An Index Methodology for Diversifying Business Risk

This paper introduces a new passive weighting methodology for diversifying business risk: functional information system (FIS)–based stratified weighting. The FIS-based stratified-weight approach diversifies related business risk (RBR) — supply chain dynamics, customer groups, product types, and other operational attributes shared across companies — that capitalization- and equal-weighted indexes regularly leave overconcentrated.

The methodology allocates constituents to specific RBR groupings, defined using FIS classification, and fixes the weight of each group through stratification. Testing against the S&P 500 and S&P MidCap 400, the authors find that FIS-based stratified-weight indexes deliver consistent, significantly higher returns than standard capitalization-weighted and equal-weighted benchmarks — on average 389 bps per annum versus the S&P 500 and 175 bps versus its equal-weighted counterpart — while exhibiting comparable beta and volatility.

This is the founding empirical test of the functional-coordinate approach applied to index construction; see Financial Markets for how it developed into the Syntax Stratified Indices.

Read the paper at pm-research.com →

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