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Market Beta is a Commodity. Don't Overpay.

Benchmarks representing the same market segments are not
sufficiently differentiated to command premium pricing.

Morningstar Inc. Volatility roiled long-placid equity markets in February 2018. Triggered by fears of rising U.S. interest
March 2018 rates, stocks plummeted early in the month, then recovered, before ending down. How did benchmarks
designed to represent the U.S. equity market gauge the volatile month?
Author
Dan Lefkovitz Exhibit 1 U.S. Equity Market Benchmarks: February 2018 Performance
Morningstar Indexes
+312 696-6649
dan.lefkovitz@morningstar.com Index 1 Month Total Return
(Feb 18)
S&P 500 TR USD -3.686
Russell 1000 TR USD -3.671
Russell 3000 TR USD -3.686
CRSP US Total Market TR USD -3.722
MSCI USA IMI GR USD -3.718
Morningstar US Market Index TR USD -3.687

Source: Morningstar Direct

The benchmarks displayed above vary in their methodologies and index parameters. Some aim to reflect
only the higher end of the market, while others provide a more comprehensive view. They might be
managed by committee or governed by precise construction rules. While some utilize a fixed count
system (e.g. 500 stocks), others capture a certain percentage of the market's value, with the number of
constituents varying accordingly. On the similarity side, all are weighted according to float-adjusted
market capitalization. All rebalance/reconstitute periodically to reflect market changes.

Despite the nuance, these benchmarks delivered nearly identical returns in February 2018. Across the
market's ups and downs, they netted out within a few basis points of each other. The commonly applied
market capitalization weighting approach, which ensures macro-consistency and low turnover, drives
this convergence. Consider the similar returns of the Russell 1000 Index and the Russell 3000 Index,
despite a 2,000 stock difference. Due to market cap weighting, both devoted more than 3% of their
respective weight to common top holding Apple in February 2018.

While the "smart beta" phenomenon has introduced enormous complexity to indexes reflecting rules-
based passive investment strategies—i.e. two index providers can define a factor like "Quality" quite
differently—benchmarks representing the market are commoditized. Investors can reduce their costs,
and thereby improve their outcomes, by paying as little as possible for market beta.
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Vanguard Takes the Lead
In 2012, Vanguard shocked the asset management industry by swapping benchmarks tracked by 22 of
the firm's index funds and ETFs. For funds focused on U.S. equities, Vanguard transitioned from MSCI to
equivalent benchmarks built by the University of Chicago's Center for Research in Security Prices (CRSP).
On the ex-U.S. equity side, Vanguard switched to FTSE. The changes impacted funds with a total of
$537 billion in investor assets, which then represented one quarter of the firm's asset base.

"There were three main reasons for this change: cost, cost, and cost," said Vanguard executive Joel
Dickson in a 2012 video interview for Morningstar.com. Dickson explained that Vanguard was reacting to
rising index licensing fees, which represent an ever-larger percentage of index-tracking funds' expense
ratios. As a firm owned by its fund holders, Vanguard constantly looks for opportunities to cut costs and
pass along savings to investors.

"Through a series of best practices that most of the index providers have converged to over the years,
the differences…are relatively small," said Dickson. In fact, this was not the first time Vanguard
switched fund benchmarks. The Vanguard Total (U.S.) Stock Market Index Fund tracked the Dow Jones
US Total Stock Market Index (formerly the Dow Jones Wilshire 5000 Index) from 2001 to 2005, the
MSCI U.S. Broad Market Index from 2005 to 2012, and the CRSP U.S. Total Market Index since 2012. It
carries a 0.15% expense ratio, a top performance ranking, and more than $700 billion in assets.

Vanguard's 2012 observation–that market benchmarks are essentially interchangeable–is borne out in
the following two case studies. The first compares the Russell 1000 Index and the Morningstar US
Large-Mid Cap Index. The second compares the MSCI All Country World Index and the Morningstar
Global Markets Large-Mid Cap Index. Returns-based and holdings-based comparisons are included.

Exhibit 2 Russell 1000 Index / Morningstar US Large-Mid Cap Index: Rolling Returns Comparison
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Source: Morningstar Direct.

Exhibit 3: Russell 1000 Index / Morningstar US Large-Mid Cap Index: Calendar Year Returns Comparison

Source: Morningstar Direct.

Exhibit 4 Russell 1000 Index / Morningstar US Large-Mid Cap Index: Risk/Reward Comparison

Source: Morningstar Direct.

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Exhibit 5 Russell 1000 Index / Morningstar US Large-Mid Cap Index: Holdings-based Comparison

Source: Morningstar Direct.

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Case Study 2: MSCI Emerging Markets Index / Morningstar Emerging Markets Large-Mid Cap Index

Exhibit 6 MSCI Emerging Markets Index / Morningstar Emerging Markets Large-Mid Cap Index: Rolling Returns Comparison

Source: Morningstar Direct.

Exhibit 7 MSCI Emerging Markets Index / Morningstar Emerging Markets Large-Mid Cap Index: Calendar Year Returns Comparison

Source: Morningstar Direct.

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Exhibit 8 MSCI Emerging Markets Index / Morningstar Emerging Markets Large-Mid Cap Index: Risk-Reward Comparison

Source: Morningstar Direct.

Exhibit 9 MSCI Emerging Markets Index / Morningstar Emerging Markets Large-Mid Cap Index: Holdings-based Comparison

Source: Morningstar Direct.

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In both cases, the comparable benchmarks display similar risk-return characteristics and portfolio
composition. The Holding-based Style Map plots the weighted average of constituent attributes on
dimensions of market capitalization and investment style (Growth v. Value). The 10-factor Morningstar
Style Box model includes metrics such as Price to Earnings and Price to Cash Flow. Other holdings-based
attributes not captured in the Style Box, such as stock concentration and sector weightings, are similar
for both sets of benchmarks compared above.

Morningstar Open Indexes Project

Since Vanguard cited index licensing costs as the driver of its decision to swap benchmarks tracked by
22 funds, the index industry has consolidated. Fees charged for benchmarking investments and related
licensing costs paid by asset managers, wealth managers, and asset owners, have risen significantly.

The paradox of increasing index licensing costs at a time of downward fund fee pressure and
undifferentiated product drove Morningstar to act in 2016. Inspired by the concept of open source
software, Morningstar launched a disruptive initiative called the Open Indexes Project. The goal is to
make benchmarking more accessible. Morningstar is offering a subset of its global market-cap equity
index series to financial services firms for general benchmarking at no cost. Morningstar is also working
to make investment products tracking beta benchmarks more affordable.

Morningstar Research has demonstrated over the years that fees are a significant driver of relative
investment performance. Lower-cost funds outperform. Fees also help to predict risk-adjusted returns,
as the managers of higher-cost investments take on more risk just to stay even with lower-cost
competitors. Because index licensing fees are ultimately passed along to investors, the lower the costs
of benchmarking, the better the investor experience.

A 2016 paper produced by the Spaulding Group in conjunction with BNY Mellon, State Street, and
Northern Trust, came to the same conclusion as Vanguard in 2012 and Morningstar:

"There is minimal difference between several index providers that serve the U.S. and global equity
markets in terms of performance; while methodology varies among indexes, those variances are largely
tempered by capitalization weighting."
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About Morningstar, Inc.
Morningstar, Inc. is a leading provider of independent investment research in North America, Europe,
Australia, and Asia. The company offers an extensive line of products and services for individual
investors, financial advisors, asset managers, retirement plan providers and sponsors, and institution
investors in the private capital markets. Morningstar provides data and research on a wide range of
investment offerings, including managed investment products, publicly listed companies, private capital
markets, and real-time global market data. Morningstar also offers investment management services
through its investment advisory subsidiaries, with more than $195 billion in assets under advisement and
management as of December 31, 2017. The company has operations in 27 countries.

To learn more about Morningstar Indexes, visit:

http://indexes.morningstar.com/products/indexes

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