TY - JOUR T1 - An Index Methodology for Diversifying Business Risk JF - The Journal of Index Investing SP - 21 LP - 37 DO - 10.3905/jii.2017.8.3.021 VL - 8 IS - 3 AU - Rory Riggs AU - Jonathan Chandler AU - Mark T. Finn Y1 - 2017/11/30 UR - https://pm-research.com/content/8/3/21.abstract N2 - This article introduces a new passive weighting methodology for diversifying business risk: functional information system (FIS)–based stratified weighting. The FIS-based stratified-weight approach effectively diversifies related business risk (RBR), such as supply chain dynamics, customer groups, product types, or other operational attributes that affect groups of companies that share common earnings drivers. The proposed methodology addresses overconcentrations of business risk that regularly occur in capitalization-weighted or equal-weighted indexes. This approach maintains a diversified weighting of an index’s underlying business risks by allocating constituents to specific RBR groupings, defined using FIS classification, and then fixing the weight of each group via stratification. The motivation behind this methodology is the fact that stock performance is the result of business performance and diversifying business performance is the ultimate goal of a diversified equity index. The authors demonstrate the performance benefit of stratified-weighted versions of the S&P 500 and S&P MidCap 400 indexes over traditional market capitalization weighting and equal weighting, especially following periods of economic stress. They find that FIS-based stratified-weight indexes deliver consistent and significantly higher returns relative to standard capitalization-weighted market indexes and equal-weighted indexes (on average, 389 bps per annum for the S&P 500 and 175 bps per annum for the S&P 500 equal weight), while exhibiting comparable beta and volatility. This article proposes that these results are robust and are not related to the choice of the universe or to particular market conditions.TOPICS: VAR and use of alternative risk measures of trading risk, performance measurement ER -