morningstar directsm asset allocation demo script...

Morningstar® DirectSM Asset Allocation Demo Script (internal use only)

© 2012 Morningstar, Inc. All rights reserved.

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Outline (15-20 Minute Script) Provide Overview of Asset Allocation Modeling Create Your Asset Classes Develop, Refine, and Test Your Asset Class Assumptions Optimize and Identify your Target Allocations Forecast Future Performance Create a Custom Workspace Communicate the Results with Presentation Studio Show location of training resources (i.e. Live Sessions) Provide Overview of Asset Allocation Modeling 1. Click here http://morningstardirect.morningstar.com/clientcomm/AAPresentationDemo.pdf and go over the slides.

http://morningstardirect.morningstar.com/clientcomm/AAPresentationDemo.pdf



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Create Your Asset Classes Before we begin to go through the Asset Allocation Modeling process, let’s first focus on creating our Asset Classes. Once we’ve demonstrated this, then we will go through the process to build our asset class set, develop our assumptions, optimize them to identify new target allocations and then forecast future performance. Let’s begin. 1. Click on the Asset Allocation folder located on the left pane to activate the inputs landing page on the right. Here, you will find various Morningstar Input files, containing asset classes and models to start your process.

2. As you create your own inputs with your distribution model of choice, you can then use these input files to build your case files for optimization and forecasting as displayed here in the Case File tab. Like the Inputs tab, only the Morningstar files will be displayed. These sample case files will contain specific charts and tables for you to use. In our demonstration today, we will create our own case file.



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3. Let’s proceed and create a sample Asset Class Set. Go to the top left wheel and select Asset Class Setup. Take note of the Owner column, which indicates who created the file. Morningstar files are provided by default and cannot be changed or erased.

4. Click on the Asset Class Set drop down and show them your existing sets.



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5. Click on New Set and we’ll demonstrate how to create an Asset Class Set consisting of 2 asset classes. Proceed to give a name to your New Set (e.g. Demo). Click OK, once complete.

6. Begin to add your new Asset Class Set. Demonstrate how to add two proxies (i.e. US and Intl Equity Asset Class). As you create your Asset Class Set, the historical date range will be provided.



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7. Once you’ve completed adding your proxies to your new set, it can then be used for your input file. Although the base currency is indicated, you have the opportunity to adjust the currency as you’re creating your inputs file.

8. Once you’re done, your new set will be listed in the drop down. Note, for demonstration purposes, we will use an Asset Class Set that has more choices than the two we just created.



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Develop Asset Class Assumptions 1. Let's now begin to create a new inputs file with our Asset Class Set. Click on New Inputs.

2. Select an Asset Class Set. For this demo, pick the set that you’ve already created, but note that you can also modify an existing Asset Class Set and Save As to keep the original. The components of the Asset Class Set will get activated automatically, but then you can uncheck the asset classes that you don’t want to include for your inputs file.



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3. Go to the Select Model drop down where you have various models to choose from. For demonstration purposes, we will use the Log-Normal (default) to determine the expected return, risk, and correlations necessary to run the optimization. You also have access to the Bootstrap Historical Data and Johnson Distribution models.

4. Should you need to change the base currency, click on the currency drop down to select another choice for your asset classes. This converts the currency, which is different from currency hedging.1 Once complete, click OK.

1 Currency conversion converts a historical return stream into a different currency using the spot rate of each day in the return stream. Another way to look at this is that currency conversion “translates” returns into the currency that matters to you, assuming no hedge whatsoever. Example: If you invest $100 in Europe, and the European instrument you invested in rose 100%, and if during that time, the exchange rate went from $1 per Euro to $0.50 per Euro, you made or lost no money. The capital gain in your investment was offset by a strengthening of the USD. Currency conversion would reflect that fact. Currency hedging, on the other hand, would have assumed that you periodically protected yourself from fluctuations in the $ to Euro exchange rate, and hence captured some of the 100% rise in the European instrument. How much you captured would depend on the frequency of your hedge and the prevalent forward rates. Currency hedging is not yet available in Morningstar Direct, although we are planning on introducing it.



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5. You will be taken to the Input Options tab. Go over the following. a. Go to the Inflation Series dropdown should you want to select an asset class to represent inflation. If you leave it

as none here, you can change this later by going to the top tool bar, click on the Inputs tab and go to Options. During forecasting, you will have the option to display your results in real or nominal returns by using previous selected inflation series. Inflation does not affect the efficient frontier.

b. Next, go to the Return Display Frequency to select the frequency to display the results. Annual is the default. c. To the right and below are Simulations and Random Seed.

o Note that some of the optimization methods and models require running Monte Carlo simulations. Here, you can also change the number of simulation runs. All Monte Carlo simulations involve producing random numbers. The randomness of the simulation should have only minor effects on the outcomes. You can leave random seed unchecked in order to get identical results every time or you can activate it and compare different results to see how much of the results are driven by the randomness of the Monte Carlo simulation.



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6. Next go to the Set-Up tab. Here, you can decide from historical inputs (default) to refine inputs such as Building Blocks, CAPM, and Black-Litterman. For demonstration purposes, we will use historical inputs. At this point, when we have the FAQ docs available, you can point them to the location. Let’s proceed to the Baseline Settings tab.



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7. In this location, you will find specific settings to calculate your inputs. Go over the following. a. The Risk-Free Rate will determine your client's investment time horizon. We will use Long-Term but you do have

the option to select Short or Intermediate choices -- click on the drop down as you’re talking about this. o Notice that the choice will drive the Current Risk-Free Rate value but you can override the value. o Whether you override it or not, the rate is not dynamic. Each time you open the file, you must click Reset

to pull in the most recent value. b. The other settings on this page (Historical Risk-Free Rate and Premia Baseline Series) pertain to refined inputs

such as Building Blocks, CAPM, or Black Litterman where all the proxies again can be overridden by your own choices.

c. At any point, you can save your settings as defaults for future inputs.



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FYI: The following baseline settings are used for the Expected Return methodologies. Keep in mind that the only method for calculating standard deviation, correlation, skewness, and kurtosis is historical. So they do not rely on these Baseline Settings.



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Refine and Test Your Asset Class Assumptions 1. You will now be taken to the Inputs default view driven by your default browser (Firefox/Google Chrome/IE9). For demonstration purposes, we will go through the process to refine and test inputs, optimize and identify target allocations, and then forecast the future performance -- where all locations talk to each other and produce dynamic results. Talk about the following: We've organized the workflow into three main sections. All results are driven by your choices from the Inputs wizard we just completed. You can also create your own workspace as we will show later. o Inputs Workspace to refine/test your inputs o Optimizer Workspace to identify target allocation o Forecast Workspace to forecast wealth/return outcomes



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2. The inputs workspace will activate four default windows. Clockwise, talk about the following: a. Go to your Input Summary window displaying the Annualized Expected Mean and Standard Deviation -- as you

recall, we kept the default to Annually in the Input Options window. b. Next, go to the right and you will find the correlations of each asset class assumption to each other. c. Next, proceed to the Asset Class Statistics table where you will find calculations such as refined arithmetic mean,

standard deviation, geometric mean, skewness, excess kurtosis, sharpe ratio, and much more including CVAR and Downside Deviation risk measures.

d. Go to the Asset Class Distributions to understand the distribution of returns.



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3. As you may have noticed, most windows will allow you to customize the settings. Keep in mind, where you see “Edit” you can change the settings in the window. For example, click on Edit in the Asset Class Distribution window. Proceed to check the box to show the histogram bars for each asset class.



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4. At any point, you can expand the window to view your results more closely. The curve represents the log normal distribution model that we developed in the inputs. Once we optimize and do forecasting, the asset class distribution will drive the results. The histogram is the historical data for each asset class. So this graph can be used to show how well the theoretical model, in this case log-normal, fits historical data.

5. Let’s continue. To alter the default windows in your display, activate the groupings at the bottom left hand corner. As you can see for Inputs Grouping, you have the various chart and table choices, some already displayed in your view. You can also utilize charts and tables from Optimizer or Forecasting windows to customize your workspace as we will show you later.



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6. Before we move on, let's practice and bring in one of the input windows into our view. Select Asset Class Growth to view historical growth of each of the asset classes. Let them know they can resize and place into one of the quadrants.

7. Let’s now discuss the top options. Go through the following but click on each button as you’re discussing the purpose. a. Go to Manage Inputs should you want to bring in multiple inputs where you can toggle between the input files. b. Go to Asset Classes should you want to add new asset classes or delete existing asset classes. Starting Dec 7,

you will also be able to select another Asset Class Set here. c. Go to Options, should you want to alter any of the input options that we covered early in the Input Wizard. d. Go to Estimates to make alterations concerning Arithmetic Mean, Standard Deviation, Correlation, and Inputs

Summary. Here you can activate User Defined inputs to input your own inputs in the Input Summary tab. e. Go to Constraints to apply constraints to each individual asset class or apply constraints at group level such as all

equities or apply relative constraints such as all equities will outweigh all fixed income. For demonstration purposes, we will not apply any constraints.



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8. Let’s discuss the Estimates window further. This is now the location to create User Defined inputs and not in the Input Wizard. This is also the location where you can examine the quality of the correlation matrix. As you’re viewing your correlations, you can activate the Estimates window to examine the correlation matrix value. You are looking for a condition number of 20 or below. Above that, the matrix become unstable, meaning it is increasingly susceptible to large changes in outputs based on tiny changes in inputs.

9. We've just completed the Inputs process. We are now ready to move onto the Optimzer Workspace. Keep in mind, all results across all workspaces are dynamic. Let’s now proceed to the Optimizer Tab.



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Optimize and Identify your Target Allocations 1. Once you’re in Optimizer Workspace, your default windows will get activated. Notice on the right hand side is the efficient frontier where each point along the frontier represents an optimal portfolio based on your inputs. Let's proceed and identify our target allocations, but for comparative purposes, let's first bring in current allocation of our client's portfolio. Go to the top and click on Add Asset Mix.

2. Proceed to type “Current Portfolio” for the name. Next, go to the Weight column. Input your weights of the current portfolio. Click OK, once complete.



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3. Your current portfolio will be displayed. As you can see on the left, your windows will now populate your first asset mix which is the current portfolio. On the right, is the location of the current portfolio below the efficient frontier.

4. Let's continue and add our first target allocation. As stated, the current portfolio falls below the efficient frontier but what if you were to search for an asset mix for the same amount of risk which is 11.56 (displayed in Asset Mix Statistics). For example, go to the location of the Current Portfolio in the efficient frontier window, line it up, and click on the efficient frontier. Proceed to select Add Asset Mix.



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5. By default, the efficient frontier is made up of 100 asset mixes. The point we found that is approximately at the same risk level as our current portfolio but is Position 52. Let's rename this.

6. Rename it to "Same Risk".



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7. Before we view our target allocation on the efficient frontier, let’s discuss the other options in the Add Asset Mix view: o If we decided not to line up on the efficient frontier, we can also search for a new target allocation by using the

“Search” function at the bottom. So here, you can search by specific standard deviation (such as our 11.56) or by other return and risk factors (left chart)

o To search for portfolios along the Efficient Frontier, enter specific target risk or return figure and specify which risk and return methodology you would like to use. Scroll down as you’re showing this.

o Once you’re complete, click OK.

8. You will now see your new target allocation with the same risk displayed on the efficient frontier in addition to the supporting data in the left windows.



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9. You can continue to add more target allocations such as one that may be more moderate and another as being aggressive. Quickly add these by lining up your cursor at the bottom and top of the efficient frontier and name them “Conservative” and “Aggressive”.

10. You can edit and delete Asset Mixes by hovering over the name of the Asset Mix in any of the chart legends and labels – look for the red ‘x’



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11. At any point, you can also customize the settings to alter the optimization results for the efficient frontier. Go to the top and click on the Optimizer Tab. Then, select Optimization to change any of the necessary settings to alter the efficient frontier which will also impact your future target allocations. Therefore, these changes will not alter the weights of your current asset mixes but can be used for comparative purposes. Note, since we’ve already covered the other options previously, we’ll only focus on Optimization.

12.. In the Optimization Settings window, you have the option to Resample which produces more diversified and robust portfolios, recognizing that Capital Market Assumptions are forecasts and not a "sure thing". If you activate resampling from here, you will resample the efficient frontier without impacting the current asset mixes. Resampling settings are available at the bottom left.



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12. We've just completed the Optimization process. At any point, you can customize the window in your workspace by using the Edit command or replacing the current windows with those listed at the bottom of your view. We are now ready to move onto the Forecasting Workspace. Keep in mind that all results across all workspaces are dynamic.



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Forecast Future Performance 1. Now that we have established our target allocations, let's proceed to forecast the future performance. Click on the Forecasting Workspace tab and you will be taken to the display view. o Here, you can utilize the various charts and tables to forecast future performance. o For example, go to the Wealth Percentiles window to compare the Current Portfolio to the target allocation with

the “same risk”: you have a 5% chance of achieving 2.18 million dollars within the next 5 years should you maintain the same portfolio but if use the “same risk” target portfolio, you have a 5% chance of achieving 2.49 million dollars within 5 years.



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2. As we've seen throughout the demonstration, you can edit your window settings. You can also access more settings from the top menu bar. For example, click on Forecasting and you will be taken to the Basic Tab should you want to change any of the settings including initial wealth, rebalancing, and the ability to show Back History. Here, you can also activate Inflation Adjust should you want to view your forecasted results in real terms. The inflation adjustment relies on the asset class you chose to represent inflation - earlier during input process.

o If you choose to rebalance, it will always take place at the beginning of each forecasting period. If you select Periodic rebalancing, the whole portfolio will be rebalanced every “x” periods, and only if one or more asset classes are away from their target by “y” % of the target allocation.

3. Go to the Display tab to customize display views for percentiles, project year, target return, and target value.



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4. Proceed to go to the Cash Flow tab to add cash flows. Go over the following: o Here, you can add cash additions and withdrawals driven by monetary amount, % of initial wealth, or % of most

recent value. o For example, you could apply a “cash addition” where your portfolio requires a contribution of 5% of its current

value every year from 2016 to 2021. o And/Or you could apply a “cash withdrawal” where your portfolio requires a distribution of 5% of its current value

every year from 2018 to 2020.

5. At any point, you can customize the window in your workspace by using the Edit command or replacing the current windows with those listed at the bottom of your view.



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Create a Custom Workspace 1. We’ve just completed going through the process of selecting our inputs, identifying our target allocations, and forecasting future performance. As we have discovered, the default workspaces are grouped into three main functionality groups: inputs, optimizer, and forecasting, but you can add additional workspaces containing your favorite windows from each gallery. For example, click on the Plus sign and select a Layout.

2. Using the galleries at the bottom of your view, you have a comprehensive list of window choices for Inputs, Optimizer, and Forecasting as you are creating your custom workspace. You can also give your workspace a name (Custom Workspace). Once complete, you have your own custom workspace.



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3. Let’s go ahead and save this file. Go to the Top Left wheel and click on Save to activate the Save window. Here, you will have an opportunity to save display settings and all components in your Optimizer, Forecast, and Custom Workspaces as a Case file. You can also save your inputs which are considered the raw data to create your windows for Optimization and Forecasting. Once complete, click OK.

4. Lastly, before we go onto Presentation Studio to communicate the results, let’s demonstrate how to add additional input files to your efficient frontier. Go to Manage Inputs at the top and select one file. In this case, we are selecting the Johnson Input file but you can select more input files such as the Bootstrap model, once you’ve created them (limit of 5 input files per case file).



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5. You will now see that the efficient frontier reflects the new inputs file. As you add your input files to the current efficient frontier, toggle between them from the top left drop down, as you add the target allocations to each one. Once the target allocations have been added to the efficient frontier, then the remaining windows will automatically populate.

6. Note, you can continue to save this file again but this time with your additional input file. Also, once saved it will be stored in your input and case folders within Direct where you can share the files with your colleagues.



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Communicate the Results with Presentation Studio Now that we have just completed the asset allocation modeling process, using Log-Normal distribution, let's now discuss how to present the results in Presentation Studio which is Morningstar Direct's platform for creating custom presentations. Presentation Studio helps you better communicate your results while being able to customize the settings and displays for each chart and table in addition to applying your own fonts, colors, and logos. 1. Open Presentation Studio and click on Asset Allocation.

2. You will automatically be taken to the Create New Report window. Keep in mind, you need to create your asset allocation case files and asset mixes ahead time and then retrieve them in this location. Let's continue and click on Morningstar Templates and select the choice from the drop down.



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3. You will be taken to the Find Asset Mixes window.

4. Go to the drop-down and locate your case file.



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5. It will automatically display the components as shown here - where we have the current portfolio and its three target allocations. Proceed to click OK.

6. You will be taken to the Asset Mix setting window to modify color and marker choices. Click OK.



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7. Your report will automatically generate using the Mstar Template as shown here. Click on the URL and go through the pages. Do not generate the report but open the URL from here. http://morningstardirect.morningstar.com/clientcomm/MstarTemplateAssetAllocation.pdf 8. In addition to the Asset Allocation chart and table choices, you can also bring additional components to present your results further for the Asset Class Assumptions and Asset Mixes. These components are all based on the historical data of your Asset Class Proxies. http://morningstardirect.morningstar.com/clientcomm/F.AssetAllocationSamples.pdf Show location of training resources (i.e. Live Sessions) 1. For more information on Asset Allocation, including the methodologies and presentations, refer to the Training folder in Direct. Here, you will also find training resources for Presentation Studio and Total Portfolio Attribution should you want to apply your new target allocation weights to your investment policy.
http://morningstardirect.morningstar.com/clientcomm/MstarTemplateAssetAllocation.pdfhttp://morningstardirect.morningstar.com/clientcomm/F.AssetAllocationSamples.pdf

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