It is commonly believed that equal-weighted indices exhibit characteristics that align with the value investing approach, while market-cap-weighted indices tend to resemble the momentum investing approach. Although an equal-weighted index can offer greater diversification across many stocks, investors seeking higher exposure to the largest and most established companies in a particular market or sector may still prefer a market-cap-weighted index.
Market-cap-weighted indices assign more weightage to larger companies, resulting in their movements having a greater impact on the index as a whole. An Equal Weight Index is like having a level playing field, where every company has an equal opportunity to contribute to the portfolio’s performance.
Let us work with an example. On 17 April, Infosys fell by 9.4 % and took the Nifty50 down by 0.7%; however, in the case of an equal-weighted average index, the index would not have fallen so much.
Infosys’ fall also became a reason for weakness in other IT stocks, and the NIFTY IT Index, which also consists of TCS, HCL Tech, and a few other IT companies, tumbled by 4.7%.
Infosys, which has a weight of 6.68% in Nifty 50, alone contributed over 100 points to the Nifty fall of 130 points. Shares of TCS, HCL Technologies, Tech Mahindra, and Wipro also contributed negatively to the index. Tech Mahindra (down 5.24 percent), HCL Technologies (down 2.77 percent), Wipro (down 1.89 percent) and TCS (1.55 percent) were other key contributors to the Nifty coming in red.
However, the same was not true with the Nifty 50 Equal Weight Index. On 17th April, the same day the Nifty50 was down by 0.7%, the Equal Weight Index was completely flat due to positive contributions by its other equal weight constituents. It would be sufficient to say that an equal-weighted index may perform better than a market-weighted one during volatile times. This is because an equal-weighted index provides more balanced exposure to each stock in the index rather than giving more weight to larger companies, as is the case with a market-weighted index. Also, equal distribution of weights ensures that the effect of both euphoria & panic for a certain sector and company have a limited influence on the overall movement of Index.
Another reason to consider the Equal Weight Index is safeguarding the overall impact due to corporate governance issues, which are difficult to pre-empt, unlike quarterly results. For quarterly results & financials, a fair bit of analyst coverage and market disclosures are available to help in decision-making. However, Corporate Governance issues always flare up without any warning and can have a catastrophic effect on Index if one of the heavyweights in the index was the one found with such findings. Markets have recently experienced such a situation a couple of months back. An equal weight index would feel less impact and pain in such kinds of scenarios. An Equal Weight Index is like a team of equally-talented players, where every member has an equal role to play in achieving the team’s goals.
So Equal Weight Index has some salient advantages over its Market Cap weighted cousin –
- Provides greater diversification across all stocks in the index.
- Reduces concentration risk by not giving more weightage to large-cap stocks.
- May perform better in certain market conditions, such as when small-cap stocks outperform large-cap stocks. If the index has small-cap stocks.
- Forces portfolio rebalancing by selling outperforming stocks and buying underperforming stocks, which can lead to better returns in the long run.
However, it comes with certain limitations, as higher costs are due to more frequent rebalancing and possibly lower liquidity.
Investing in an Equal Weight Index can give investors a sense of fairness and equality, where every company is given an equal opportunity to contribute to the portfolio’s success.
(Rahul Bhutoria is Director and Founder of Valtrust, a Bespoke Multi Family Office)
