How equal weight index will assist all through volatility

Indian markets have been beneath pressure attributable to quite a few world elements, along with fears of a looming recession. All of this has weighed down the Indian benchmark indices, which can be down by virtually 10% from its all-time extreme, remaining seen in December.

One of the primary contributors to this correction has been some shares carrying elevated weightages throughout the banking and the vitality (oil and gas) sectors, which account for nearly 12% and 37%, respectively, of the Nifty 50 index universe. Traditional indices such as a result of the Nifty 50 and the S&P BSE Sensex are based mostly totally on free float market capitalization. Free float means the market price of a company which is not owned by its promoter. So, greater the free float, elevated is the weightage of such a company in standard indices. For occasion, Reliance industries Ltd has a weightage of 10.5%, whereas banking majors like HDFC Bank and ICICI Bank carry a weightage of larger than 9.2% and 7.8%, respectively. In the case of a sharp correction in an individual stock with a relatively elevated market cap, an index such as a result of the Nifty 50 may get weighed down.

The totally different most prevalent index type globally is the equal-weight index. This follows an alternate methodology, whereby specific particular person shares are assigned equal weights regardless of the free-float market capitalization. Even throughout the event of a free fall in an index half, the index itself will probably be comparatively immune to the correction attributable to a 2% weightage cap for each agency. Here are some parts which makes this index an attention-grabbing funding proposition:

Overcomes inefficient markets: The equal-weight mechanism ensures the portfolio does not succumb to the inefficiencies created all through phases of over-optimism or pessimism. For occasion, when euphoria is created in a certain pocket, the irrational nature of market/patrons will are more likely to push prices elevated. Similarly, all through situations of damaging sentiment, shares may face sharp correction, and all of these inefficiencies get mirrored in a free-float market capitalization-weighted index. An equal weight index shouldn’t be going to be impacted to the extent of an ordinary index. For occasion, financial corporations, which account for 37% weightage throughout the standard index similar to the Nifty 50, accounts for underneath 23.3% in an equal weight index. So, throughout the event of a harmful enchancment throughout the financial home, an equal weight index will probably be a lot much less impacted.

No market cap bias: In an equal-weight index, the funding is equally unfold all through all index constituents, resulting in elevated weightage to even comparatively smaller firms. Since the Nifty equal weight index allocates 2% to each of its constituents, the affect created by bigger firms on the index effectivity stands curtailed.

Index effectivity: During the pre-pandemic situations in calendar yr 2019, when a handful of heavyweight names had been inflicting the index to surge, the benchmark indices had been polarized by the use of effectivity. The Nifty 50 TRI delivered a 13.5% return, whereas the Nifty50 Equal Weight TRI return was merely 4.3%. So, in a polarized market, this system will probably be beneath pressure. While in 2023 (year-to-date basis) the equal weight index has lagged by 0.4%, the effectivity has been sturdy when there is a broad-based market uptrend, corresponding to a rally post-covid correction, whereby the equal-weight method has outperformed the Nifty 50 TRI in calendar years 2020, 2021 and 2022 by 3.2%, 9.4% and a few.4%, respectively.

Chintan Haria is head of funding method, ICICI Prudential AMC.

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