Adjusted market index: Meaning, Criticisms & Real-World Uses

What Is Adjusted Market Index?

An Adjusted Market Index is a financial benchmark that has undergone modifications from its standard index construction methodology to account for specific factors or biases. These adjustments aim to create a more accurate representation of a particular market segment, investment strategy, or economic reality, aligning closely with the broader field of Market Indexing. Unlike raw market indexes that might simply track the total market capitalization of included securities, an Adjusted Market Index incorporates changes to criteria such as constituent weighting, inclusion rules, or the treatment of certain corporate events. The goal of an Adjusted Market Index is often to provide a more investable or theoretically sound representation for portfolio management and performance measurement.

History and Origin

The concept of adjusting market indexes evolved as financial markets became more complex and the use of indexes broadened beyond simple market barometers. Early market indexes, like the Dow Jones Industrial Average, were price-weighted, meaning stocks with higher prices had a greater impact, regardless of their total market value. As the understanding of market dynamics deepened, market capitalization-weighted indexes became prevalent, reflecting the total value of companies.

However, even market capitalization weighting presented limitations, leading to the development of adjusted methodologies. For instance, the introduction of float adjustment by major index providers like S&P Dow Jones Indices and FTSE Russell marked a significant historical shift. Float adjustment, which only considers shares available for public trading, rather than all outstanding shares, was adopted to ensure indexes better reflected the investable opportunity set in equity markets. Such changes are part of a continuous review process by index providers to ensure their benchmarks remain relevant and representative. FTSE Russell, for example, regularly reviews its methodologies to meet the evolving requirements of investors and to incorporate feedback from advisory committees¹¹. S&P Dow Jones Indices also details its methodology for U.S. indices, including float adjustment, to ensure accurate market representation¹⁰.

Key Takeaways

An Adjusted Market Index modifies standard index methodologies to enhance accuracy or reflect specific investment objectives.
Adjustments can involve changes to weighting schemes, constituent selection rules, or the handling of corporate actions.
These indexes are crucial for creating more precise financial instruments, such as index funds and Exchange-Traded Funds (ETFs).
Common adjustments include float-weighting, capping constituent weights, or applying specific criteria for environmental, social, and governance (ESG) factors.
The continuous evolution of an Adjusted Market Index aims to mitigate biases and provide more investable or representative benchmarks.

Formula and Calculation

The calculation of an Adjusted Market Index generally follows a modified version of the standard index formula, which is typically value-weighted (or market capitalization-weighted) but incorporates an adjustment factor or a modified divisor.

For a float-adjusted market capitalization-weighted index, the index level at a given time (t) can be expressed as:

I_t = \frac{\sum (P_i \times S_i \times F_i)}{D_t}

Where:

(I_t) = Index level at time (t)
(P_i) = Price of constituent security (i)
(S_i) = Total shares outstanding of constituent security (i)
(F_i) = Float adjustment factor (Investable Weight Factor) for security (i), representing the proportion of shares available for public trading. This factor typically ranges between 0 and 1.
(D_t) = Index Divisor at time (t)

The Index Divisor is a crucial component that ensures the index level remains unaffected by non-market-related events, such as stock splits, dividends, or changes in index composition (e.g., additions or deletions of securities). When a corporate action occurs or a change in shares outstanding or float factor happens, the divisor is adjusted to maintain continuity in the index level⁹.

For example, if a security is added to the index, the new divisor (D_{\text{new}}) is calculated to ensure the index value remains the same immediately after the change:

D_{\text{new}} = \frac{\sum_{\text{new}} (P_i \times S_i \times F_i)}{I_{\text{old}}}

Where:

(\sum_{\text{new}} (P_i \times S_i \times F_i)) = New total adjusted market value of the index after the change
(I_{\text{old}}) = Index level immediately before the change

This ensures that the Adjusted Market Index reflects only market price movements and not artificial changes due to index maintenance.

Interpreting the Adjusted Market Index

Interpreting an Adjusted Market Index involves understanding the specific adjustments made and their implications for the index's behavior and representativeness. For instance, a float-adjusted index aims to reflect the actual market that investors can access, providing a more realistic benchmark for actively managed funds or passive investing vehicles. If an index is adjusted to cap the weight of individual constituents, it prevents any single large company from dominating the index's performance, which can reduce concentration risk management and offer broader diversification.

Investors and analysts typically use an Adjusted Market Index to gain a clearer picture of market segments, measure the effectiveness of specific investment strategies, or as the basis for creating investable products. The adjustments mean that the index might behave differently from a standard market capitalization-weighted index, potentially exhibiting lower volatility or different sector exposures. Understanding the methodology behind an Adjusted Market Index is essential for accurate performance measurement and informed asset allocation decisions.

Hypothetical Example

Consider a hypothetical "Diversification.com US Large Cap Adjusted Index" which aims to track large U.S. companies but with a focus on liquidity and limited concentration.

Initial Index State:

Total float-adjusted market value of all constituents = $10 trillion
Current Index Divisor = 10 billion
Current Index Level = $10 trillion / 10 billion = 1,000

Scenario: A major constituent, "TechGiant Corp.", which currently represents 15% of the index, announces a significant share buyback that reduces its publicly traded shares (its float) by 20%.

Step 1: Calculate the impact of TechGiant Corp.'s float reduction.

Initial float-adjusted market value of TechGiant Corp. = $1.5 trillion (15% of $10 trillion)
Reduction in float = 20%
New float-adjusted market value of TechGiant Corp. = $1.5 trillion * (1 - 0.20) = $1.2 trillion
Decrease in total index float-adjusted market value (due to this specific adjustment) = $1.5 trillion - $1.2 trillion = $0.3 trillion

Step 2: Calculate the new total float-adjusted market value for the index before divisor adjustment.

New total index float-adjusted market value = Old total - Decrease from TechGiant's float adjustment = $10 trillion - $0.3 trillion = $9.7 trillion

Step 3: Adjust the Index Divisor to keep the index level constant. This prevents the index level from dropping solely due to the float change, as it's not a market price movement.

Old Index Level = 1,000
New Divisor = New total float-adjusted market value / Old Index Level
New Divisor = $9.7 trillion / 1,000 = 9.7 billion

Going forward, the Adjusted Market Index will be calculated using this new divisor of 9.7 billion. This ensures that the only changes to the index level reflect true market price movements, and not the corporate actions affecting float.

Practical Applications

Adjusted Market Indexes are widely used in the financial industry for various practical applications. They form the basis for numerous financial instruments and investment strategies.

One primary application is in the creation of passive investing products, such as index funds and Exchange-Traded Funds (ETFs). Fund managers often track an Adjusted Market Index that aligns with their investment mandate, for example, an index that excludes companies based on specific environmental, social, and governance (ESG) criteria or an index that caps sector weights to ensure diversification. Morningstar, for instance, offers various factor indexes that employ transparent, rules-based methodologies to target specific factor characteristics while considering diversification and capacity⁸,⁷.

Index providers like S&P Dow Jones Indices and FTSE Russell also use adjusted methodologies to maintain their flagship indexes, making continuous refinements based on market structure changes or investor feedback. For example, FTSE Russell's policy details how they consult on changes to their ground rules, including adjustments for free float definitions and investability weights, to ensure indexes remain relevant benchmarks⁶. These adjustments facilitate accurate performance measurement for portfolio managers and enable the development of more precise investment products that reflect specific market exposures or investment philosophies.

Limitations and Criticisms

While Adjusted Market Indexes aim to improve representativeness or address specific investment objectives, they are not without limitations and criticisms. One significant concern relates to the discretionary nature of some adjustments. While major index providers like S&P Dow Jones Indices and FTSE Russell have robust governance structures and public consultation processes for methodology changes⁵,⁴, the decisions regarding which factors to adjust for, and by how much, can introduce potential biases or unintended consequences. For example, S&P Dow Jones Indices announced changes in 2017 to exclude companies with multiple share class structures from the S&P Composite 1500 and its component indices, including the S&P 500, due to corporate governance concerns³. While this adjustment aimed to address a perceived governance issue, it also meant that certain widely held companies were no longer eligible for inclusion, potentially affecting the index's broad market representation.

Another criticism can arise from the trade-off between strict adherence to an adjustment rule and practical liquidity or investability concerns. Overly complex adjustments might lead to higher turnover within the index, which can increase transaction costs for funds tracking the index. Additionally, the very act of adjusting an index, while intended to be beneficial, can sometimes lead to an "index effect," where changes in index composition themselves influence stock prices and trading volumes, a topic frequently discussed in academic literature². These effects highlight the ongoing challenge of balancing theoretical purity with practical implementation in index construction.

Adjusted Market Index vs. Market Capitalization-Weighted Index

The primary distinction between an Adjusted Market Index and a standard Market Capitalization-Weighted Index lies in the modifications applied to the latter. A pure Market Capitalization-Weighted Index ranks and weights its constituents solely based on their total market capitalization (share price multiplied by total shares outstanding). This means that larger companies, regardless of their public float or other characteristics, will have a proportionally greater influence on the index's performance.

An Adjusted Market Index, conversely, takes this basic weighting scheme and introduces specific rules to modify it. For example, most major market indexes today are float-adjusted market capitalization-weighted indexes. This adjustment considers only the shares available for public trading, excluding strategic holdings, cross-owned shares, or government holdings. This aims to create a more investable index. Other adjustments might include capping the weight of individual securities or sectors to prevent overconcentration, or applying specific filters for environmental, social, and governance (ESG) factors. The goal of an Adjusted Market Index is often to refine the benchmark's exposure, making it more aligned with specific investment objectives or to mitigate perceived flaws of a simple market capitalization-weighted approach, thereby providing a more nuanced reflection of the equity markets it seeks to represent.

FAQs

What is the main purpose of an Adjusted Market Index?

The main purpose is to create a more precise or representative financial benchmark by modifying traditional index methodologies. This can address issues like liquidity, concentration risk, or specific investment preferences, making the index more suitable for portfolio management or as the basis for investment products.

How do index providers decide on adjustments?

Index providers typically have rigorous governance processes involving internal committees and external consultations. They evaluate market changes, investor feedback, and academic research to determine necessary adjustments to their index construction methodologies, as detailed by entities like FTSE Russell¹.

Can an Adjusted Market Index outperform an unadjusted one?

Not necessarily. An Adjusted Market Index is designed to reflect a specific market segment or investment philosophy more accurately, not to guarantee outperformance. Its performance relative to an unadjusted index will depend on market conditions and how the applied adjustments impact the index's exposure to various factors or sectors.

Are all major market indexes adjusted?

Many prominent market indexes, such as the S&P 500 and FTSE Global Equity Index Series, incorporate significant adjustments, most commonly float adjustment, to improve their investability and representativeness. Therefore, a purely unadjusted market capitalization-weighted index is less common as a mainstream benchmark.

How does an Adjusted Market Index affect ETFs and mutual funds?

Exchange-Traded Funds (ETFs) and mutual funds that track an Adjusted Market Index will mirror the specific characteristics and performance profile of that adjusted index. This allows investors to gain targeted exposure to a particular market segment or strategy, consistent with the index's design, which is crucial for effective asset allocation.