr Average Average
against it over the past three years. In the context of this low active risk,
5-Yr Average Below Avg QQQ
Mid

the fund’s factor exposures seem more potent. Plus, it doesn’t take much
10-Yr — — —
for the fund to recoup its fee. Its 0.09% expense ratio makes it one of
Small

the cheapest multifactor funds available and ranks in the large-blend peer Overall Rating QQQ

group’s cheapest decile.

Top 5 Sectors 12/31/2023
A broad reach keeps sector- and holding-level concentration at bay. Each
■ Fund ❙ Category Average
sector allocation hewed within 2.5 percentage points of the S&P 500
a Technology 26.73 28.85
as of November 2023. Like that index, tech stocks led the way, with a 29%
portfolio weight. The top 10 holdings represented between 15% and d Healthcare 13.72 13.95

25% of the portfolio over the past five years, comparable to the Russell 1000 t Consumer Cyclical 10.07 12.08
Index, the large-blend Morningstar Category index. K y Financial Services 10.47 12.99

Ryan Jackson is a manager research analyst at Morningstar Research Services LLC. p Industrials 9.31 9.96
0% 10 20 30

48 Morningstar Q1 2024
An Attractive Transformation
Secular tailwinds support growth and margin expansion
for Johnson Controls.
BEST IDEAS: EQUITY

Brian Bernard Johnson Controls JCI

This article is adapted from a Morningstar equity research report dated Stats 12/31/2023
Jan. 3, 2023. Morningstar Rating Sector Industry
QQQQ p Industrials Building Products & Equip
Johnson Controls JCI has transformed over the last decade, shedding its
automotive exposure and expanding its commercial building products Price Fair Value Estimate Uncertainty
$57.64 $72.00 Medium
portfolio with the addition of Tyco’s fire and security businesses. Now, roughly
45% of revenue is tied to commercial HVAC, and 40% is from fire and
Economic Moat Capital Allocation Market Cap
security. Residential HVAC, industrial refrigeration, and other solutions Narrow Standard $39.22 Billion
account for roughly 15% of revenue.

Price/Fair Value 12/31/2023

Over the next five years, we project that Johnson Controls will increase
revenue at a mid-single-digit compound annual rate as it benefits from $100
product innovation (supporting market share gains and pricing), increased
Fair Value
service penetration (a higher-margin opportunity), and participation in Estimate
80 Per Share
meaningful growth themes (energy efficiency, smart buildings, and indoor
72.00
air quality solutions).
60 Month-End
Closing Price
We’ve been impressed by Johnson Controls’ cost synergies it produced after 57.64
40
the 2016 Tyco merger and subsequent cost-reduction initiatives. The firm’s
01/2021 01/2022 01/2023
profit margins have also been bolstered by its growing services and connected
products offerings. We project adjusted operating margin to expand to
approximately 14% over the next five years compared with 11%, on average,
over the trailing five years. HVAC equipment, building automation and controls, and fire and security.
We believe that Johnson Controls’ technological know-how is a key
While HVAC-focused peers like Carrier Global CARR, Lennox International LII, differentiator, especially for large, complex commercial building systems.
and Trane Technologies TT outperformed the broader U.S. equity market in 2023, Indeed, there are only a handful of competitors in that specific market.
Johnson Controls was a laggard, perhaps due to its significant commercial
exposure (given fears of slowing commercial construction) and uneven financial New commercial HVAC, building automation, and fire and security systems are
performance (free cash flow conversion has disappointed). And Johnson large investments that can require lengthy installation times. As such,
Controls trades at a significant discount to HVAC peers; its forward price/ we believe building operators would be reluctant to completely replace these
earnings multiple as of early January was 16 compared with the peer systems and instead prefer to upgrade, retrofit, or reconfigure existing systems.
group average of 22. Nevertheless, we're confident that management can close
this valuation gap as the firm proves that its strategy can deliver stronger After reviewing Johnson Controls’ fiscal fourth-quarter results and full-year
financial performance, including organic top-line growth and margin expansion. 2024 outlook, we’re maintaining our $72 fair value estimate, which
equates to about 20 times our projected fiscal 2024 EPS estimate and a forward
We think Johnson Controls benefits from durable competitive advantages enterprise value/EBITDA ratio of about 13. K
that should support economic profits for at least the next 10 years. As
such, we assign it a narrow economic moat rating. Johnson Controls’ building Brian Bernard, CFA, CPA, is director of industrials equity research for Morningstar Research
Services LLC.
technologies and solutions business holds a strong position in commercial

morningstar.com/products/magazine 49
 Investors

An Oasis of Bond Opportunities

Fixed income is relevant again—finally.

Undiscovered Manager MORNINGSTAR CONVERSATION whose funds have earned Silver and Gold ratings
56 GoodHaven 2.0 Brian Moriarty from Morningstar’s fixed-income manager
research analysts: Andrew Norelli, lead manager
Sector Rap of the multisector JPMorgan Income JMSIX
59 Restaurant Revolution The bond market ended 2023 with a bang. and comanager of JPMorgan Core Plus Bond
Easing inflation pressures and a moderation of the HLIPX; Ford O’Neil, comanager of Fidelity
User Profile Federal Reserve’s interest-rate policy sparked Total Bond Fund FTBFX and Fidelity Total Bond ETF
62 Keeping Cool fixed income’s fourth-quarter comeback. Meanwhile, FBND; and Jerome Schneider, head of
the stock market surged. The current environment Pimco’s short-term desk and lead manager
makes bonds relatively attractive for 2024— of several short-term strategies and comanager
but the possibilities of continued inflation and of Pimco Active Bond ETF BOND.
recession still loom.
Our conversation took place on Dec. 12.
For insight into the current state of the bond The transcript has been edited for length
market, I turned to three portfolio managers and clarity.

Andrew Norelli, portfolio manager at J.P. Morgan Ford O’Neil, portfolio manager at Fidelity Jerome Schneider, portfolio manager at Pimco.
Asset Management. Management & Research.

50 Morningstar Q1 2024
Brian Moriarty: There’s been a dramatic turnaround
in the fixed-income markets over the last six
weeks or so. Ford, can you lay out what has happened?
Ford O’Neil: At the beginning of 2023, lots
of smart economists were expecting a recession.
We were in a late cycle from a monetary policy
perspective; whether it was an inverted yield curve
or leading economic indicators, or global
short rates, it all made sense. Our work said that
we were more midcycle from a private-sector
perspective. As the year unfolded, you had China
reopening its economy, and you still had significant
fiscal largesse from the U.S. government
spurring on the economy. Additionally, the consumer
remained very, very strong: They had locked
in their mortgage rates at 3%, and they hadn’t
expended all their savings, as a lot of people
expected. Lastly, the September SEP [the Federal
Reserve’s Summary of Economic Projections]
still expected another hike in December.
Then, sentiment reversed in the middle of
October. Suddenly, there were expectations for
weaker growth in the fourth quarter. You
started seeing green sprouts in the inflation data.
Lo and behold, you started hearing from some
Fed governors that they were taking a more
balanced view—meaning that they were as likely
to hike as they were to lower rates.
That rang the bell, and we got the “everything rally”
in November. The Bloomberg Agg had its
best month since 1985, the first year I was in the
business. The Fed hadn’t unfurled the mission
accomplished banner yet, but they clearly started
hinting that the hiking cycle was nearing
a peak, which the market viewed as good news.
Andrew Norelli: It’s been a paradigm shift
in fixed income for several reasons. The
primary one is, of course, the Fed tightened
monetary policy dramatically, almost setting a
new precedent for how quickly it could be
done. It’s been a complete reset in the amount
of future return and future income that can
be expected from fixed-income markets across
the quality spectrum.
The data that was released in October increases
the probability of a soft landing. When market
practitioners talk about that, commonly
it’s a knee-jerk reaction to stock markets being
buoyant, interest-rate markets being well
behaved, and the economic data being not too hot
and not too cold.
But when you define it mathematically, it’s
very difficult for the central bank to engineer a soft
landing because we are at or near full employ-
ment. That means the central bank has to balance
four things in perfect harmony in order to
achieve a durable soft landing. First, you need the
unemployment rate to stay stable at NAIRU, the
nonaccelerating inflation rate of unemployment,
neither higher nor lower.
Second, you need growth to stay at our
potential growth rate [the rate of growth that an
economy can sustain at full employment
without generating excess inflation]. Putting
unemployed workers to work adds growth
and doesn’t really add inflation pressure. But once
you’re at full employment, potential growth acts
like a speed limit on growth.
Then you need the policy rate to be right, the
neutral rate. Right now, we are above the neutral
policy rate. Because inflation—and growth—
are responding to tight monetary conditions, it’s
clear that we’re in fairly restrictive territory,
and the Fed would acknowledge that.
Finally, you need inflation to be stable at the
inflation target—not above, not below,
and not trending up or down. You need to flatline
at the inflation target of 2%. And most of the
ways that you can look at inflation today would
suggest that we’re still a bit above target,
and it’s trending downward.
In November, we got very encouraging data from
a soft-landing perspective. Growth slowed
sequentially compared to Q3; it’s kind of right at
potential right now, but maybe trending down-
ward. And we had an encouraging inflation report
toward target and the unemployment rate
not really rising, and in fact, dropping by two
tenths. However, when you look back in history to
1948, when the unemployment rate data starts,
we’ve never spent longer than about 24 months at
full employment without the unemployment rate
going higher and having a recession.
Moriarty: Jerome, it’s possible now to get quite
an attractive yield on the short end of the fixed-income
markets. Have recent market moves done anything
to change that attractiveness?
Jerome Schneider: Investors have been
challenged over the past decade or two to produce
returns in a low-rate environment. Driven by
expectations of low rates for longer, they pressed
on the accelerator of capital appreciation.
That fundamentally changed as we got into 2023.
The second component of total return—
income and yield generation—is now providing
a glide path for investors to reduce risk while
at the same time hoping to obtain historically
attractive total returns. When rates recalibrated,
it elicited a response from a whole generation
of investors who had never even thought
about fixed income primarily. Cash became king
very quickly.
But now begins the discussion of how to create
portfolios that are more diversified to withstand
the intermediate future that we see in 2024.
Perhaps not a hard recession, but something less
than the 5%-plus growth rate we witnessed
in the third quarter of 2023. There’s going to be
a natural tendency for people to move out of cash
into duration strategies, which may not necessarily
be at the far end of the curve but at least
gets them out of that money market mindset.
The marketplace right now has begun to expect
that the Federal Reserve will cut rates to buoy risk
markets and the economy as we enter 2024.
At the same time, the expectation is that investors
should move out the curve, add interest-rate
exposure on the fixed-income side, because
there’s potential for capital appreciation. That’s
a discussion that’s beginning to percolate within
the advisor and investor landscape.
Are there better ways to adapt to the
fixed-income market for a landing that may
not be the soft landing that the broader
market expects? We think that there’s a better
opportunity slightly beyond that money
market space, leading to structural
outperformance over the secular horizon.
Moriarty: Ford and Andrew, how have higher
short-term yields affected your portfolio construction?
morningstar.com/products/magazine 51
 Investors
O’Neil: It was a fairly easy decision in 2022. We
didn’t own any Treasuries between zero and
five years. If a two-year is offering you 25 basis
points in yield, the risk/reward is pretty
unattractive. We thought there was going to be a
hiking cycle, but we never expected to see four
75-basis-point hikes in a row. So, underweighting
the front end of the Treasury curve worked well.
Toward the later innings of the hiking cycle, we
added a lot of floating-rate securities, AAA
securitized products in the asset-backed area. In
funds that can be a little more aggressive, we
added BB and B leveraged loans. You were getting
rising SOFR [the secured overnight financing
rate] yields, plus very attractive spreads on top of
that, without risking the capital losses that
fixed-rate securities were suffering in the front
end of the curve. In 2023, we have embraced
these higher yields as we found bargains across
the short end of the curve.
Exercising Flexibility
Norelli: This is one of these situations where
active management and flexible mandates,
as all three of us manage, are important for our
fixed-income client base. Interest-rate
duration is not your friend in an environment
that’s characterized by tightening policy into
unexpected inflation.
Remember back at the beginning of this,
in 2021, the central banks told us they wanted
inflation. They didn’t even view that as a negative
consequence. We were able to anticipate
that inflation was the inevitable consequence of
monetary-financed fiscal transfers. You position
your portfolios as short as they can be from
an overall duration-risk perspective, depending on
the mandate. Once spreads have adjusted,
which happened at points in the last two years,
then you start to look at short-dated securitized
spread products where you have good
fundamental visibility on the underlying collateral
creditworthiness and that pay you a significant
spread over the base rate.
We were successful in shortening our portfolios
dramatically. But as Jerome said, times are
52 Morningstar Q1 2024
a-changing. If we go into a recession, it’s quite
likely that long-term yields will fall, providing
upward price pressure on a fixed-income allocation
that has duration when equities may be
declining. Importantly, that correlation right now
between risk assets and duration is still
what we call “wrong-way,” meaning a positive
price correlation between bonds and stocks.
For now, as was the case for most of 2022
and 2023, duration is actually additive to a 60/40
portfolio risk profile.
We’re keenly paying attention to when we may
flip back to negative price correlation between
bonds and stocks. I think we’re pretty darn
close. For the 2024 calendar year, I expect fixed
income with interest-rate duration to provide
ballast for the first time in three years to an equity
portfolio. And, by the way, for a chosen fixed-
income risk profile, the income production is
triple-ish to what it was in 2022 and maybe 5 times
what it was in 2021.
Schneider: Investors are thinking about the
volatility that could emanate from the markets’
digestion of all these economic and policy
factors. Not to mention geopolitical factors, which
are unknown unknowns at this point, and the
elections, which are known unknowns. When you
put it all together, investors are thinking ultimately
of not just returns, but volatility-adjusted returns in
2024. This will probably lead to a bit more of a
defensive posture tilted toward income generation.
Norelli: I agree with that. Equity risk premiums
don’t look so good compared to what’s available in
fixed income with much less volatility.
Moriarty: Given the pace of the tightening, the markets
seem to have done a good job of digesting it. Are
you all surprised that more things did not break—and
are you still waiting for something else to break?
Norelli: I am surprised that Silicon Valley Bank
and the ensuing regional bank fallout was
not sufficient to tip the U.S. into recession.
However, the response from the Fed massively
increased the monetary base, the money
supply, back in March. That is one factor that
caused the actual money in circulation in the U.S.
to be about the same as it was when the Fed
started QT [quantitative tightening], even though
they dropped assets by $1.3 trillion at the time
of our conversation here today. That has bought
time in this expansion. But I think they’re at
a precarious balance of policy and price level and
economic output; it prolonged the expansion, but
it did not remove the risk of something breaking.
O’Neil: I have been analyzing fixed-income
markets for 34 years at Fidelity, but experience
hasn’t been a friend in the last three years,
with the pandemic, 9% inflation, and $5 trillion of
fiscal stimulus and $5 trillion of QT all in the
last 36 months. It’s awfully hard to say what we
should expect and not expect given some
of the factors that we’ve had to live through.
Schneider: It’s easy to think that the game
is over, but it’s probably just halftime. While we
have done a great job removing systemic
risks due to the Fed’s policy measures, investors
became acutely aware of the idiosyncratic
risks—credit risks, equity risks, things like that—
in specific market contexts. That theme is going to
continue to percolate in 2024 and beyond
and is something that we as active managers must
use resources to underwrite and understand
and then pivot to or away from as we see fit. That
maneuverability will determine outcomes over
the cyclical horizon.
Moriarty: Jerome, aside from the idiosyncratic SVB
case, what is the downside of higher short-term yields?
Schneider: There are three elements of those
higher short-term rates that people should be
made aware of. Investors celebrated higher
short-term rates by putting money into money
market funds. But being in a money market fund,
while it has a relatively high nominal rate in recent
historical context, is a drag on performance.
The average money market yields below the
Federal Reserve’s benchmark rates. Investors are
paying for the right for liquidity to the tune
of 25 to 50 basis points or more. Even by moving
slightly out the curve, you could remain up in
the quality stack with AAA asset-backed securities
and get closer to 6% or 6.5% absolute yields.
The second thing is what higher yields mean
in a practical sense for the financial system. The
cost of capital is higher, which means that
transactional costs have gone higher. We can see
that through liquid markets like Treasuries and
sovereign bonds, as well as through more bespoke
markets like loans and mortgages. Investors must
be mindful not only of relative value opportunities
in terms of credit and risk, but also the cost
of moving into and getting out of the asset class.
The third element is that issuers, the borrowers in
the capital markets, have been buying assets
at low yields. We saw that in the regional banking
crisis, where asset/liability mismatches became
apparent. In the nonfinancial sector, we’re
also seeing a potential for stress as lower-quality
Equity risk premiums don’t look so good
compared to what’s available in fixed income with
much less volatility.
Andrew Norelli
arenas have to refinance their debt burden.
The private market will see some of those impacts
because interest coverage ratios may not be as
sufficient as they were in a low-rate environment.
This is not only an early warning, but also
a potential opportunity for investors as we get
a more transparent look into some of those private
markets in 2024.
Norelli: Eventually, the market will be forced
to reckon with a cash shortage, and the probability
of a funding crunch will rise. I think the reason we
haven’t had it yet is that the drop in the Fed
reverse repo facility from a bit over $2 trillion down
to around $600, $700 billion now has been an
offset to the monetary impact of QT. So, liquidity
has been abundant. Every time a bank needs
reserves, and they’re willing to pay just above the
reverse repo rate for it, they’re going to get
filled from the money market fund universe. I think
the reverse repo facility will go all the way back
down to zero around the middle of 2024,
extrapolating from current trends. QT is very likely
to be proceeding still. When reverse repo
can no longer act as a shadow offset to the
monetary impact of QT, then the risk rises quite
significantly of a funding crunch and the
traditional impact of a funding crunch on risk
tolerance. But we still have a little more
runway left.
Moriarty: Ford, has your team noticed a material
impact of rising costs in the bank loan market
or in high yield or corporates—areas where companies
might run into trouble? Has it affected your portfolio?
O’Neil: As of now, no. We’ve scrubbed below-
investment-grade companies that have lots
of leverage via floating-rate loans, which become
riskier as short-term rates rise. For those
highly leveraged companies that are willing to
answer the question whether they’ve hedged
any of that floating-to-fixed risk, if the answer’s no,
we would most likely avoid those securities.
But as of right now, given the robustness of the
economy, defaults have been very small.
Landing Lights
Moriarty: Let’s go into a little bit more detail on the
probability of a soft landing and expectations.
Norelli: Markets can continue to embrace
the soft-landing optimism for a bit longer, but the
probability is fairly narrow over the intermediate
term. The Fed needs to be able to continue this
period of economic expansion, meaning positive
economic growth, without inflation reaccelerating.
That’s possible, maybe even probable, over
the near term, but it’s historically been difficult
to fine-tune policy to prolong a period of full
employment that lasts several years.
Now, there are escape hatches. We think
about what the speed limit is on growth at full
morningstar.com/products/magazine 53
 Investors
employment: Growth without inflation
at full employment is demographic effects plus
productivity effects—call it 0.5% labor force
growth and 1% productivity growth, which gets
you to 1.5%. That is similar to the GDPNow
forecast for Q4 as we sit here at the beginning
of December. If we get a big expansion in
the labor force from immigration, that would be
very helpful and lift the speed limit on growth in
the absence of inflation. Or if we get a big
productivity renaissance—the potential for that
from artificial intelligence has been well
telegraphed, but it can come from any source.
I have been analyzing fixed-income markets
for 34 years at Fidelity, but experience hasn’t
been a friend in the last three years …
Ford O’Neil
54 Morningstar Q1 2024
Looking out a year, the most probable outcome
is that the Fed is unable to balance growth
and inflation risks while we’re at full employment
and that we end up in a recession where the
unemployment rate rises a couple of percentage
points. The risk is that inflation reaccelerates,
which right now, the market isn’t worried about.
But when you’re at full employment and
you have above-potential growth, the textbook
says you get inflation. Weirdly, if the data’s
too good, it would feel like 2022 again, with bonds
and stocks down at the same time. We haven’t
fully ruled that out yet. It’s too soon to declare
that the probability of a reacceleration of inflation
is zero, because we’re at full employment and
growth is volatile.
Moriarty: Ford, what’s your take?
O’Neil: Forecasting accurately is virtually
impossible. I prefer nowcasting, which is more
along the lines of thinking about what sectors and
securities are rich and cheap in the market and
what the potential paths of the economy may be.
I would say that real rates were very cheap
in the middle of October at 2.5%. They’re still very,
very cheap relative to the last 20 years. I think
Treasury rates are attractive and on the spread
side, short and intermediate investment-
grade corporate bonds. You’re close to the bottom
quartile in terms of richness for longer-term
investment-grade bonds, so not a lot there left in
the tank. Non-investment-grade spreads and
high-yield loans are fair. If we get the soft landing,
even a mild recession, I expect rates to be lower
and spreads probably not to do much. Maybe
high-yield loans continue to tighten a little bit. If
we get the hard recession, I think rates go a
lot lower and spreads go a lot wider. The biggest
concern I have is stagflation, which I’m not
expecting. I would rank the probability of these
scenarios as soft landing/mild recession, then hard
landing, then stagflation. In the first two, rates
tend to do fairly well. So, therefore, intermediate
Treasuries are probably one of the more attractive
asset classes, and that’s in the portfolio today.
Moriarty: Jerome, what are Pimco’s expectations?
Schneider: We see a case for marginal growth in
2024 that probably leads to a very modest
recession. A hard landing seems to be an outlier
event to us. We put GDP growth in 2024 around
1% globally, and in the developed markets,
about half that. Nothing to wave a victory flag
about, but not a severe recession. The question for
2024 ultimately is, what does that last mile look
like in the conquest of inflation? The challenges
are going to become quite apparent, if they aren’t
already: How do you get from a 3.5% core to a
2% target and do so without breaking the economy?
That’s not necessarily a clear path. There’s
a possibility that recession risk remains elevated at
the latter half of 2024. That’s something to
consider, especially as risk premiums and equity
risk premiums are relatively tight at this point.

The question for 2024 ultimately is,
what does that last mile look like in the conquest
of inflation?
Jerome Schneider
Moriarty: What are you excited about in the
marketplace right now?
Norelli: I would say that the biggest opportunity
right now is in securitized credit. This is a very
diverse sector of fixed income, with lots of
different pools of collateral in order to secure your
risk premium. Generally, securitized credit
has not tightened in the big risk rally that we got
in November. In fact, it’s kind of been leaking most
of the year. It has struggled to keep pace with
spread tightening that we’ve seen in the more
well-known credit sectors of IG credit, high
yield, and emerging markets. The expected return
in securitized credit is higher than in the corporate
credit equivalents.
O’Neil: For 15 years, we’ve been in the desert
as fixed-income portfolio managers with incredibly
low yields. There’s income back in fixed income!
We are encouraging folks who own equities
to think about bonds for the first time in 15 years.
If you look at the inverted price/earnings on a
forward basis for the S&P 500, it’s 5%. Cash is 5%.
Bonds are 5%. My team and I think bonds
on a risk-adjusted basis look really attractive
compared to equities unless you have a very, very
bullish view on earnings growth.
We’re also encouraging folks to think about
moving out the risk curve. As you look at our more
modest growth prospects for 2024 and the
chance for Fed easing, cash may not be 5% at the
end of next year. Money market holders
who have enjoyed a good 2022 and 2023 should
think about bonds. Intermediate Treasuries and
short, high-quality securitized products are two of
the largest overweights in the portfolio.
Schneider: I liked Ford’s metaphor. We have
been in the desert for a decade-plus, but
now there’s an oasis of opportunity in fixed
income. Fundamentally, that means maintaining
optionality in portfolios, higher degrees
of liquidity so you have the latitude, flexibility, and
guidelines to pivot to those opportunities
as they emerge over the next one to two years.
You do that by shifting out further into the
fixed-income universe, into high-quality structured
products. This helps produce a resilient
fixed-income portfolio that allows you to actively
navigate a landscape that is not paved with
landing lights. We need to look at this data in real
time, just as the Federal Reserve will, and
determine the proper sequencing of portfolios as
they emerge over the course of the next year.
The oasis of opportunity comes from an initial
allocation to fixed income, but understand
that that will require some gentle calibrations for
the landscapes that will emerge over the
next 12 to 24 months. It’s a great opportunity, but
you need the tools to get to that destination
of favorable risk-adjusted returns.
O’Neil: Jerome, well said, and thank you for the
reminder that we’re still relevant! K
Brian Moriarty is an associate director, fixed-income
strategies, for Morningstar Research Services LLC.
Photography by Chris Lane, Matthew Lomanno, and
David Zentz.
morningstar.com/products/magazine 55
 Investors
GoodHaven 2.0
A reboot has revitalized a value-
oriented shop.
UNDISCOVERED MANAGER
Drew Carter
There are undiscovered managers, then there are
rediscovered managers. GoodHaven Capital
Management is more the latter, and in more ways
than one.
The firm has been featured here before.
GoodHaven and its co-founders, Larry Pitkowsky
and Keith Trauner, appeared in the February/
March 2012 issue of the magazine, not long after
the launch of GoodHaven Fund GOODX.
But the firm and fund featured back then were
notably different. Pitkowsky calls that iteration
GoodHaven 1.0. In late 2019, just before
the pandemic hit, Trauner stepped down as a
managing partner and portfolio manager, leaving
Pitkowsky squarely in charge. Welcome
GoodHaven 2.0.
The revamped strategy has rediscovered its mojo.
After years of performance that could
objectively be described as horrible, the fund
has reemerged as a top performer.
A Smooth Start, Then Turbulence
When Pitkowsky and Trauner launched
GoodHaven in November 2010, it was a scion
of iconic value investor Bruce Berkowitz’s
Fairholme Capital Management. They had
contributed to the success of Fairholme Fund FAIRX
from its 1999 inception through October
2010, helping its performance top the large-
value Morningstar Category, with an
annualized 13.6% gain versus 3.6% for the
typical peer.
56 Morningstar Q1 2024
Their reasons for striking off on their own are still
shrouded—Pitkowsky would not speak to them
then nor will he today. Disruptions to Fairholme’s
investment team likely played a role, with a
new comanager apparently supplanting Pitkowsky
and Trauner. As we noted in our previous article,
“That experience could only fuel the duo’s desire to
prove themselves on their own.”
And prove themselves they did, at least at the start.
From its April 2011 inception through the end
of that year, the GoodHaven fund outpaced 89% of
large-value category rivals. For its first full calendar
year in 2012, it topped 91% of peers.
Then followed a string of ugly years, each worse
than the next. In 2013, the fund gained 19.4%—
reasonable, but less than 96% of large-value peers.
In 2014, when the typical peer’s fund rose
10.8%, GoodHaven lost 8.9%, worse than 99% of
peers. And finally, in 2015, the fund lost 18.4%—
the third-worst showing in the category and
nearly 20 percentage points behind the S&P 500,
the fund’s prospectus benchmark. Between
then and 2019, the fund had two good years,
interspersed with two more bad ones.
Seeds of Change
“I think we did a couple of things that hurt,”
Pitkowsky says of the performance. The portfolio
was structured in three basic parts—higher-
quality companies, special-situation turnaround
stories, and what he (dis)affectionately calls “stuff
in the middle.” These were stocks that were
neither high quality nor really that special, despite
needing to turn around.
Trading wasn’t perfect in any of the categories.
Some pain came from selling good companies too
soon. The portfolio owned a lot of Microsoft MSFT
when it was around $25 to $40 per share, but
when the managers thought it had grown
too expensive, “we felt we needed to sell it all.
Once in a while, I wake up in the middle of the
night and make that (potential growth) calculation,
and it’s quite upsetting,” Pitkowsky says. (The
stock was above $370 at the end of December.)
The burgeoning tech names at the time remind
Pitkowsky, in hindsight, of a Mark Twain quote:
“The cat, having sat upon a hot stove lid, will not sit
upon a hot stove lid again. But he won’t sit
upon a cold stove lid, either.” The point is the risk
of being overcautious. In the early/middle
2010s, he could recall the fates of Nifty Fifty stocks
or once-dominant companies whose “franchises
went cold,” making him wary of big winners being
able to justify high stock prices. But in the
case of today’s so-called Magnificent Seven stocks
(Alphabet GOOG, Amazon.com AMZN, Apple AAPL,
Meta META, Microsoft, Nvidia NVDA, and
Tesla TSLA), “they’ve gotten stronger, proving their
valuations never got to be ridiculous.” One
hot lid he’s sat on a long time is Alphabet, which
he’s held since the fund’s inception.
On the other end of the portfolio spectrum,
some of GoodHaven’s special situations never
turned around—names like Sears, Dundee,
and Walter Investment. But ultimately, it was the
“stuff in the middle” that hurt performance the
most, according to Pitkowsky. That stuff was
stocks that were decent companies but not that
cheap, or statistically cheap companies that
weren’t that great.
In GoodHaven 2.0, the notion of quality—
or a business’ competitive dynamics
and advantages—has come into sharper focus.
“I think we always talked about quality, we
were well aware of it, had plenty of quality in the
portfolio,” Pitkowsky says. “But we let a
bunch of other things creep in, and we were too
quick to sell quality when it became not cheap.
I’m not sure we weighted it enough.”
Developing 2.0
Pitkowsky owns his role in these shortcomings:
“It’s important to note on 1.0 that whatever
imperfections there were, I was in the room
for those imperfections.” Still, he knew
something had to change. In 2019, Pitkowsky and
Trauner started talking about what might turn
things around. As with the departure from
Fairholme, Pitkowsky won’t share a lot of details
of how the decision was made, but the
upshot was that Trauner left the firm at the end
of November that year, leaving Pitkowsky
as the firm’s leader, primary owner, and sole
portfolio manager. Trauner holds a small
ownership stake but is no longer involved in
day-to-day operations.
Larry Pitkowsky, managing partner and portfolio
manager at GoodHaven Capital Management.
Pitkowsky describes the move to 2.0 as taking
“a step back and a hard look at bringing the
process of decision-making to a better spot, which
it had been at many other points in my
career.” Doing so wasn’t out of character. “I do
think people who know me would say, ‘Oh
yeah, it’s not surprising for him to look in the
mirror and say, Wait a minute, why isn’t
this going as well as it should? What do I need
to do differently and where has the decision-
making magic somehow gone a bit awry?’
People who know me could see me being
obsessed with that.”
Looking at changes in portfolio holdings from
early 2019 to about mid-2020 gives some insight
into the stuff-in-the-middle stocks Pitkowsky
was eager to jettison. Out were stodgy businesses
like airlines (American AAL and Delta DAL),
telecom provider Verizon VZ, and department store
Macy’s M.
At first, replacements were mostly financial
stocks—Bank of America BAC and JPMorgan
Chase JPM, KKR KKR, and Progressive PGR. But he
also gave more room in the portfolio to some
existing holdings, like legendary insurer-cum-value
morningstar.com/products/magazine 57
 Investors
GoodHaven Fund GOODX
Growth of $10K
$18K
16
14
12
10
8
01/31/2021 12/31/2023
Morningstar Category Mid-Cap Value
Morningstar Rating
QQQQ
Expense Ratio (%) 1.10
Source: Morningstar Direct. Data as of Dec. 31, 2023.
investor Berkshire Hathaway BRK.B, building
materials provider Builders FirstSource BLDR, and
homebuilder Lennar LEN.B. Those stocks saw their
weightings double in the period.
A Distinct Portfolio
It’s an eclectic mix overall. Conceived as an
all-cap approach benchmarked against the S&P
500, the fund has consistently landed in the
mid-value Morningstar Category since September
2015. In the 2.0 era, Pitkowsky has overweighted
financials by about 35 to 45 percentage points over
the S&P 500. In the four years since its
reconfiguration, the fund has owned not a single
healthcare stock and very few tech stocks.
“Healthcare is a very tricky sector,” Pitkowsky says,
pointing to large pharmaceutical company
stocks whose prices have stagnated for years,
and parts of the sector, particularly biotechnology,
that require specialized knowledge to under-
stand. “Was UnitedHealth UNH something I could
have understood? The answer is yes,” he
mused. “The only thing I can say about having not
owned it or something like it is that it was
a mistake.”
58 Morningstar Q1 2024
The portfolio has also held a lot of cash at
times. For example, as of August 2023, about 36%
of portfolio assets were invested in cash
or short-term Treasuries after an influx of new
investments—an estimated $60 million of the
GoodHaven fund’s $215 million total. Nonequity holdings were
Fund
about 25% when 2.0 started in November
$16,130
2019. That said, for most of the intervening period,
Morningstar cash was around 10%—still fairly high, but
US Mid Value not as much as the period’s bookends might
$13,972 suggest. In December 2023, Pitkowsky says cash
had fallen to the high 20s, and he expected
it to continue to decline as he put more of it to
work on portfolio names.
A much smaller portion of the nonequity stake
falls into what Pitkowsky calls special situations,
or investments that have “dramatic upside
potential but may be riskier and more esoteric”
than the portfolio’s stocks. They include
stock warrants—a type of derivative security—
on Occidental Petroleum OXY; preferred shares of
Fannie Mae, which has been in government
conservatorship since the global financial crisis in
2008; and bonds issued by Ligado Networks.
In all three cases, Pitkowsky believes the positions
to be small, prices paid to be attractive,
and upside to be potentially significant. (The
Occidental warrants are in the money.)
Night-and-Day Returns
With the benefit of hindsight over the past four
years, few market observers would have expected
significant outperformance from a fund that
held nearly no tech or healthcare stocks and that
was in a seven-year performance rut entering
the period. But Pitkowsky’s distinctive portfolio has
distinguished GoodHaven for the better since
the revamp.
In fact, its performance has been outstanding
since the move to 2.0. Over the four years
ended Nov. 30, 2023, GoodHaven topped
all mid-value category peers, pounding both the
mid-value benchmark and typical peer
(by about 7 percentage points annualized each).
It also beat its prospectus benchmark,
the S&P 500, by 2.4 percentage points annualized.
This is despite the hurdle of a 1.1% expense
ratio, which is above average for a mid-
cap fund.
The fund’s trailing returns show the stark contrast
between the 1.0 and 2.0 eras. Its one-, three-,
and even five-year returns through November 2023
beat 94% or more of peers. Even so, the fund’s
10-year performance—despite the outstanding
returns of the past four years—still ranks among
the worst 5% of the pack.
Pitkowsky has done this with a team of only
two, including himself. Artie Kwok, a nearly 10-year
veteran of the firm and managing director,
contributes research and insights to the portfolio.
Pitkowsky points to David Abrams of Abrams
Capital, Warren Buffett of Berkshire Hathaway,
and Tom Gayner at Markel as examples of
successful but very small teams. (Markel is both
a part owner and a client of GoodHaven.)
“If it was all about resources, every shop
with a gigantic research budget would outperform
dramatically,” he says. Still, having so much
responsibility rest on Pitkowsky’s shoulders
creates key-person risk—it’s hard to imagine the
fund’s future without him.
What’s important to Pitkowsky is to “really be
patient with finding things we think we can
understand” that also offer a margin of safety, or
discount to what he thinks they’re worth,
and to be willing to take a profit or kill a beloved
idea when the facts change. “It helps that we’re
not managing $100 billion,” he adds.
The fund is indeed nowhere near the
approximately $3 billion asset limit where
Pitkowsky would consider closing to new investors,
so there’s plenty of room for investors
wishing to rediscover the fund. Granted, this
distinctive all-cap strategy may not have
broad appeal, but GoodHaven 2.0 has found
a receptive audience: That significant
inflow of cash last summer came primarily from
new clients. K
Drew Carter is a manager research analyst with
Morningstar Research Services LLC.
Photography by Chris Lane.
 Restaurant Revolution
New technology could reshape
the industry.
SECTOR RAP
Ivanna Hampton
Here’s something to chew on: Innovation could
remake the restaurant industry within the next
few years.
For decades, restaurants had very little reason
to invest in innovation, given that they had
cheap labor, thin margins, and scant customer
data, says Sean Dunlop, who covers the industry
for Morningstar Research Services. Then the
coronavirus pandemic accelerated a tech evolution,
led to a worker shortage, and contributed to
higher food and labor costs.
“Consumers are starting to balk at price hikes
when they walk into a restaurant and realize that
a hamburger’s not as cheap as it used to be,”
Dunlop says.
Now restaurants are looking to technology to
cut costs and build relationships. An AI-driven latte?
What about robot-crafted tortilla chips? Improved
digital ordering and revamped loyalty programs?
These are some of the developments that Dunlop
notes in his most recent restaurant technology
research.1 The industry could face some challenges
in 2024, but opportunities exist for investors who
want a taste of this sector.
I spoke with Dunlop on Dec. 6 for Morningstar’s
Investing Insights podcast.2 Our conversation
reflects conditions and valuations as of that date.
It has been edited for length and clarity.
1 Dunlop, S. 2023. “Restaurant Technology’s New Dawn Should Serve Astute Investors Tasty Opportunities.” Morningstar Consumer Observer. April.
2 Investing Insights is available on Morningstar.com, YouTube, and all podcast apps.
Ivanna Hampton: Why has the restaurant industry
trailed other industries in adopting technology?
Sean Dunlop, CFA, is a consumer
equity analyst for Morningstar
Research Services LLC.
Sean Dunlop: For starters, the industry is
very reliant on cheap, abundant labor. About a
third of industry sales are tied to wages
and benefits, and that labor has only recently
grown expensive. As you look back to February
2019, wages in that leisure and hospitality
space have increased 26% to 27% relative to
prepandemic levels.
The second piece is thin margins. The restaurant
industry disincentivizes investment. As you look
at a fragmented industry with a lot of independent
restaurants, you’re typically operating at low-
single-digit net margins. If I’m a mom-and-pop
coffee shop, how much am I willing to invest
to cut my inventory waste by 25% to 33%? In most
cases, it wasn’t enough to justify an ROI in a lot
of these technology investments.
The third piece is data access, which has been an
issue really until recently. McDonald’s MCD
only knew about 5% of its customers as recently as
2021 in terms of names, addresses, and unique
identifiers, when it rolled out its MyMcDonald’s
rewards program.
Hampton: Let’s talk about artificial intelligence’s role.
How can it speed up the tech evolution?
Dunlop: We would look at three big ones.
Artificial intelligence can help with restaurants as
a cost center. It can help as a sales lever. And
then it can help with menu innovation. If you think
about something like automating inventory
forecasting, restaurants waste roughly a third of
the food that they purchase, sometimes more
than that. Even incremental improvements
can have a big impact on a restaurant profit-and-
loss statement, particularly because food
costs are about 30% of total restaurant costs.
As a sales lever, AI is already increasingly
integrated with loyalty programs. A lot of the
offers that you receive with push notifications are
spooky close to when you’re thinking about
ordering dinner. That’s an AI integration. It’s
segmenting customers within a cohort that looks
a lot like them—when they might order a
meal. That’s only liable to increase. Today, we see
about an 18% to 30% increase in guest frequency
for members of loyalty programs, and there
are several companies, like Starbucks SBUX,
that have more than half of their North American
sales coming from loyalty program members.
As for that third piece, menu innovation: AI
integration allows restaurants to see what sells
well, what sells well with what, and identify
consumer trends much more quickly than they
used to in the past. Think about Starbucks’
rollout of its cold foam cold brews, its nitro cold
brews, its whole line of Refreshers beverages.
That’s something they might not have been
able to do in 2016, 2017, 2018. That’s increasingly
accessible with its Deep Brew AI technology.
Hampton: You’ve written that restaurants can grow
their bottom lines without raising prices on customers
if they shift towards digital adoption. Explain how.
Dunlop: In 2021 and 2022, we saw massive price
increases for restaurants across the board, in
many cases, as much as the midteens as you look
back on a two-year stack. We’re just getting
to a point where consumers are starting to balk.
The response that we would recommend
for restaurants in most cases comes from three
morningstar.com/products/magazine 59
 Investors

EXHIBIT 1

different buckets. We mentioned the inventory A Transforming Industry These companies are part of the restaurant industry’s
management piece. By reducing inventory digital evolution.
waste by roughly 15%, restaurants can carve out
almost 2 points of restaurant profit margin. Fair Value Morningstar Economic
Company Price $ Estimate $ P/FV Rating Moat

Then we’ve got payroll solutions. Restaurant Chipotle Mexican Grill CMG 2,286.96 1,800.00 1.27 QQ Wide
managers will usually spend eight hours a week Domino’s Pizza DPZ 412.23 387.00 1.07 QQQ Wide
working on scheduling and tip management.
DoorDash DASH 98.89 155.00 0.64 QQQQ Narrow
It can be cut to about two hours a week in most
cases with automated scheduling. As you Just Eat Takeaway.com JTKWY 3.00 — 0.17 * QQQQQ * Narrow
map that out by what those managers’ salaries McDonald’s Corp MCD 296.51 310.00 0.96 QQQQ Wide
cost, you can save 40 to 50 basis points.
Papa John’s International PZZA 76.23 72.00 1.06 QQQ Narrow
And enabling and encouraging digital orders is a Restaurant Brands International QSR 78.13 71.00 1.10 QQQ Narrow
huge unlock. It has proved somewhat incremental. Starbucks SBUX 96.01 105.00 0.91 QQQ Wide
Those consumers are using restaurants for
Toast TOST 18.26 19.20 0.95 QQQ Narrow
occasions that used to be coming from grocery
and convenience stores. It’s typically a lower cost Uber Technologies UBER 61.57 68.00 0.91 QQQ Narrow
to serve. If customers are ordering through Wendy’s WEN 19.48 21.00 0.93 QQQ None
an app, a restaurant can sequence their orders
Yum Brands YUM 130.66 139.00 0.94 QQQQ Wide
better—for example, funnel people toward a
*Based on share price and estimated fair value in euros.
different Chipotle CMG that has a shorter line and Source: Morningstar. Data as of Dec. 29, 2023.
increase speed of service. You also don’t need
somebody at the point of sale taking an
order, so those employees are free to focus on
the customer experience or making food. Hampton: There’s the argument that as restaurants and consumers don’t usually think of tips in
adopt software and become more automated the same mental bucket as the rest of the check.
Hampton: Wage growth has put pressure on that job losses will follow. What’s Morningstar’s view? We recommend that obviously for sit-down
restaurants, along with staffing shortages. How can Dunlop: I think in some ways, it’s almost occasions, it makes a lot of sense. But restaurants
digital expansion address those concerns? definitional. That’s not necessarily a bad thing. must be careful that consumers don’t start
Dunlop: This is the first period of meaningful Chipotle has put quite a bit of capital behind considering the entire cost of the bill inclusive of
wage growth in the industry in decades. We saw automating making chips, where people typically the tip. And if they start to see a traffic decline,
massive layoffs in 2020 as workers were sent get oil burns, and automating the coring of it might be worth taking that prompt out.
home, as people weren’t allowed to dine in avocados. The jobs that are being automated are
restaurants, and a lot of those workers retrained. not necessarily the jobs that workers want Hampton: The pandemic accelerated restaurants rolling
They went into retail applications and warehouses. to be doing. Instead, they’re spending more time out mobile ordering. What chains are doing this well,
E-commerce was exploding. Only recently making orders and serving customers. who’s struggling, and why?
did we see some of those pressures start to abate. Dunlop: Almost all chains are doing mobile
For a long time, the restaurant industry Hampton: What about point-of-sale tipping? It has ordering well. Yum Brands YUM and McDonald’s
was operating at 90% staffing, and that created caused some friction and led to so-called tipflation. are both doing more than 40% of sales through
a high-turnover environment. As workers Dunlop: It’s become a bit of a pain point digital channels, from basically zero in the late
are jumping from job to job, wages are liable to industrywide. From a consumer perspective, 2010s. Domino’s DPZ said they’re doing 85%
increase. They had all the power there. when you’re prompted, should you tip for coffee of sales through digital channels. There are a lot of
if you’re taking it to go? Should you tip for benefits to mobile ordering. It’s less labor-
We’re within 2% of prepandemic staffing levels, a burger? How much should you tip for an Uber intensive. It’s easier to schedule. You can really
and we’re just starting to see wages come down. Eats delivery? increase the transaction capacity of a restaurant.
Operators have spent quite a lot of money
on order sequencing and funneling orders towards Our recommendation is that restaurants proceed The restaurant chains that are struggling are
digital channels. The goal is working towards with caution. In some ways, they’ve been those that have struggled to drive loyalty traction.
fewer, easier, and better-paid restaurant jobs. using this to defray their elevated labor costs, as in Burger King or Popeyes, under the Restaurant
they’re passing more of those costs to consumers, Brands QSR umbrella, these second or third

60 Morningstar Q1 2024
players are competing for space on consumers’
phones. It’s unlikely that somebody’s going to
have McDonald’s, Burger King, and Wendy’s WEN
apps downloaded.
Independent restaurants are in a similar boat. That
doesn’t mean they shouldn’t try. There are
benefits to digital orders. But for some brands, it
may not make sense to do loyalty programs.
Hampton: What are the benefits and risks of
delivery partnerships with Uber Eats, DoorDash
DASH, and Grubhub?
Dunlop: Delivery aggregators account for
15% to 20% of total industry sales. They’re too
big to ignore. Domino’s was one of the last
holdouts. They recently announced a partnership
with Uber Eats across all their international
markets, something like 70 markets. There’s a
definite benefit from incremental sales.
Papa John’s PZZA does 15% of their sales through
partnerships with DoorDash and Uber Eats.
But we calculate that if more than about
40% of these sales cannibalize a restaurant’s own
platform, and more than 22.5% goes to
commissions, then the restaurant won’t break
even. If I’m giving away a big chunk of my
order to these aggregators, and if that same
customer might have ordered through
my own website or app, that quickly can turn
dilutive, and in extreme cases, it can be negative
from an operating income perspective.
We recommend that brands are very careful and
distinct on a platform. If I’m Papa John’s, I don’t
want people to think of me as categorically
pizza. I want them to think of me as Papa John’s.
They need to continuously reevaluate whether
they’re cannibalizing too many orders or whether
the commission rates are too high to justify using
the channel and to be willing to pull the plug
if that’s the case. And then it’s important
competing on value that the best offers stay on
restaurants’ own channels.
Hampton: Loyalty programs can lead to higher
customer spending and more frequent returns, yet
they’re not a fit for everyone. Talk about that.
Dunlop: You would think the more loyalty, the
better. Starbucks has widely publicized that their
customers spend two to three times more than
nonloyalty customers and spend more at Starbucks
than the average U.S. coffee consumer spends at
any coffee chain over a year. McDonald’s said their
loyalty base spends twice what the nonloyalty
users spend, at about $133 a year by our estimates,
and visits 15% more frequently. For a lot of chains,
it makes a ton of sense.
But not for everybody. If you’re a restaurant that
has reasonably tight margins, you don’t
generate much incremental operating profit per
order. Or if your customers are only visiting
five or six times per year. Most programs offer
a freebie in 15 or 16 visits. For Dunkin’ Donuts or
Chipotle, that makes a ton of sense. But if
I’m a consumer and I’m not getting a free item
for an entire calendar year, I’m just not going
to use that program. You have the same
amount of fixed costs for development and launch
either way. For restaurants that see a little
bit less guest frequency and for restaurants that
have lower profit per check, maybe it doesn’t
make so much sense.
Hampton: Social media buzzed over McDonald’s
Grimace promotion and restaurant spinoff CosMc’s.
How does social media fit into a digital strategy?
Dunlop: McDonald’s has done extraordinarily
well with its marketing and creative over
the past couple of years. They’ve brought Grimace
and the Hamburglar back. They had the Cactus
Plant Flea Market promotion. They had adult
Happy Meals and famous orders. If you think back
just over the last three years, they’ve had
a lot of marketing buzz, and they would tell you
that that correlates strongly with an uplift
in same-store sales.
It’s challenging to do. It’s tough to see an
ROI from the outside looking in. But a big part
of the success that they have had is they’ve
coalesced their menu around 17 core menu items.
They’ve got 17 separate platforms, from
McNuggets to Filet-O-Fish, that generate more
than a billion dollars in sales per year. The core
menu is 65% of McDonald’s sales, so it’s
extremely important. It’s much easier for marketers
globally to market behind the McCrispy, which
is a $4 billion brand, than it is to be able to
market behind chicken categorically if you’ve got
50 SKUs running through your restaurant.
McDonald’s has recognized that there are certain
trends and certain innovations that are more
the same than different across markets, like
the Raise Your Arches campaign recently, and
been able to export those quickly.
Hampton: What’s your forecast for the industry?
Dunlop: We saw the consumer hold up better than
we expected in 2023, so the impact that we
expected to delay comparable-store sales growth
in 2023 has been pushed out into 2024.
In big, broad, qualitative strokes, I would expect
pricing to come in the low-single-digit range
for restaurants, 2% to 4%. Mix is probably going
to be slightly negative. We’ve seen people
trading down the menu. Maybe they’re not getting
fries or getting one fewer alcoholic beverage.
I think that probably continues. Traffic has been
negative for each of the last 18 months. We’ll
probably see consumers continue to move certain
visits over to grocery or over to convenience
stores, which are proportionally cheaper. That’s
typically what we see with consumer downturn
behavior. It reads to us like low-single-digit
growth in 2024 for the industry.
Beyond that, the secular trends that we’ve
identified are intact. Consumers are valuing the
convenience of chain restaurants. Restaurants
are getting better omnichannel ordering. They’re
getting more relevant with loyalty programs.
Consumers are willing to pay for that. I still think
growth slightly ahead of nominal GDP is entirely
plausible over the medium term.
Hampton: What names on your coverage list look like
opportunities for investors?
Dunlop: We like Wendy’s. We have a $21 intrinsic
valuation for the stock. We like Toast TOST
at $19.20. That’s sold off very hard recently as
they’ve struggled to add new stores to that
platform. Then, we like Yum Brands at $139. It
is a really solid, globally diversified operator
with a lot of brands that perform well on value. K
Ivanna Hampton is lead multimedia editor
for Morningstar.
morningstar.com/products/magazine 61
 Investors
Keeping Cool
A family lesson helped advisor
Jeff Fishman support his clients during
recent Hollywood strikes.
USER PROFILE
Charles Keenan
Even though the recent labor strikes for actors and
writers have ended, Jeff Fishman counsels
caution to his Hollywood clients as film and
television production returns to normal. Fishman,
founder of JSF Financial, based in Los Angeles,
relies on an old family mantra to guide his clients
through these volatile times in the markets.
“My grandfather’s lesson was always to keep
an even keel,” he says. “You can’t let your lows get
you too low, and you can’t let your highs get you
too high.”
Those words of wisdom resonated with many of
Fishman’s clients last year, when many writers and
actors weren’t earning any income from
employment. The walkouts by two major unions
were historically long and crippled Hollywood
by occurring at the same time. Yet settlements by
the Writers Guild of America and the Screen
Actors Guild-American Federation of Television and
Radio Artists mean that many are returning to
work in 2024.
Some of the major studios are talking about cost-
cutting, though, so nothing’s a given. Which
means that for Fishman and these clients, much
work needs to be done. It’s time again to save, pay
down debt, and maybe forgo a big vacation.
“This is going to be a recovery year,” Fishman says.
“Clients need to replenish savings from what
they had to take out last year, if they had no other
ancillary sources of income.”
62 Morningstar Q1 2024
Not all of Fishman’s clients are actors and writers.
He also works with heads of studios, production
company owners, and entertainment lawyers,
with the industry making up about half his
business. His roster also includes professionals
such as doctors, accountants, and sports stars.
Getting Prepared
While these clients might not face the same
volatility of contract work, the strikes are
a reminder that anyone can be vulnerable to
financial setbacks. Fishman and the entertainment
industry anticipated the labor stoppages well
in advance, so he was able to work with clients to
get ready for tougher times. But clients—and
advisors—need to be ready for the next disruption.
“We could see the strikes coming a little
bit more easily than maybe some other things,”
Fishman says. “But they still reinforce
why it’s so important to be prepared for life’s
uncertainties and eventualities.”
Clients like that approach, and Fishman’s affable
and humble nature. He has built a formidable
roster over the last 28 years, mainly through
referrals. Assets had grown to over $2 billion by
mid-November, up from roughly $1 billion
four years ago. The firm serves 1,200 households,
about $2 million for the average client.
Fishman’s financial planning work includes
the full range of services, such as reviews of
assets and liabilities, strategies for cash flow and
budgeting, liability and risk management,
education planning, pension analysis, retirement
income and lifestyle planning, estate planning, tax
minimization strategies, and coordination
with tax and legal advisors. The firm also handles
investment management and private wealth
management. Fees are generally 1%, but financial
planning fees can range from $600, all the
way up to $100,000 for complex financial issues,
more suited to his wealthiest clients.
No matter the level of wealth, with the financial
world constantly in flux, Fishman says it’s
important to keep a close eye on people’s finances.
“We try to meet with clients regularly,” he says.
“That communication helps you be able
to work with them to make good decisions.”
Interest rates drive part of the conversation
today. One obvious action is to put cash
into instruments with some yield, such as money
market funds, U.S. Treasuries, and short-term
bond funds.
Fishman has also pressed clients who didn’t
make much income last year to do Roth IRA
conversions. “Every calamity is also an opportunity,”
Fishman says. “You just have to figure out
where it is.”
Interest in Law, Passion for Finance
Fishman developed his passion for finance
while growing up in Hancock Park in Los Angeles.
His father and grandfather were major role
models. His dad ran an insurance brokerage,
pushing him to think about personal finance. From
his grandfather, he learned how to not get
too emotional and try to make good decisions.
He went to college at Yeshiva University in
New York, majoring in economics and
communications, then earned his law degree from
Yeshiva’s Cardozo School of Law, focusing
on tax and estate planning. He returned to L.A.
in 1992 to work as an associate at a law firm
but knew he didn’t want to practice law
for the long haul. He enrolled in a financial
planning program at the University of California,
Los Angeles in 1994, completing it in 1995.
“I realized the impact I could have on people,”
Fishman says. “Financial decisions need to
be well-thought-out. And they could be different
for everybody, depending on what their
situation is. That’s what resonated with me.”

Jeff Fishman, JD, PFP, founder, JSF Financial.
How he caught our eye: Helped clients navigate
recent strikes in Hollywood by Writers Guild of
America and SAG-Aftra.
Career path: Graduated from Yeshiva University
in 1989, then obtained a law degree from the
institution’s Cardozo School of Law in 1992. He first
worked as an associate at a local law firm, then
enrolled in a financial planning program at UCLA in
“Clients have been dealing with the same people
1994, where he earned a personal financial
planning designation in 1995. He opened his financial
practice in 1996. Fishman also sits on the State Bar
of California.
Personal: Married to Shari Fishman, chief compliance
officer of the firm. They have two daughters, 26
and 19, and a son, 23. Jeff and Shari met in law school
and got married shortly after that. Fishman is
a Los Angeles sports fan, often going to Dodgers and
Rams games.
morningstar.com/products/magazine
He opened his practice in 1996, gaining clients
by conducting continuing education classes for
lawyers on topics such as income tax, estate
planning, pensions, and business formation. Some
of those early clients are now general counsels
of major corporations, studio heads, or running
successful businesses.
Personal relationships also led to clients. Via a
young couples group through the Jewish
Federation, Fishman befriended J. Brian Gadinsky,
a producer who had worked on TV shows such
as America’s Most Wanted and American
Gladiators. Gadinsky hired Fishman to help with his
financial planning. Gadinsky, who would go on
to serve as executive producer for many more shows,
including American Idol, introduced Fishman
to other friends in the industry. (Gadinsky is still
a client and a close friend today.)
As the firm grew, Fishman hired his brother,
Mordechai Fishman, in 2004 as a financial planner.
His wife, Shari, joined the firm in 2010 as chief
compliance officer. The firm now has six financial
planners, and employee retention is high.
here now for a couple of decades or longer,”
Fishman says. “That has been a major part of our
success, the continuity and consistency.”
Fishman uses model portfolios ranging from
conservative to aggressive, using a blend
of exchange-traded funds and mutual funds. For
clients with greater assets, Fishman will layer on
third-party money managers, such as in
alternatives. A longtime user of Morningstar
products, he relies on Morningstar Direct to track
the model portfolios and conduct research on
products. He also uses Morningstar Office for
client portfolio analysis and proposals, including
Portfolio X-Ray and Quick Snapshot reports.
It’s all part of Fishman’s process to build wealth for
his clients and, as the recent strikes showed,
prepare them for the next rainy day. “You really
have to be prepared in life for some kind of
an unforeseen change,” Fishman says. “Something
that you can’t predict.” K
Charles Keenan is a freelance financial journalist.
Photography by David Zentz.
63
 Data Dashboard

Morningstar Global Market Barometer

Developed Markets 17.91%
Emerging Markets 11.92% U.S. 26.43%

< –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 12/31/2023

1-Year Trailing Performance

Norway 5.8%

Canada 14.4% U.K. 14.1%

China –10.5%
Ireland 24.6% Turkey –7.5%
Japan 19.2%
United States 26.4%
Italy 36.4% South Korea 24.0%
Mexico 44.3%
Egypt 46.6% Taiwan 32.1%
Colombia 28.3%
Brazil 33.3% India 25.0%
Peru 12.4%
New Zealand 2.0%
South Africa 0.7% Australia 13.3%
Chile 6.6%

Leading Developed Markets Lagging Developed Markets Leading Emerging Markets Lagging Emerging Markets
Poland Italy Spain Hong Kong Finland Israel Hungary Greece Egypt Thailand China Turkey
52.6% 36.4% 30.3% –17.0% –3.3% 1.6% 52.3% 49.7% 46.6% –11.8% –10.5% –7.5%

1-Year Trailing Performance and Risk Measures 3-Year Growth of $10,000

Morningstar US Market Return Standard Deviation 15.36% $14K
US Market
TR USD 26.43% Sharpe Ratio 1.27% $12,814
1,324 Constituents Max Drawdown –10.48% 12
Developed Markets
Morningstar Developed Return Standard Deviation 17.19% ex-US
Markets xUS GR USD 17.91% Sharpe Ratio 0.73% 10
$11,323

2,982 Constituents Max Drawdown –11.51% Emerging Markets

$9,183
Morningstar Emerging Return Standard Deviation 16.97% 8
Markets GR USD 11.92% Sharpe Ratio 0.43%
6
3,765 Constituents Max Drawdown –11.60%
12/31/2020 12/31/2021 12/31/2022

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.

64 Morningstar Q1 2024
Morningstar Fixed-Income Indexes 12/31/2023

1-Year Trailing Performance and Risk Measures 3-Year Growth of $10,000

Morningstar US Core Bd Return Standard Deviation 8.27% $12K

TR USD 5.31% Sharpe Ratio 0.03%
11
US High Yield Bond
$10,619
9,092 Constituents Max Drawdown –7.24%
10 US Corporate Bond
Morningstar US Return Standard Deviation 10.14% $9,036
Corporate Bond TR USD 8.41% Sharpe Ratio 0.32% 9
US Core Bond
6,341 Constituents Max Drawdown –6.92%
8 $9,016

Morningstar US High Return Standard Deviation 7.26%

Yield Bond TR USD 13.48% Sharpe Ratio 1.06% 7
6
1,826 Constituents Max Drawdown –4.21%
12/31/2020 12/31/2021 12/31/2022

Morningstar Allocation Indexes 12/31/2023

1-Year Trailing Performance and Risk Measures 3-Year Growth of $10,000

Morningstar Aggressive Return Standard Deviation 16.04% $12K
Aggressive Target Risk
Target Risk TR USD 18.30% Sharpe Ratio 0.80% $11,666
15 Index Constituents Max Drawdown –11.02% 11
Moderate Target Risk
Morningstar Moderate Return Standard Deviation 12.85% $10,633
Target Risk TR USD 13.22% Sharpe Ratio 0.62% 10
Conservative Target
19 Index Constituents Max Drawdown –8.71%
Risk
$9,569
Morningstar Conservative Return Standard Deviation 9.24% 9
Target Risk TR USD 7.74% Sharpe Ratio 0.28%
8
17 Index Constituents Max Drawdown –6.36%
12/31/2020 12/31/2021 12/31/2022

Morningstar Style Indexes 12/31/2023

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

11.82 18.64 47.26 10.85 9.48 2.18 11.22 15.88 14.67 8.96 11.97 12.87
Mid

Mid

Mid

Mid

10.94 13.45 25.38 11.79 7.46 –0.85 10.91 13.20 14.15 8.71 9.78 10.59
Small

Small

Small

Small

14.58 21.45 26.65 12.14 7.99 –5.79 11.31 11.63 8.90 7.11 7.91 7.20

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

65
 Data Dashboard

Morningstar Global Valuation Lens

Greater Asia –22.3%
Greater Europe –9.8% U.S. –0.6%

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

Undervalued Fairly Valued Overvalued

Valuation by Country 12/31/2023

Finland –14.4%

Norway –10.9%

Canada –5.9%
Sweden –7.1%
France –3.4% China –12.8%
Poland –12.6%
United States –0.6%
Italy –8.7%
South Korea –18.4%
Mexico –7.6%
Hong Kong –32.2%
India 5.3%
Colombia –23.2%
Singapore –16.3%
New Zealand –5.4%
South Africa –15.2% Australia –0.3%
Chile –17.9%

Cheaper Developed Markets Pricier Developed Markets Cheaper Emerging Markets Pricier Emerging Markets
Hong Kong Belgium Israel Denmark Australia United States Colombia Chile Turkey India Czech Republic Indonesia
–32.2% –23.3% –17.9% 7.0% –0.3% –0.6% –23.2% –17.9% –16.3% 5.3% –4.5% –5.8%

Monthly Valuation 12/31/2023

+30%
A percentage of 0.0 connotes fairly valued

15 U.S.
–0.6

0 Greater Europe
–9.8

15 Greater Asia
–22.3
P/FV

–30
2019 2020 2021 2022 2023
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.

66 Morningstar Q1 2024
 Morningstar Global Star Rating Tracker Number of stocks that Morningstar’s global equity U.S. Breakdown 12/31/2023
analyst team rated as undervalued (4 and 5 stars) or overvalued (1 and 2 stars) over time. Valuation % Date
12-Month High* –0.6 12/31/2023
12-Month Low* –13.0 10/31/2023
01/01/2021–12/31/2023
*Month-end highs and lows over trailing 12 months.
1,500

Style Valuation
1,000

Large
Undervalued
Number of Stocks

–9.7 4.1 7.8 2.9

839
500
Overvalued

Mid
0 320 –11.9 –4.5 4.6 –4.6
01/01/2021 01/01/2022 01/01/2023

Small
–21.7 –13.6 –6.6 –14.8
Morningstar Best Companies: 10 Cheapest 12/31/2023
Fair Value Morningstar
Company Sector Price $ Estimate $ P/FV Rating
–12.1 –0.5 6.5 Averages
Yum China Holdings YUMC t Consumer Cyclical 42.43 80.00 0.53 QQQQQ
Roche Holding RHHBY d Healthcare 36.23 59.00 0.61 QQQQQ Value Core Growth
British American Tobacco BTI s Consumer Defensive 29.29 47.00 0.62 QQQQQ
Imperial Brands IMBBY s Consumer Defensive 23.31 36.00 0.65 QQQQQ
Moat Valuation
Pfizer PFE d Healthcare 28.79 42.00 0.69 QQQQQ Company
GSK GSK d Healthcare 37.06 54.00 0.69 QQQQQ Economic Moat Valuation % Count

Zimmer Biomet ZBH d Healthcare 121.70 175.00 0.70 QQQQQ None –11.8 1,618
Campbell Soup CPB s Consumer Defensive 43.23 61.00 0.71 QQQQ
Narrow –7.1 799
Corteva CTVA r Basic Materials 47.92 67.00 0.72 QQQQQ
Anheuser-Busch InBev BUD s Consumer Defensive 64.62 90.00 0.72 QQQQQ
Wide 5.4 250

Morningstar Best Companies: 10 Priciest 12/31/2023

Fair Value Morningstar Sector Valuation
Company Sector Price $ Estimate $ P/FV Rating
r Basic Mat –5.9
Cyclical

Sherwin-Williams SHW r Basic Materials 311.90 214.00 1.46 Q

t Cons Cyc –2.7
Ansys ANSS a Technology 362.88 262.00 1.39 Q
y Fin Svcs –2.6
Costco Wholesale COST s Consumer Defensive 660.08 480.00 1.38 Q
u Real Estate –10.0
Fastenal FAST p Industrials 64.77 48.00 1.35 QQ
i Comm Svcs –11.4
Sensitive

Rollins ROL t Consumer Cyclical 43.67 32.50 1.34 QQ

o Energy –9.3
TJX Companies TJX t Consumer Cyclical 93.81 71.00 1.32 QQ
p Industrials 4.0
The Home Depot HD t Consumer Cyclical 346.55 263.00 1.32 QQ
a Technology 8.3
James Hardie Industries JHX r Basic Materials 38.67 29.50 1.31 QQ
s Cons Def –0.7
Defensive

Cintas CTAS p Industrials 602.66 460.00 1.31 QQ

d Healthcare –4.4
Stryker SYK d Healthcare 299.46 229.00 1.31 QQ
f Utilities –6.1
Morningstar Best Companies have Wide Economic Moat Ratings; Capital Allocation Ratings of Exemplary or Standard; and Fair Value Uncertainty Ratings
of Low or Medium. –12% 0 12

morningstar.com/products/magazine 67
 Data Dashboard

Morningstar Wide Moat Focus Index 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 12/31/2020–12/31/2023 Valuation as of 12/31/2023

$16K
Morningstar Wide
Overall Index P/FV 0.86
Moat Focus
14 $14,364 1-Year Index Performance
Morningstar US Return 32.41%
12
Large Core Standard Deviation 20.39%
$13,123 Sharpe Ratio 1.22%
10
Max Drawdown –14.94%
8
49 Constituents
12/2020 12/2021 12/2022

Five Cheapest Index Holdings Top Five Sectors

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

Etsy ETSY 81.05 145.00 0.56 QQQQ Wide d Healthcare 20.5

International Flavors & Fragrances IFF 80.97 130.00 0.62 QQQQ Wide y Financial Services 18.5
Pfizer PFE 28.79 42.00 0.69 QQQQQ Wide p Industrials 17.9
Zimmer Biomet Holdings ZBH 121.70 175.00 0.70 QQQQQ Wide a Technology 15.6
Campbell Soup CPB 43.23 61.00 0.71 QQQQ Wide r Basic Materials 7.4

Morningstar Dividend Yield Focus Index This index is designed to deliver a portfolio of U.S. 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 12/31/2020–12/31/2023 Valuation as of 12/31/2023

$16K
Morningstar US
Overall Index P/FV 0.93
Large Value
14 $13,621 1-Year Index Performance
Morningstar Return 1.87%
12
Dividend Standard Deviation 11.83%
Yield Focus Sharpe Ratio –0.24%
10 $13,043
Max Drawdown –9.45%
8
75 Constituents
12/2020 12/2021 12/2022

Five Cheapest Index Holdings Top Five Sectors

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

Verizon Communications VZ 37.70 54.00 0.70 QQQQQ Narrow o Energy 21.5

Western Union WU 11.92 17.00 0.70 QQQQQ Narrow d Healthcare 18.9
Comcast CMCSA 43.85 60.00 0.73 QQQQ Wide s Consumer Defensive 14.7
Medtronic MDT 82.38 112.00 0.74 QQQQ Wide f Utilities 10.4
Kellanova K 55.91 75.00 0.75 QQQQ Narrow i Communication Services 9.7
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.

68 Morningstar Q1 2024
 Morningstar Exponential Technologies Moat Focus Index This index is designed to provide exposure to 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 12/31/2020–12/31/2023 Valuation as of 12/31/2023

$14K
Morningstar Global
Overall Index P/FV 0.86
Large Cap
12 $12,046 1-Year Index Performance
Morningstar Return 36.93%
10
Exponential Tech Standard Deviation 25.70%
Moat Focus Sharpe Ratio 1.15%
8 $10,632
Max Drawdown –16.17%
6
57 Constituents
12/2020 12/2021 12/2022

Five Cheapest Index Holdings Top Five Sectors

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

Nexi NEXI:IT EUR 7.41 EUR 15.80 0.47 QQQQQ Narrow a Technology 51.3
Albemarle ALB $144.48 $300.00 0.48 QQQQQ Narrow d Healthcare 22.4
Aptiv APTV $89.72 $152.00 0.59 QQQQQ Narrow r Basic Materials 6.7
Roche Holding ROG:CH CHF 244.50 CHF 414.00 0.59 QQQQQ Wide p Industrials 5.6
Illumina ILMN $139.24 $228.00 0.61 QQQQQ Narrow i Communication Services 4.0

Morningstar Global Markets Sustainability Moat Focus Index 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 12/31/2020–12/31/2023 Valuation as of 12/31/2023

$13K
Morningstar Global
Overall Index P/FV 0.86
12 Large Cap
$12,046 1-Year Index Performance
11 Return 16.66%
Morningstar Global
10 Sustainable Standard Deviation 19.65%
Moat Focus Sharpe Ratio 0.61%
9 $11,772
Max Drawdown –14.34%
8
300 Constituents
12/2020 12/2021 12/2022

Five Cheapest Index Holdings Top Five Sectors

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

Delivery Hero DHER:DE EUR 25.01 EUR 88.00 0.28 QQQQQ Narrow a Technology 18.21
China Education Group 00839:HK HKD 4.90 HKD 12.10 0.40 QQQQQ Narrow y Financial Services 17.42
Tencent Holdings 00700:HK HKD 293.60 HKD 704.00 0.42 QQQQQ Wide t Consumer Cyclical 16.78
SJM Holdings 00880:HK HKD 2.47 HKD 5.80 0.43 QQQQQ Narrow i Communication Services 13.72
Nexi NEXI:IT EUR 7.41 EUR 15.80 0.47 QQQQQ Narrow d Healthcare 11.08
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 69
 Data Dashboard

Morningstar Global Fund Flows

Flows by U.S. Category Group 12/31/2023

Organic Growth Rate % Total Net Assets

Category Group Q4 1-Mo 1-Mo Active 1-Mo Passive 1-Yr $Bil Mkt Sh% Rank
US Equity 0.55 0.36 –0.61 1.02 –0.14 13,377 50.43 1
Sector Equity –1.26 –0.26 –1.23 0.24 –4.87 1,274 4.80 5
International Equity –0.30 0.10 –0.67 0.98 0.42 3,874 14.60 3
Allocation –2.14 –0.67 –0.68 0.46 –6.52 1,380 5.20 4
Taxable Bond 0.73 0.43 –0.05 1.06 4.65 5,195 19.59 2
Municipal Bond –0.83 0.03 –0.17 1.41 –0.76 864 3.26 6
Alternative 0.05 –0.32 –0.40 0.11 –3.28 207 0.78 7
Commodities –1.70 –0.72 –3.94 0.23 –8.53 157 0.59 8
Nontraditional Equity 2.10 0.34 0.36 0.19 — 94 0.35 10
Miscellaneous –2.67 –2.74 –0.50 –2.83 3.04 102 0.39 9
All Long Term 0.16 0.22 –0.49 0.94 0.34 26,524 100.00 —
–3 –2 –1 0 1 2 3

Quarterly Flows for Largest Morningstar Categories 12/31/2023

The technology Morningstar Category saw net inflows in the fourth quarter, The high-yield bond Morningstar Category was one of the more popular
perhaps a result of investor enthusiasm for artificial intelligence technology. in 2023’s fourth quarter. Meanwhile, inflation-protected bond funds saw net
Fund investors also showed a preference for small-blend funds. outflows as investors became less concerned with inflation.

Total Net Largest Fixed-Income Total Net

Largest Equity Categories Q4 Organic Growth Rate % Assets $Bil Categories Q4 Organic Growth Rate % Assets $Bil

Large Blend 1.50 6,803 Intermediate Core Bond 1.99 1,292

Large Growth –0.31 2,514 Intermediate Core-Plus Bond –0.29 762
Large Value –1.05 1,687 Short-Term Bond –3.67 496
Foreign Large Blend 0.91 1,467 Ultrashort Bond 0.65 340
Diversified Emerging Mkts 0.09 635 High Yield Bond 3.01 318
Mid-Cap Blend –0.38 612 Muni National Interm 1.38 314
Small Blend 2.17 562 Multisector Bond 0.88 281
Foreign Large Growth –2.11 491 Global Bond-USD Hedged 1.71 274
Mid-Cap Growth –1.80 379 Intermediate Government 1.65 247
Technology 1.62 346 Inflation-Protected Bond –4.04 216
–3 0 3 –5 0
–0.39 5
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.

70 Morningstar Q1 2024
Morningstar Medalists

Short List: The Best Active Taxable-Bond Funds

Last year will go down as an “everything rally,” but
bond funds saw the most significant net inflows:
Overall, taxable fixed-income categories had a nearly
5% growth rate. While the economic and inflation
outlooks remain cloudy, the top portfolio managers
interviewed in this issue’s Morningstar
Conversation agree that bonds are currently more
attractive than equities on a risk-adjusted
basis—and that discriminating managers are best
positioned to navigate the changing terrain
(“An Oasis of Bond Opportunities,” Page 50).
The actively managed funds below have earned
Morningstar Medalist Ratings of Gold
from Morningstar’s manager research team.

1-Year Performance and Risk %

Morningstar Morningstar Morningstar Standard Sharpe Fund Size
Name Morningstar Category Medalist Rating Fee Level Rating Return Deviation Ratio $Bil

T. Rowe Price Floating Rate PRFRX Bank Loan ΠAverage QQQQQ 12.29 2.93 2.17 3.38
BlackRock Strategic Global Bond Instl MAWIX Global Bond ΠBelow Avg QQQQ 6.75 8.65 0.19 0.75
Dodge & Cox Global Bond I DODLX Global Bond ΠLow QQQQQ 12.31 9.19 0.74 2.58
Pimco International Bond (Unhedged) Instl PFUIX Global Bond ΠLow QQQ 6.69 11.34 0.16 0.86
Pimco International Bond (USD-Hdgd) Instl PFORX Global Bond-USD Hdgd ΠLow QQQQQ 9.49 4.74 0.83 14.16
BlackRock High Yield Bond K BRHYX High Yield Bond ΠLow QQQQ 13.68 7.29 1.08 20.82
PGIM High Yield A PBHAX High Yield Bond ΠAverage QQQQ 11.90 7.25 0.86 17.82
American Funds Bond Fund of Amer A ABNDX Interm Core Bond Œ Average QQQQ 4.70 8.50 –0.04 80.15
Baird Aggregate Bond Inst BAGIX Interm Core Bond ΠLow QQQQQ 6.43 8.63 0.15 42.62
Fidelity Investment Grade Bond FBNDX Interm Core Bond ΠBelow Avg QQQQQ 6.50 8.73 0.16 8.68
Baird Core Plus Bond Instl BCOIX Interm Core-Plus Bond ΠLow QQQQ 6.89 8.47 0.20 27.77
BlackRock Total Return K MPHQX Interm Core-Plus Bond ΠLow QQQQ 6.03 9.09 0.11 18.55
Dodge & Cox Income I DODIX Interm Core-Plus Bond ΠBelow Avg QQQQQ 7.70 8.60 0.29 70.16
Fidelity Total Bond Fund FTBFX Interm Core-Plus Bond ΠBelow Avg QQQQQ 7.25 8.34 0.25 34.12
Loomis Sayles Core Plus Bond A NEFRX Interm Core-Plus Bond ΠAbove Avg QQQ 5.91 9.88 0.09 7.02
Pimco Total Return ESG Instl PTSAX Interm Core-Plus Bond ΠAverage QQ 5.79 8.68 0.08 1.93
Pimco Total Return Instl PTTRX Interm Core-Plus Bond ΠBelow Avg QQQ 6.30 8.64 0.14 54.77
JPMorgan Government Bond I HLGAX Interm Government Œ Below Avg QQQQ 4.38 7.64 –0.09 1.92
Pimco GNMA and Government Secs Instl PDMIX Interm Government ΠAverage QQQQQ 6.32 9.00 0.14 1.37
Pimco Long Duration Total Return Instl PLRIX Long-Term Bond ΠAverage QQQ 7.58 17.99 0.20 2.98
Muzinich Credit Opps Supra Instl MZCSX Multisector Bond ΠLow QQQQ 7.48 6.05 0.35 0.26
Pimco Diversified Inc Instl PDIIX Multisector Bond ΠAverage QQQ 10.39 8.08 0.61 3.33
Pimco Income Instl PIMIX Multisector Bond ΠLow QQQQQ 9.32 6.74 0.57 137.46
BlackRock Strategic Income Opps Instl BSIIX Nontraditional Bond ΠLow QQQQ 7.26 4.79 0.39 35.99
Baird Short-Term Bond Instl BSBIX Short-Term Bond ΠLow QQQQ 5.65 2.21 0.12 9.53
Baird Ultra Short Bond Instl BUBIX Ultrashort Bond ΠLow QQQQ 5.71 0.43 0.72 6.29
Pimco Short Asset Investment Instl PAIDX Ultrashort Bond ΠAverage QQQ 5.66 0.45 0.58 2.51
Source: Morningstar Direct. Data as of Dec. 31, 2023. 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 71
 Ten Questions
Mike Valentine joined Wasatch Global
Investors in 2016. He is a portfolio manager
on the U.S. small-cap and global research
teams and the co-head of U.S. small-cap
investing. Before joining Wasatch, Valentine
was a portfolio manager at Point72 in
Boston where he led a team of analysts and
managed a long/short fund focused on the
technology and telecom sectors. He
worked from 2005 to 2012 as an analyst and
a portfolio manager at Fidelity Investments.
Valentine has a Bachelor of Arts degree
in computer science from Amherst College.
Photography by Kim Raff.
72 Morningstar Q1 2024
Wasatch’s Mike Valentine on
big opportunities in small-cap stocks.
Laura Lallos, managing editor of Morningstar
magazine, interviewed Valentine in December.
1. Is now a good time to invest in small caps?
We think it’s an opportune time. 2022’s broad
market selloff was especially hard on small-cap
companies outside the commodities-oriented
sectors. Some of these companies beat Wall Street
estimates, and grew revenues by over 15% but
were down double-digits. We haven’t witnessed
this phenomenon since 2008 and think it’s
an excellent opportunity to add to quality names
at attractive valuations.
2. How might the Fed’s higher-for-longer stance
affect small caps?
The environment hasn’t changed much for
companies that don’t rely on borrowing to fund
their growth. We’re finding plenty of high-
quality, best-of-breed small caps that we think can
continue to post double-digit growth despite a
“higher-for-longer” scenario while weaker players
struggle to find capital.
3. What qualities do you look for in a small-cap company?
We look for companies with self-funded
growth, low debt, and sustainable competitive
advantages. We also spend an extensive amount
of time evaluating management teams. Our
thorough assessment and systematic ranking of
management teams have proven vital, with
our highest-ranked teams consistently aligning
with our best-performing stocks.
4. What issues are these management teams
raising today?
In 2022, discussions revolved around inflation,
supply chains, and hiring. Those concerns
have been replaced with worries about how
artificial intelligence will impact their businesses.
In the face of an uncertain future, we
trust that top-tier management teams can best
navigate this complex environment.
5. Are any sectors particularly attractive now?
We’re finding great opportunities in the sectors
with the weakest performance over the
last few years, including consumer discretionary,
information technology, and industrials.
Our five-plus-year investment horizon allows
us to be patient.
6. Can you share a couple of picks?
Consumer-oriented housing names like Floor &
Decor FND, Pool POOL, and Trex TREX have
executed exceptionally well despite the challenges
consumer stocks have faced in recent years.
We anticipate significant growth for all
three companies in the next five years. Wasatch
has held Pool for over two decades, and it
continues to demonstrate consistent growth.
7. What’s the best advice you’ve received?
“There are a million different ways to make money
in the market. Pick one.” I take this as advice to
do what you love, and I’m passionate about finding
and investing in high-quality growth companies.
8. What do you enjoy doing outside work?
I earned my pilot’s license in college and still enjoy
flying whenever possible. While investment
management tends to be all-consuming, flying is
one of the rare chances I can fully get away.
9. Is there a charity or cause you support?
The Youth Sports Alliance offers after-school
programs to introduce students to winter sports
activities. Utah has fantastic winter sports facilities,
but many families lack the financial means
to get started. Several of my Wasatch colleagues
are also active supporters.
10. What are you reading these days?
I recently reread On Writing by Stephen King,
where he offers advice to aspiring writers. I have
no plans to write a novel, but effective
communication relies on strong writing skills.
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