The Pros and Cons of Equal Weight Indices

Equal weight indices are in vogue. You must have noticed fresh index fund launches from various AMCs.

In this post, let us look at some of the good and not-so-good points about equal weight indices. We will see how equal weight indices have performed over the last 2 decades compared to the market-cap based indices.

Sharing in brief at the beginning. Will discuss the nuances later.

Cap-Based Indices Vs Equal Weighted Indices

In a market cap-based index (Nifty 50, Sensex, Nifty Next 50, Nifty Midcap 150), a stock with a higher free-float market cap gets a higher weightage in the index.

In an equal weight index, all the stocks have the same weightage. Yes, the weights may change based on the performance of constituent stocks but are rebalanced to the same weight on the rebalancing date.

For instance, Nifty 50 Equal Weight index, weights of all the stocks in the index will be rebalanced to 2% on the date of rebalance. The index is rebalanced semi-annually on the last working day of March and September.

With a market-cap based index, the weightage of a stock will increase (decrease) with good (bad) performance of the stock. The allocation to rising stocks will increase. This will happen in an EW index too, but the portfolio will reset to equal weight on the portfolio rebalancing date.

In an EW index, the money would move from better-performing stock to an underperforming stock on the rebalancing date. This makes more of a “Value” play. Market-cap based indices let the stocks ride the “momentum”.

#1 Diversification

With a market-cap based index, outperformance in a single or few top stocks can supercharge the index returns. Similarly, the under-performance of a few top stocks can make the entire index suffer. This will not happen in an equal weighted index.

Equal weight indices are likely to be more diversified, as a single stock (or a few stocks) will not be able to hijack the entire index. EW indices are likely to have a better diversified industry exposure.

Consider industry and constituent-wise break up for Nifty 50.

Source: Factsheets for respective indices on NiftyIndices.com. Data as on July 31, 2024

Now for Nifty 50-Equal Weight.

In the cap-based Nifty 50 Index, the weightage of top stocks is quite high.

In Nifty 50 Equal weight, the weightage of stock is close to 2%. Will get back to exact 2% on the rebalancing date.

Hence, on the diversification front, equal weight indices seem to score over cap-based indices.

#2 Liquidity

When a stock’s free-float market cap is higher, it is reasonable to except that the stock will also be liquid i.e., you may be able to buy and sell the stock at a low impact cost. Bid and ask prices may be closer. The liquidity in a stock is important because the fund manager needs to buy and sell stock to manage purchases and redemptions.

While in a cap-based index, the fund manager will have to buy in proportion of their market cap. For instance, if a fund manager must deploy Rs 10 crores in a Nifty index fund, he/she must invest say about 1.1 crore each in HDFC Bank, 94 lacs in Reliance Industries and so on. These amounts are based on weights as on July 31, 2024.

However, in an equal-weight index, the fund manager must buy all the stocks for the same amount. 20 lacs in each of the stocks in Nifty 50.

Now, this liquidity may not be a problem for Nifty 50 Equal Weight. But there are other equal weight indices as well.

Consider Nifty 500 Equal Weighted index.

Would the stock which ranks between 450 and 500 in terms of market cap have the same liquidity and volumes as Reliance Industries, HDFC Bank, or Infosys? But the fund manager must buy/sell all these stocks for the same amount. It is an equal-weighted index. Would that increase tracking difference?

Market cap-based indices take care of these issues by design. The allocation depends on the free float market cap. A bigger stock gets a higher allocation. And a small stock gets a lower allocation. No such luxury in equal weight indices.

Hence, if you are interested in an equal weighted index, do keep an eye on the tracking difference.

#3 Exposure

What does a Nifty 500 index fund give you exposure too?

Gives you exposure to almost the entire market spectrum. Large cap, midcap, and small cap. Here is the classification of stocks as per SEBI definition.

Large cap: 1-100^th stock by market cap

Midcap;101^st-250^th stock by market cap

Small cap: 251^st-500^th stock by market cap

What does not a Nifty 500 Equal Weight index give you exposure to?

To the same set of stocks. Top 500 stocks.

While the stocks are the same, the allocation to the large, midcap, and small cap indices is drastically different.

Nifty 500: Large cap: ~72%, Midcap: ~17%, Small cap: ~10%

Nifty 500 Equal Weight: Large cap: 20%, Midcap: 30%, Small cap: 50%

Data as on July 31, 2024. Source: Nippon AMC presentation

Disclaimer: The securities shown above are not recommendatory.

Nifty 500 seems more like a large cap or a multicap fund.

Nifty 500 Equal Weight is more like a mid and small cap fund.

I am not implying that the Nifty 500 index is better than Nifty 500 Equal Weight index or vice versa. Merely saying that these are 2 hugely different funds and give you vastly different stock market exposure.

Irrespective of how indices have performed in the past, there will be times in the future when Nifty 500 will outperform. And there will be times when Nifty 500-EW will outperform Nifty 500. When there is a broader market rally and mid and small cap stocks are outperforming, you can expect Nifty 500-EW to perform better.

When the large caps are outperforming, Nifty 500 will likely beat Nifty 500-EW.

And before you invest in any product, you must know how your money must be invested.

How have Equal Weight Indices fared?

All this information is fine, but how these EW indices have fared compared to popular market-cap based indices.

I have picked up prominent equal weight and market cap-based indices for the comparison.

1. Nifty 50
2. Nifty 50 Equal Weight
3. Nifty 100
4. Nifty 100 Equal Weight
5. Nifty Next 50
6. Nifty Midcap 150
7. Nifty Smallcap 250
8. Nifty 500
9. Nifty 500 Equal Weight

I have used month-end data from April 1, 2005, until August 31, 2024.

I have used Price index data (PRI) for comparison. And not Total Returns index. Please understand you cannot invest in the index fund directly. You must invest by way of index funds or ETFs. Hence, while evaluating, you must keep an eye on the expense ratio and the tracking difference.

While evaluating any investment for your portfolio, you must also try to see when those products have outperformed.

Since we are speaking about equal weight indices, you need to see if the outperformance of equal weight indices comes when smaller stocks have done well. This will likely be the case as well. For instance, a way to view the performance of Nifty 50 and Nifty 50 Equal Weight is to assess along with the performance of Nifty Next 50 index. I know this is not the correct way to evaluate performance. The reason I picked Nifty Next 50 is because it has stocks just outside of Nifty 50 and smaller than Nifty 50 stocks.

I will leave this data to your interpretation.

Nifty 50 vs Nifty 50 Equal Weight

As discussed above, bringing in Nifty Next 50 for comparison too.

Nifty 100 vs Nifty 100 Equal Weight

Since Nifty 100 index comprises of stocks in Nifty 50 and Nifty Next 50 index fund, I have added these funds for comparison too.

Nifty 500 vs Nifty 500 Equal Weight

Since Nifty 500 Equal weight has 30% midcap and 50% small cap stocks, I have added those indices too for comparison.

You can notice that Nifty 500 Equal Weight outperforms when the midcap and small cap indices have done well. You can check this from calendar year returns too. Along expected lines.

Should you invest in Equal Weight indices?

There is no black and white answer to this question. Depends on your preference and how you want to use these in your portfolio. For instance, an investor can combine Nifty 500 and Nifty 500 Equal Weight in a specific ratio portfolio to get the desired allocation to large, midcap, and small cap funds in the portfolio.

If you plan to invest in an equal-weight index fund, you must consider the following aspects.

1. Do not just go by fancy presentation by AMCs. Understand kind of exposure the EW index fund offers.
2. Consider past performance. While past performance is not an indicator of future performance, try to see if you can get the experience of EW index fund by mixing 2 cap-based indices. By experience, I mean both returns and volatility.
3. You don’t invest in the index. You invest in index funds and ETFs. Consider expense ratio and tracking difference
4. Assess if the equal weight index fund adds sufficient value to warrant another fund in the portfolio.

Passive investing is picking up in India. Hence, expect AMCs to launch new ideas on a regular basis, but you cannot invest everywhere.

Have you invested in Equal Weight indices? If yes, which one and why? Do let me know in the comments section.

Disclaimer: Registration granted by SEBI, membership of BASL, and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors. Investment in securities market is subject to market risks. Read all the related documents carefully before investing.

This post is for education purpose alone and is NOT investment advice. This is not a recommendation to invest or NOT invest in any product. The securities, instruments, or indices quoted are for illustration only and are not recommendatory. My views may be biased, and I may choose not to focus on aspects that you consider important. Your financial goals may be different. You may have a different risk profile. You may be in a different life stage than I am in. Hence, you must NOT base your investment decisions based on my writings. There is no one-size-fits-all solution in investments. What may be a good investment for certain investors may NOT be good for others. And vice versa. Therefore, read and understand the product terms and conditions and consider your risk profile, requirements, and suitability before investing in any investment product or following an investment approach.