Equal Weight Index – Superior Performance Route Over A Market Cap Based Index

By Anuragg Jhanwar,

Investing is all about seeking an equilibrium between risk and reward. The recent governance issues as observed in corporate India have given us enough learnings that risks can always emerge without any warnings and can have a detrimental impact on the index. So, if the index is based on market cap, a heavyweight in the index with such findings, carries the potential to bring down the entire index. This was experienced by the market a few months back when both Nifty 50 and more importantly Nifty Next 50 were down.

Both have their advantages and limitations yet, the equal weight index stands out, here is why:

Market Capitalization-Weighted Indices: This method gives more weight to companies with a larger market capitalization (current market price of a company's outstanding shares*total number of outstanding shares). The Nifty 50, or BSE Sensex, is an example of a market capitalization-weighted index.

Advantages:

1.           Reflect Market Sentiment: Stocks with higher market capitalizations tend to influence the index's performance more, aligning with investor’s perceptions of their importance.

2.           Simple and Transparent: It is easy to understand and calculate since the weight of each stock is directly proportional to its market capitalization.

3.           Reflective of Market Performance: Since larger companies typically have a greater impact on the economy and market trends, market capitalization-weighted indices represent the broader market's performance.

4.           Low Turnover & Cost: These indices typically have lower turnover than other weight methodologies. Changes in index composition occur gradually as companies' market capitalizations fluctuate, reducing the need for frequent rebalancing, and reducing the overall cost.

Disadvantages:

1.           Momentum Bias: In extended bull markets, the stocks that perform best see their market capitalization increase the most, thus becoming even larger allocations within the index. This can lead to a vicious cycle, whereby more money flowing into index funds is proportionally allocated to top-performing stocks, which may further drive up their prices.

2.           Concentration Risk: Concentration risk arises when a few large-cap stocks heavily influence an index's performance, leading to increased volatility. Recent events, such as Hindenburg issues related to the Adani group, caused sharp corrections in both Nifty 50 and Nifty Next 50 due to their significant exposure to Adani stocks. Similarly, the market once surged due to ‘HRITHIK Stocks’, where seven stocks with over 40% of the index's market cap drove the market to new highs.

Equal-Weighted Indices:

For example - the Nifty50 Equal Weight Index, where each company in the index shall be assigned equal weights irrespective of the market cap of the company.

Advantages:

1.           Diversification - Every company has the same weight, ensuring a more balanced exposure across sectors and company sizes.

2.           Reduced Concentration Risk: An equal-weight portfolio spreads investment across all holdings, reducing reliance on the performance of a few large companies. This can lead to a smoother ride with less volatility compared to market-cap-weighted index.

3.           More Opportunities: Investors are exposed to smaller businesses with more room for expansion than bigger businesses.

4.           Realistic approach: These funds offer a more realistic reflection of the overall market due to their lack of large-cap company getting overweight allocation.

5.           Value Investing Approach: Equal weighting can act like a built-in value investing strategy. As stock prices fluctuate, the index automatically adjusts weights, potentially buying more undervalued stocks and selling the overvalued ones. 

Disadvantages:

1.           Rebalancing the portfolio to maintain equal weights of each stock can lead to higher turnover and transaction costs.

2.           They can have higher tax consequences compared to market cap indices.

Historical Performance:

Given this backdrop, when we compare the performance of the two indices over the long term or even the short term, the Nifty 50 Equal Weight Index has outperformed the Nifty 50 Index consistently.

Upwisery Data Insights – As on 28th March, 2024

CONCLUSION

Investors seeking to spread out their investments and potentially earn better returns may consider equal-weighted index funds. Many mutual fund houses have equal weight funds like HDFC NIFTY 50 Equal Weight Index Fund, DSP Nifty 50 Equal Weight Index Fund and SBI Nifty 50 Equal Weight Index Fund amongst others. These funds allow you to invest in a variety of companies, reducing your dependence on just a handful of large stocks. While equal-weighted index funds can fluctuate more in value, they have historically outperformed funds weighted by market capitalization. The investor should understand his/her investment goals and risk appetite before opting for an index-based approach.

(The author is Partner and Co-Founder, Upwisery Private Wealth.)

Disclaimer: Views expressed in the above article are personal and do not necessarily reflect the official position or policy of the Outlook Media Group or its employees.