Clinical Trials & Investing
In clinical trials, patients with diseases like cancer are stratified by certain characteristics, like age or gender, to get a random sample. That gives researchers the right number and type of patients to create a normalized control group to test a drug. The same methodology is used to create an index, but researchers sort stocks.
Riggs, who has an extensive background in biotechnology, tested drugs for idiopathic pulmonary fibrosis, and as part of a drug trial, the Food and Drug Administration gave the research firm the data for the stratified population. The trial was for a drug that was designed to improve outcomes, which Riggs says it did. That’s the genesis for the index.
Whereas clinical trials have categories like demographics or genomics, Syntax created a new classification system for economics, tagging securities with what it calls “functional value” to create a diverse population.
“We put values on your customer, your product and your customer’s product,” Riggs said.
Different Classification Approach
Syntax did this for 6,000 companies and all their product lines, sorting by risk groups. “We find that classifying people by what they do is a better measure of correlation then using covariance analysis,” Riggs noted.
He sees similarities in today’s markets to 1999, when 12% of the firms in the S&P 500 created switchers and routers. After the technology bear market, all but two firms were bankrupt. “Covariance wouldn’t save you [in that situation],” he said.
Now, the S&P 500 Index has 25% of the index dominated by technology, and within sectors, often the top 10 companies with similar business risks make up at least half of the sector. By stratifying the sectors, it creates greater diversification, Riggs said. The methodology takes the S&P 500 and breaks it into eight sectors of its choosing. Then the sectors are stratified. The index rebalances quarterly.
In an example using the industrials sector, the methodology assigns the sector a 12.5% weighting during rebalances, and within that, weights final products each by 3.5%. The materials sector, on the other hand, is evenly broken into plastics and natural resources.
Shift In Focus
Although Syntax has just one ETF, it created 15 indices—including midcap, European and Asian indices, and individual sector indices—in hopes of building a suite of funds. Riggs says they’re in talks with MSCI, Russell and Wilshire to create stratified versions of their indices.
Until recently, Syntax was mostly calling institutions to explain its process, but now Syntax seeks institutional investment, Riggs says.
The problem the stratified indices solve for institutions is finding ways to avoid correlation with the major market-cap-weighted indices. “Institutions need groups [of indices] that don’t correlate. We solve the model of diversification,” he explained. “Also, it shows you your risk exposures. Our goal is to have eight unique categories that don’t correlate.”
So why create an ETF for a retail audience if Syntax still wants to attract institutional money?
“It gives [investors] a better benchmark to track our performance, because they know exactly what our constituents are,” Riggs said. “I know that when they give [an investor] a constituent group, here’s what it looks like this way and here’s what it looks like another way.”