Different index methodologies exist in finance to cater to different investment strategies, preferences, and market conditions. When it comes to index-based investing, there are various ways in which an index can be put together. Some of the popular indexing strategies are as follows:
Market Capitalization Weighted Index: Market capitalization-weighted indices, such as the S&P BSE 30 or the Nifty 50, assign weights to constituent stocks based on market capitalization (price per share multiplied by the number of shares outstanding). This approach reflects the relative size of companies in the market, giving larger companies a higher weight. Market-cap weighted indices are commonly used because they are easy to understand and closely track the overall market.
Equal Weighted Index: Equal-weighted indices assign equal weight to each constituent stock, regardless of market capitalization or stock price. This approach aims to provide equal exposure to all stocks in the index. The Nifty 50 Equal Weight is an equal-weighted index that includes the top 50 stocks listed on the NSE. Each stock in the index has an equal weight, irrespective of its market capitalization.
Price-Weighted Index: In a price-weighted index, every stock is weighted according to its current share price. This means companies with a higher share price have a greater weight than those with a low share price. Consequently, higher-priced stocks have a greater impact on the index’s movement compared to lower-priced stocks. The biggest price-weighted indices are the US Dow Jones Industrial Average (DJIA) and Japan’s Nikkei225. Price-weighted indices were historically used before market capitalization became the dominant factor. They are less common today but still have relevance for certain purposes.
Strategy-Based Indices: Strategy-based indices employ specific investment strategies, such as low volatility, high dividend yield, momentum, or value. These indices are designed to reflect the performance of a particular investment approach or style. They cater to investors who seek exposure to specific investment strategies or factors beyond traditional market-cap weighting. The Nifty 100 Low Volatility 30 is a strategy-based index that comprises 30 stocks from the Nifty 100 index with the lowest historical volatility. It aims to provide exposure to low-volatility stocks.
Hybrid Indices: Regarding hybrid approach, benchmark indices use a combination of methodologies to construct a diversified index. These hybrid approaches may include market capitalisation weighing, equal weighing, or other methodologies to achieve a balanced market representation. For instance, the Nifty hybrid index series comprises six indices that blend Nifty50 TRI and aggregate fixed-income indices in various proportions to reflect the performance of hybrid portfolios investing in both asset classes.
The choice of index methodology depends on various factors, including investment objectives, risk tolerance, and investment style, to name a few. Each methodology has its own advantages and drawbacks, and different investors may prefer different approaches based on their unique requirements. An investor today has access to most of the strategies in the form of passive fund offerings, a simple, diversified and cost-effective way to invest for the long term.
Index Options based on the Nifty 50 universe
For an investor looking to invest in the Indian equity space, the Nifty50 index is regarded as a good starting point. But there are multiple ways in which an investor can take exposure to the same universe of Nifty50 stocks. One can either invest in a Nifty 50 index fund, a market capitalisation-based index or Nifty50 Equal Weight Index Fund wherein the index is equal-weighted.
Each of the two strategies has its unique features. In a market capitalisation method, larger companies with higher market capitalisation tend to have a greater impact on the index. So, a rally or a correction in higher-weighted stocks can impact the index excessively. On the other hand, the Nifty50 Equal Weight Index invests equally across the Nifty50 stocks. This means even comparatively smaller companies get higher weightage in the index.
Further, the index is re-balanced quarterly such that the weights are not distorted. So, even if any stock rallies, its weightage would be restricted to the original equal-weight index levels and no single stock can exceedingly influence the index movement. It also has empirically higher dividend yield as it allocates funds equally to its components. Compared to the free float strategy, the equal weight approach provides better downside protection due to a 2% weightage cap on each stock.
During periods of increased volatility or broad-based market rallies, as seen over the past three years, the equal-weight index tends to perform better than the market capitalisation-based index. In this period equal weight index outperformed the Nifty50 TRI in the range of 2.4% to 9.4%. However, this strategy tends to lag when there is a narrow rally as seen during 2019 when the Nifty50 TRI delivered a return of 13.5% while the Nifty50 Equal Weight TRI return was 4.3%.
To conclude, while both strategies focus on the Nifty50 stocks, the investment outcomes can vary depending on the index strategy one chooses. Hence, it would be prudent to diversify your equity allocation with varying index methodologies such as the Nifty50 Index and Nifty50 Equal Weight index. Given that these strategies are available in index fund form, an investor can consider initiating a SIP into these funds.
The writer is Head, Investment Strategy, ICICI Prudential AMC