Understanding equal weight index investing and its many advantages

When it involves indices, there are a number of methods during which an index may be shaped. Globally, the preferred fairness market indices are free-float market capitalization weighted. This kind of index invests in particular person shares in proportion to their relative free-float market capitalization. The different most prevalent index kind world over is the equal-weight index. An equal weight index follows an alternate index weighing methodology whereby the person shares are assigned equal weights no matter their free-float market capitalization.

Globally, many institutional cash managers go for equal weights within the shares they select to put money into. This is essentially as a result of there’s a extensively held perception that, over the long run, equally weighting a broad universe of shares tends to outperform a cap-weighted portfolio. Given beneath are the explanations they usually ascribe to:

Counting inefficiencies: By being equally invested in all of the shares in a portfolio, an equal-weight mechanism ensures the portfolio doesn’t succumb to inefficiencies created throughout phases of over-optimism or over-pessimism.

For instance, when euphoria is created in a sure pocket, the irrational nature of traders will are inclined to push the costs increased. Similarly, throughout instances of adverse sentiment, shares might face sharp correction. All of those inefficiencies get mirrored in a free-float market capitalization-weighted index. On the opposite hand, an equal weight index is not going to be impacted to the extent as that of the normal index.

Diversification: In a standard index just like the Nifty 50, financials account for 37% of the weightage. In the occasion of a adverse improvement within the monetary house, the index is certain to be closely weighed down. But when the identical index is equal-weighted such because the Nifty50 Equal Weight, the focus of financials is decreased to 23.3%. So, by equal weighting, the difficulty of focus threat stands largely addressed because the index is healthier diversified and renders higher stability to the general portfolio.

No market cap bias: In a traditional market capitalization-based index, shares with smaller market cap get decrease weightage in an index. But within the case of an equal-weight index, the funding is equally unfold throughout all of the shares of the index leading to increased weightage to even comparatively smaller corporations. For instance: As of August 2022, the heaviest weightage inventory was at 11.7% and the subsequent two have been weighted at 8% every within the Nifty 50 index. Meanwhile, the weightage of the identical firm within the Nifty50 Equal Weight Index was at 1.8%, 1.9% and 1.8%, respectively. Since the index intends to don’t have any dimension bias, it tries to scale back affect of larger corporations on the index efficiency.

Room for Rebalancing: Unlike a standard index, there may be periodic rebalancing in an equal-weight index. For instance: In the case of the Nifty50 Equal Weight Index, NSE rebalances the providing on a quarterly foundation. This means earnings shall be booked and the weights of the latest winners shall be trimmed on the time of rebalancing. Because of this mechanism, an equally-weight portfolio helps an investor to lock in beneficial properties time to time and in addition profit from any imply reversal taking part in out between rebalancing instances.

An equal-weighted index tends to outperform a market-capitalization weighted index when there’s a broad market uptrend. For instance: Post the Covid correction, because the markets rebounded, the rally was comparatively broad-based. Hence, the equal-weight technique has outperformed the Nifty 50 TRI in 2020, 2021 and YTD 2022 by 3.2%, 9.4% and a couple of% respectively. (Data as on 31 August 2022).

However, throughout pre-pandemic instances, a handful of heavyweight names prompted the index to surge; at such occasion, conventional benchmark indices are inclined to carry out nicely. For instance: In calendar 2019, when benchmark indices have been polarised by way of efficiency, the Nifty 50 TRI delivered 13.5% return. During the identical timeframe, the Nifty50 Equal Weight TRI return was simply 4.3%. This clearly exhibits that in a polarised market, the equal-weight technique is certain to come back underneath strain. Another occasion when the technique might come underneath strain is throughout instances of market consolidation. The final time when such a part performed out was throughout calendar yr 2018. At that point, the Nifty 50 TRI was at 4.6%, whereas the Nifty 50 Equal Weight Index delivered a adverse 4.6% return.

Performance exhibits completely different indices carry out in another way underneath various market situations. So, it’s prudent to diversify throughout indices with completely different weighting methodologies.

Chintan Haria is head, product improvement & technique, ICICI Prudential AMC

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