Adjusted index index

What Is Adjusted Index?

An adjusted index is a financial benchmark or data set that has been modified using a specific factor or formula to more accurately reflect real-world conditions, incorporate new methodologies, or achieve particular investment objectives. These adjustments go beyond standard market capitalization weighting and are a key component of modern index construction within the broader field of investment strategy. The purpose of an adjusted index is to enhance the usefulness of historical and current data by making it more precise or consistent over time, or to create a specialized passive investing vehicle with characteristics different from traditional benchmarks. Adjusted indices often aim to provide targeted exposure to specific investment themes or factors, moving beyond the simple market-value weighting of traditional indices.

History and Origin

The concept of adjusting indices to reflect something beyond pure market capitalization gained significant traction in the early 21st century, largely in response to perceived limitations of traditional market-cap-weighted benchmarks. While market-cap weighting dominated indexing for decades, its inherent tendency to allocate more weight to larger, often more expensive, companies led some researchers to explore alternative approaches.

A pivotal development in the history of adjusted indices was the emergence of "fundamental indexation." Pioneered by Rob Arnott and Research Affiliates in the mid-2200s, this approach proposed weighting index constituents based on fundamental measures of company size, such as sales, earnings, book value, or dividends, rather than stock price or market capitalization. Rob Arnott on fundamental indexation challenged the conventional wisdom of market-cap weighting, arguing that it inherently overweights overvalued stocks and underweights undervalued ones. This innovation laid foundational groundwork for what became known as "smart beta" strategies, a broad category of adjusted indices that systematically deviate from market-cap weighting to achieve specific outcomes, such as enhanced risk-adjusted returns or reduced volatility. Major index providers like MSCI and S&P Dow Jones Indices have since developed extensive families of adjusted indices, including those focused on specific factor investing exposures. MSCI Factor Indexes are rules-based indices designed to capture systematic factors like value, momentum, and quality.

Key Takeaways

• An adjusted index modifies a standard index or data set using predefined rules or a formula to achieve specific objectives.
• These indices often diverge from traditional market-capitalization weighting to offer different risk and return characteristics.
• They are a core component of "smart beta" strategies, which blend elements of both active and passive investment management.
• Common adjustment methods include weighting by fundamental factors, equal weighting, or targeting specific investment factors like low volatility or value investing.
• While aiming for improved performance or diversification, adjusted indices can introduce complexities and may not always outperform traditional benchmarks.

Formula and Calculation

The "formula" for an adjusted index is not a single, universal equation but rather a set of rules and methodologies that dictate how the index's constituents are selected and weighted. Unlike a simple price-weighted index or a market-cap-weighted index, an adjusted index's calculation involves a deliberate alteration of how each component impacts the overall index value.

For example, in an equally weighted adjusted index, each constituent stock is assigned the same weight, irrespective of its market capitalization. If an index has (N) components, the weight (W_i) for each component (i) would be:

$W_i = \frac{1}{N}$

For a fundamentally weighted index, the weight of each component (i) might be based on a measure like its revenue, book value, or dividend yield. If using revenue ((R_i)) as the fundamental factor, the weight (W_i) could be calculated as:

$W_i = \frac{R_i}{\sum_{j=1}^{N} R_j}$

where (\sum_{j=1}^{N} R_j) is the sum of revenues for all components in the index.

These weighting methodologies require periodic rebalancing to maintain the desired exposure, as market movements or changes in fundamental data will naturally cause weights to drift.

Interpreting the Adjusted Index

Interpreting an adjusted index requires understanding its underlying methodology and the specific objective it aims to achieve. Unlike market-cap-weighted indices, which primarily reflect the aggregate market performance proportional to company size, an adjusted index emphasizes different characteristics. For instance, an index adjusted for value factors will likely overweight companies that are considered undervalued based on metrics like price-to-earnings or price-to-book ratios. Conversely, a momentum investing adjusted index will typically assign higher weights to stocks that have shown strong recent price performance.

Investors interpret an adjusted index by comparing its performance and risk profile to traditional market benchmarks and by assessing how well it captures the targeted investment factor or theme. For example, if an adjusted index aims to reduce volatility, its performance should exhibit smaller drawdowns during market downturns than a broad market index. The effectiveness of an adjusted index is judged by its ability to consistently deliver on its stated objective, whether that's enhanced returns, reduced risk, or greater portfolio diversification.

Hypothetical Example

Consider a hypothetical "Diversification.com Quality Adjusted Index" composed of three fictional companies: Alpha Corp, Beta Inc., and Gamma Ltd. A traditional market-cap-weighted index might weight them based on their current market values.

Initial State (Traditional Market-Cap Weighted):

• Alpha Corp: Market Cap = $10 billion, Weight = 50%
• Beta Inc.: Market Cap = $6 billion, Weight = 30%
• Gamma Ltd.: Market Cap = $4 billion, Weight = 20%
• Total Market Cap: $20 billion

Now, let's say our "Quality Adjusted Index" uses a measure of "Quality Score" (based on consistent earnings, low debt, and high returns on equity) to weight its constituents.

Quality Scores (Arbitrary for example):

• Alpha Corp: Quality Score = 80
• Beta Inc.: Quality Score = 95
• Gamma Ltd.: Quality Score = 70

To calculate the weights for the adjusted index:

1. Sum of Quality Scores: (80 + 95 + 70 = 245)
2. Adjusted Weights:
   • Alpha Corp: (80 / 245 \approx 0.3265) or 32.65%
   • Beta Inc.: (95 / 245 \approx 0.3878) or 38.78%
   • Gamma Ltd.: (70 / 245 \approx 0.2857) or 28.57%

In this adjusted index, Beta Inc., despite having a smaller market capitalization than Alpha Corp, receives the highest weight due to its superior quality score. This demonstrates how an adjusted index deliberately alters exposures away from market-cap proportionality to reflect a specific factor or characteristic, such as strong fundamental analysis attributes.

Practical Applications

Adjusted indices are widely applied across the financial industry, serving various purposes for investors and asset managers. One of the most common applications is in the creation of Exchange-Traded Fund (ETF) products. These ETFs track specific adjusted indices, allowing investors to gain exposure to particular investment strategies in a cost-effective and transparent manner. For example, investors can access strategies like value, growth, momentum, low volatility, or high dividend yield through ETFs that track corresponding adjusted indices.

Furthermore, adjusted indices are used by institutional investors and wealth managers to construct diversified portfolios that go beyond traditional market-cap weighting. They enable targeted exposure to specific risk premiums or investment styles that academic research has identified as potential sources of long-term outperformance. For instance, the S&P Dow Jones Indices and RobecoSAM launched an S&P Dow Jones Indices' smart beta ESG index series, which incorporates environmental, social, and governance (ESG) factors into their weighting schemes. This illustrates how adjusted indices can facilitate investment in line with specific non-financial objectives, alongside financial ones.

Limitations and Criticisms

Despite their growing popularity, adjusted indices and the broader "smart beta" movement face several limitations and criticisms. One primary concern is the potential for data mining, where strategies appear successful in backtests due to historical data fitting but fail to deliver similar results in live trading. Research suggests that while smart beta strategies might show significant outperformance in historical simulations, their real-world performance after fees can be considerably lower or even negative. Criticisms of smart beta strategies highlight that the benefits often disappear when transaction costs and implementation challenges are considered.

Another limitation is the inherent complexity introduced by alternative weighting schemes. While traditional market-cap indices are relatively simple and transparent, adjusted indices often involve more intricate rules for constituent selection and weighting. This complexity can make it harder for investors to fully understand the drivers of returns and potential risks. Additionally, some critics argue that the outperformance of certain adjusted indices may simply be a reward for taking on additional, uncompensated risk, rather than a truly "smarter" form of beta. Factors that work well in one market cycle may underperform significantly in another, leading to periods of prolonged underperformance. The focus on maximizing factor exposures in multi-factor adjusted indices can also lead to excessive concentration and specific risks.¹

Adjusted Index vs. Market-Cap Weighted Index

The fundamental difference between an adjusted index and a market-cap weighted index lies in their underlying construction philosophy and weighting methodology.

While a market-cap weighted index proportionally invests more in companies as their stock prices rise, an adjusted index, especially a fundamentally weighted one, may reduce exposure to stocks that have become expensive relative to their underlying financial metrics. This aims to break the link between price and weight, offering a contrarian tilt.

FAQs

What are some common types of adjusted indices?

Common types of adjusted indices include fundamentally weighted indices (based on sales, earnings, book value, dividends), equally weighted indices (each stock has the same weight), and factor-based indices (targeting factors like value, momentum, low volatility, and quality).

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

Investors might choose an adjusted index to gain exposure to specific investment styles, potentially achieve higher long-term returns, reduce certain types of risk, or improve overall portfolio diversification compared to a standard market-cap weighted index. They offer a systematic way to implement investment beliefs.

Are adjusted indices considered active or passive?

Adjusted indices often sit in a grey area between active management and passive investing. While they are rules-based and do not involve discretionary stock picking in the traditional sense, the initial design choices—selecting factors, defining weighting methodologies, and determining rebalancing schedules—are active decisions. This is why they are frequently categorized under "smart beta," implying a smarter or alternative form of market beta exposure.