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Why you should invest in equal weight index funds

Kumar Shankar Roy | Updated on April 10, 2021

The strategy moderates volatility, mitigates risk when largest weighted stocks underperform

Investors looking for balanced diversification and anti-momentum ways to play equity index funds can consider buying units of equal weight index funds tracking Nifty 50 and Nifty 100 for their core portfolio. You get the same set of top-quality stocks that the bluechip baskets have, but with an important twist — equal weight for all.

While passive investing has, of late, picked up significant pace, there is an unsavoury side to the more popular market weight index products — when a stock or a sector performs well, they become a larger portion of the index if market capitalisation weighting is used.

More weight to the historical winner stocks exposes a portfolio to higher risks because stocks/sectors regularly go through rotation and when the largest market-cap stocks in a portfolio underperform, they have an outsized impact on the overall performance. In contrast, smart beta products based on equal weight indices offer an anti-momentum, forced buy-low-sell-high mode of investing that clearly comes with lower stock and sector concentration risks.

The traditional Nifty 50 and Nifty 100 indices are computed using free float market capitalisation method. So, they comprise stocks of companies with higher free float market cap. Since market cap is a function of stock price, index constituents with high free float market cap also typically get high weight. A plain-vanilla index fund tracking such indices, especially after a strong rally will have high concentration in a few stocks or sectors. For instance, Financial Services alone has 38 per cent weight in the 50-share Nifty, heavily tying the fortunes of the portfolio to one sector. The top-four sectors including IT, Oil & Gas, and Consumer Goods, account for 78 per cent weight of the Nifty even though the index has over a dozen sectors.

At stock level, just 5 Nifty 50 stocks, viz. HDFC Bank, RIL, Infosys, HDFC and ICICI Bank, form over 41 per cent of the index. Widen the coverage to the top 10 stocks and you have 60 per cent of money riding on them. The story is similar for the Nifty 100 index where Financial Services alone accounts for 35 per cent weight and just ten stocks have over 51 per cent allocation.

Smart beta approach

Alternative index strategies offer smarter beta. The equal weight index strategy simply allocates equal weight to all stocks, instead of considering market capitalisation as the sole criteria for asset allocation. Nifty 50 Equal Weight index has the same 50 stocks in Nifty 50, but gives equal weight (about 2 per cent) to each. This means Tata Steel, Hindustan Unilever, UPL, Titan, JSW Steel, Shree Cement, Bajaj Finserv, Nestle India, etc., get as much exposure as the HDFC twins, RIL, ICICI Bank or Infosys. Nifty 100 Equal Weight index has the same 100 stocks of Nifty 100, but gives about 1 per cent weight to all. The equal weight indices are rebalanced semi-annually, which means booking profit in outperformers and buying more of underperformers, as well as right-sizing of sectors. The funds undergo quarterly rebalancing regardless of the size of each index company.

Given that market cap indices have performed better than equal weight indices in the last few years, mean reversion is on the cards. A trailer has already started playing out. In the past one year period Nifty 50 Equal Weight index has given 86 per cent returns compared to 71 per cent of Nifty 50. In the same period, the Nifty 100 Equal Weight index has gained 78 per cent compared to 70 per cent of Nifty 100. Both equal weight indices delivered higher returns but with lower volatility. Out of the last twenty years, the equal weight indices have outperformed in ten years generally when there is a broad-based market rally. Hence, investors already holding actively managed large-cap schemes or plain-vanilla index funds can add DSP Equal Nifty 50 Fund, Sundaram Smart Nifty 100 Equal Weight Fund or Principal Nifty 100 Equal Weight Fund for better diversification. These smart beta funds carry lower expense ratios than actively managed funds.

For risk-averse investors, equal weight index strategy is a suitable investment. Of course, these funds can witness higher turnover but there would be no higher impact costs given their large-cap portfolios.

(This is a free article from the BusinessLine premium Portfolio segment. For more such content, please subscribe to The Hindu BusinessLine online.)

Published on April 10, 2021

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