Adjusted assets index

What Is Adjusted Assets Index?

An Adjusted Assets Index is a type of equity or fixed-income benchmark where the constituent securities are weighted based on fundamental measures of a company's or issuer's size, rather than solely on their market capitalization. This approach falls under the broader umbrella of indexing strategies within portfolio theory, aiming to mitigate potential biases inherent in traditional market-capitalization-weighted indexes. Instead of assigning larger weights to companies with higher stock prices—which might be overvalued—an Adjusted Assets Index typically considers metrics like sales, earnings, book value, dividends, or other economic scale indicators. The goal is often to capture different risk premia or enhance risk-adjusted return compared to conventional indexes.

History and Origin

The concept behind an Adjusted Assets Index emerged from criticisms of traditional market capitalization-weighted indexing. Critics argued that market-cap weighting inherently leads to over-allocating to overvalued securities and under-allocating to undervalued ones, as security prices fluctuate based on market sentiment, not just fundamental strength. This concern gained prominence in the early 2000s, leading to the development of alternative weighting schemes.

A significant innovation in this area was the introduction of "Fundamental Indexing" by Research Affiliates, co-founded by Rob Arnott. This methodology proposes weighting index constituents based on measures of company size like sales, earnings, book value, and dividends, often averaged over several years to smooth out volatility. The aim was to create an index that reflects the "macroeconomy" rather than just market prices. The foundational concepts and methodologies for this approach were detailed in academic and practitioner papers, providing a robust framework for constructing an Adjusted Assets Index. Research Affiliates describes the core tenets of its Fundamental Index strategy, emphasizing its deviation from traditional cap-weighting by using fundamental measures of company size for selection and weighting.

#⁵# Key Takeaways

• An Adjusted Assets Index weights securities based on fundamental metrics (e.g., sales, earnings, book value, dividends) rather than market capitalization.
• This approach aims to reduce the inherent bias of market-cap-weighted indexes, which can over-allocate to overvalued stocks.
• It is considered a "strategic beta" or "smart beta" investment strategy that seeks to improve risk-adjusted returns.
• The methodology typically involves periodic rebalancing to maintain target weights based on the chosen fundamental criteria.
• Such indexes often target specific factors like value or quality, offering diversified exposure beyond pure market price.

Formula and Calculation

The calculation of an Adjusted Assets Index involves determining the weight of each constituent based on its contribution to the total "adjusted assets" of the index. Unlike a simple market capitalization weighting where an asset's weight is its market cap divided by the total market cap of the index, an Adjusted Assets Index uses a specific fundamental measure.

The weight (W_i) of a security (i) in an Adjusted Assets Index can be generally expressed as:

Where:

• (W_i) = The weight of security (i) in the index.
• (A_i) = The adjusted asset (or fundamental) value for security (i) (e.g., average sales, book value, profits, or a composite of these).
• (\sum_{j=1}^{N} A_j) = The sum of the adjusted asset values for all (N) securities in the index.

The specific "adjusted asset" used ((A_i)) varies by index and can be a single metric or a composite of several factors. For example, some indexes might use average gross revenues over five years, while others might use a combination of sales, cash flow, and dividends. The choice of adjustment methodology is crucial to the index's behavior and its potential for delivering alpha.

Interpreting the Adjusted Assets Index

Interpreting an Adjusted Assets Index involves understanding that it reflects the economic footprint or fundamental scale of companies rather than their fluctuating market valuations. A higher weight in an Adjusted Assets Index signifies a larger economic presence based on the chosen fundamental metric, irrespective of whether the market currently assigns a high or low multiple to that company's earnings or assets.

This contrasts with a market capitalization-weighted index, where a company's influence is directly proportional to its share price times shares outstanding. Therefore, an Adjusted Assets Index can provide a different perspective on market composition, potentially offering a more stable representation of economic activity or a systematic tilt towards certain investment styles like value investing. Investors often use these indexes to diversify beyond market-cap biases and pursue specific investment objectives.

Hypothetical Example

Consider a simplified hypothetical market with three companies: Alpha Co., Beta Corp., and Gamma Inc.

Market-Cap-Weighted Index:

• Alpha Co. weight: $1,000 / $3,500 = 28.57%
• Beta Corp. weight: $2,000 / $3,500 = 57.14%
• Gamma Inc. weight: $500 / $3,500 = 14.29%

Adjusted Assets Index (using Annual Sales):

• Alpha Co. weight: $2,000 / $4,500 = 44.44%
• Beta Corp. weight: $1,500 / $4,500 = 33.33%
• Gamma Inc. weight: $1,000 / $4,500 = 22.22%

As seen in this example, Beta Corp. has the largest market capitalization, giving it the highest weight in a traditional index. However, Alpha Co. has higher annual sales, resulting in a significantly larger weight in the Adjusted Assets Index. Gamma Inc. also receives a higher weight relative to its market capitalization. This illustrates how an Adjusted Assets Index prioritizes fundamental business size over market valuation, leading to a different asset allocation within the portfolio.

Practical Applications

Adjusted Assets Indexes are primarily used in the construction of passively managed investment strategy products, such as exchange-traded funds (ETFs) and mutual funds. These funds aim to provide investors with exposure to market segments using a weighting scheme that differs from traditional market capitalization for potentially enhanced returns or reduced risk.

Such indexes are a core component of what is often referred to as "strategic beta" or "smart beta" investing. Strategic beta strategies employ rules to exploit specific factors (like value, quality, or low volatility) to improve a portfolio's return profile or alter its beta,. F⁴o³r example, a strategic beta fund tracking an Adjusted Assets Index might select and weight holdings based on historical profitability, aiming to capture the "quality" factor. J.P. Morgan Asset Management highlights that strategic beta aims to provide cost-effective, passive exposure to specific markets while reducing risks inherent in market-cap-weighted indexes by using criteria other than company size to determine portfolio holdings.

#²# Limitations and Criticisms

While an Adjusted Assets Index offers potential advantages, it also has limitations. One significant critique is that by deviating from market capitalization weighting, these indexes intentionally incur higher tracking error relative to broad market-cap benchmarks. This means their performance will often diverge from widely followed market indexes like the S&P 500, which can be perceived as an unwanted source of risk by some investors.

Another limitation is the potential for increased turnover due to the periodic rebalancing required to maintain the desired fundamental weights. Unlike market-cap indexes that naturally adjust with price changes, an Adjusted Assets Index must actively buy and sell securities as their fundamental attributes change, which can lead to higher transaction costs and potential tax inefficiencies in certain investment vehicles.

Furthermore, the selection of specific fundamental metrics for "adjusting assets" can introduce its own biases. While attempting to capture true economic size, the chosen metrics might not always translate to superior investment performance, especially during periods when growth investing or other market dynamics are dominant. The regulatory environment for index fund products, including those based on adjusted assets, falls under oversight bodies such as the U.S. Securities and Exchange Commission (SEC), which regulates investment companies under the Investment Company Act of 1940. Th¹is regulation focuses on disclosure to protect investors but does not judge the merits of investment decisions or strategies.

Adjusted Assets Index vs. Market-Capitalization-Weighted Index

The primary distinction between an Adjusted Assets Index and a Market-Capitalization-Weighted Index lies in their weighting methodology.

Confusion often arises because both are forms of passive indexing. However, a Market-Capitalization-Weighted Index is often seen as the purest form of passive investing, aiming to track the overall market's performance. An Adjusted Assets Index, by contrast, is a form of "smart beta" that applies a specific, rules-based investment strategy to potentially outperform or manage risk relative to the traditional market benchmark.

FAQs

What is the main idea behind an Adjusted Assets Index?

The main idea is to weight companies in an index based on their fundamental economic size, such as sales or profits, rather than just their stock market value. This aims to reduce the risk of over-investing in overpriced stocks and under-investing in undervalued ones.

How does an Adjusted Assets Index differ from a standard market index?

A standard market index, like the S&P 500, weights companies based on their market capitalization (share price multiplied by shares outstanding). An Adjusted Assets Index uses different criteria, such as a company's sales, earnings, or book value, for weighting. This difference can lead to a different asset allocation and potentially different performance outcomes.

Are Adjusted Assets Indexes actively or passively managed?

They are generally considered passively managed because they follow a predefined, rules-based methodology rather than relying on a fund manager's subjective decisions. However, because their rules differ from traditional market capitalization weighting, they are often categorized as "strategic beta" or "smart beta" strategies, bridging the gap between traditional passive and active management.

Can I invest in an Adjusted Assets Index directly?

No, you cannot invest directly in an index. Instead, you can invest in financial products like exchange-traded funds (ETFs) or mutual funds that are designed to track the performance of an Adjusted Assets Index. These products hold the underlying securities in the same proportions as the index.