Adjusted index

What Is an Adjusted Index?

An adjusted index is a financial benchmark whose calculation methodology has been modified from a standard, typically market capitalization-weighted, approach to account for specific factors or achieve particular investment objectives. These adjustments aim to refine the representation of a market segment or incorporate alternative weighting schemes that deviate from simply assigning greater influence to companies with larger market capitalization. An adjusted index falls under the broader category of investment theory and is a key concept in portfolio management and passive investing. Unlike a raw, unadjusted index, an adjusted index seeks to mitigate certain biases or emphasize specific characteristics, making it a tailored tool for investors and analysts.

History and Origin

The concept of stock market indices dates back to the late 19th century, with Charles Dow's creation of the first stock index in 1884, leading to the Dow Jones Industrial Average (DJIA)³⁰. Early indices, like the DJIA, were price-weighted indices, where higher-priced stocks had a greater impact²⁹. As financial markets evolved and computing power increased, market capitalization-weighted indices became dominant, exemplified by the S&P 500 Index, which took its current form in 1957²⁸. This shift provided a more intuitive reflection of a company's actual market value within an index.

However, the inherent biases of pure market capitalization-weighting, such as overconcentration in large, potentially overvalued companies, led to the development of "adjusted" or alternative indexing methodologies²⁷. The U.S. Securities and Exchange Commission (SEC) has also played a role in modernizing the regulatory framework for financial products that track indices, such as exchange-traded funds (ETFs), which has facilitated greater innovation in index construction²², ²³, ²⁴, ²⁵, ²⁶. The continuous search for more robust and representative benchmarks has driven the evolution of adjusted indices, pushing beyond traditional weighting schemes.

Key Takeaways

• An adjusted index modifies a standard index calculation to reflect specific investment criteria or market views.
• These adjustments can involve altering weighting methodologies, such as moving from market capitalization to factors like revenue, dividends, or volatility.
• The primary goal is often to address perceived limitations of traditional indices, like concentration risk or momentum bias.
• Adjusted indices serve as benchmarks for tailored investment strategy and underpin various financial products.
• Their construction requires careful consideration of underlying data, rebalancing rules, and the specific objectives they aim to achieve.

Formula and Calculation

The general formula for a market capitalization-weighted index, before any specific adjustments, involves summing the market capitalization of all index constituents and dividing by an index divisor:

Where:

• (P_i) = Price of constituent security (i)
• (Q_i) = Number of shares outstanding (or float-adjusted shares) for security (i)
• (n) = Total number of constituents in the index
• Divisor = A proprietary number maintained by the index provider to ensure continuity during changes (e.g., stock splits, mergers, or constituent changes)¹⁹, ²⁰, ²¹.

An adjusted index modifies this base formula by changing how (Q_i) (the weighting factor) is determined, or by introducing new factors into the numerator. For example, a "fundamentally weighted" adjusted index might replace (Q_i) with a value derived from a company's sales, earnings, or book value, rather than its market capitalization¹⁸. Similarly, an equal-weighted adjusted index would assign the same (Q_i) to all constituents after rebalancing.

Interpreting the Adjusted Index

Interpreting an adjusted index requires understanding the specific adjustment made and its intended outcome. For instance, an equal-weighted index treats every company equally, regardless of its size, offering a different perspective than a market capitalization-weighted index that is dominated by a few large companies¹⁷. This means a small-cap company's performance will have the same impact as a large-cap company's performance in an equal-weighted adjusted index.

An adjusted index designed to reduce volatility might show smoother performance trends compared to a broad market index. Conversely, one focused on high-dividend stocks might exhibit higher income generation. The interpretation hinges on recognizing that the index is no longer a pure reflection of market capitalization, but rather a filtered or re-weighted view based on its unique construction rules. Investors use the adjusted index to gauge the performance of a specific investment approach or asset class.

Hypothetical Example

Consider a hypothetical "Revenue-Adjusted Technology Index" that tracks ten technology companies. Instead of weighting them by market capitalization, this adjusted index weights them by their annual revenue to reflect their operational scale, rather than just market valuation.

Let's say on January 1st, three companies have the following revenues:

• Company A: $100 billion
• Company B: $50 billion
• Company C: $25 billion

In a pure market capitalization-weighted index, Company A might have a disproportionately large weight if its market cap is significantly higher due to investor sentiment, even if its revenue is only moderately higher than Company B.

In our Revenue-Adjusted Technology Index, the initial weight of each company would be proportional to its revenue.

• Total Revenue = $100B + $50B + $25B = $175 billion
• Weight of Company A = $100B / $175B = 57.14%
• Weight of Company B = $50B / $175B = 28.57%
• Weight of Company C = $25B / $175B = 14.29%

If Company C's revenue doubles to $50 billion due to strong sales growth, and its stock price rises modestly, while Company A's revenue remains flat but its stock price soars due to speculative interest, the revenue-adjusted index would assign more weight to Company C at the next index rebalancing. This provides a different performance indicator that emphasizes fundamental business growth over pure market sentiment.

Practical Applications

Adjusted indices have numerous practical applications across various facets of finance:

• Fund Creation: Many index funds and ETFs are built to track adjusted indices. These funds offer investors exposure to specific investment factors (e.g., value, growth, low volatility) or themes (e.g., ESG, artificial intelligence) without needing individual stock selection¹⁶.
• Performance Benchmarking: Active managers often compare their performance against an adjusted index that aligns with their investment style. For example, a quantitative manager focusing on value might benchmark against a fundamentally weighted index rather than a broad market capitalization-weighted one.
• Research and Analysis: Financial researchers use adjusted indices to study the effectiveness of different weighting schemes and to analyze market anomalies¹⁵. Academic papers often delve into the construction and performance of various adjusted index methodologies¹², ¹³, ¹⁴.
• Risk Management: Some adjusted indices are designed with risk management in mind, such as those that minimize volatility or equally weight constituents to reduce concentration risk associated with large market capitalization companies¹¹. The SEC's Rule 6c-11, adopted in 2019, has further streamlined the process for bringing new ETFs, including those tracking adjusted indices, to market, fostering innovation and competition⁶, ⁷, ⁸, ⁹, ¹⁰.

Limitations and Criticisms

Despite their tailored benefits, adjusted indices have limitations. One common criticism, particularly when the adjustment deviates significantly from market capitalization, is that they may not fully capture the collective wisdom of the market, as market-cap weighting naturally reflects the overall consensus valuation of publicly traded companies.

Critics of some adjusted indices, particularly those employing alternative weighting strategies, argue that they can introduce unintended biases or higher turnover, leading to increased trading costs⁴, ⁵. For example, Research Affiliates, a firm known for its work on fundamental indexing, has highlighted how even traditional cap-weighted indices can "buy high and sell low" due to the mechanics of their rebalancing, and has proposed alternative adjusted index constructions to mitigate these issues¹, ², ³. This suggests that while adjustments aim to improve on standard indices, they can also introduce new complexities or hidden costs. Investors should carefully evaluate the methodology and expected outcomes of any adjusted index before incorporating it into their portfolio diversification strategy.

Adjusted Index vs. Market Capitalization-Weighted Index

The core distinction between an adjusted index and a market capitalization-weighted index lies in their weighting methodology.

While a market capitalization-weighted index offers simplicity and broad market exposure, an Adjusted Index provides a more nuanced or targeted exposure, often seeking to address specific investment goals or overcome perceived shortcomings of traditional indexing.

FAQs

What types of adjustments can be made to an index?

Adjustments can involve various methodologies beyond market capitalization, such as equal weighting, fundamentally weighting (based on sales, earnings, or dividends), minimum volatility, or focusing on specific factors like momentum or value. The goal is to create a different exposure or risk profile than a standard market-cap index.

Why would an investor choose an adjusted index over a traditional one?

Investors might choose an adjusted index to achieve specific investment objectives, such as reducing concentration risk, gaining exposure to particular factors (e.g., value, growth), or aiming for potentially superior risk-adjusted returns. For example, a value investor might prefer an index adjusted to favor undervalued companies.

Are adjusted indices more expensive to track?

Sometimes. Adjusted indices, particularly those with complex methodologies or higher turnover due to frequent rebalancing, may have higher associated costs compared to broad, market capitalization-weighted indices. The fees for funds tracking adjusted indices can reflect the additional complexity in managing and rebalancing the portfolio.

How often are adjusted indices rebalanced?

The rebalancing frequency for an adjusted index depends on its specific methodology and the index provider's rules. Some may rebalance quarterly, semi-annually, or annually, similar to traditional indices. Others, particularly those tracking dynamic factors, might have more frequent adjustments to maintain their target characteristics.

Do all adjusted indices outperform market capitalization-weighted indices?

Not necessarily. While adjusted indices are designed to address certain limitations or capture specific premiums, their outperformance is not guaranteed and can vary significantly over different market cycles. Performance depends on the effectiveness of the chosen adjustment methodology in different economic conditions and compared to the broader market performance.