Indian markets have been under pressure due to various global factors including recession fears. All this has dragged down Indian benchmark indices, which are down nearly 10% from their all-time highs seen last December.
One of the major contributors to this correction are some stocks with high weightings in the banking and energy (oil and gas) sectors, which account for around 12% and 37%, respectively, of the Nifty 50 index universe. Traditional indices like Nifty 50 and S&P BSE Sensex are based on free float market capitalisation. Free float means the market value of a company that is not owned by its promoters. Therefore, the larger the free float, the higher the weighting of such a company in traditional indices. For example, Reliance Industries Limited has a weightage of 10.5%, while banking giants such as HDFC Bank and ICICI Bank carry weightages of over 9.2% and 7.8%, respectively. In case of a sharp correction in any single stock with a relatively high market cap, an index like the Nifty 50 may lose weight.
The other most prevalent index type globally is the equal-weight index. It follows an alternative methodology, in which equal weighting is given to individual stocks regardless of free-float market capitalization. Even in the event of a free fall in an index component, the index itself would be relatively resistant to correction due to the 2% weighting cap for each company. Here are some aspects that make this index an interesting investment proposition:
Overcomes inefficient markets: The equal-weighting mechanism ensures that the portfolio does not succumb to inefficiencies created during phases of over-optimism or pessimism. For example, when euphoria arises in a certain sector, the irrational nature of the market/investors tends to push the prices up. Similarly, in times of negative sentiment, stocks may face sharp corrections, and all of these inefficiencies are reflected in the free-float market capitalization-weighted index. The equal weighting index will not be affected to the extent of the traditional index. For example, financial services, which has 37% weightage in a traditional index like Nifty 50, has only 23.3% weightage in a similar index. Therefore, in the event of negative developments in the financial sector, an equally weighted index would be less affected.
No market cap bias: In an equal-weighting index, investment is spread equally across all index components, resulting in higher weightings even to comparatively smaller companies. Since the Nifty index allocates equal weighting of 2% to each of its constituents, the impact created by large companies on the index performance is minimized.
Index performance: In calendar year 2019, in the pre-pandemic period, when a handful of heavyweight names were driving the index rally, the benchmark indices were polarized in terms of performance. Nifty 50 TRI gave 13.5% return, while Nifty 50 Equal Weight TRI returned just 4.3%. So this strategy will be under pressure in a polarized market. While the equal-weighting index has lagged 0.4% in 2023 (on a year-to-date basis), when a broad-based market trend is bullish, such as a rally post-Covid correction, in which equal-weighting Performance has been strong. The strategy has outperformed Nifty 50 TRI by 3.2%, 9.4% and 2.4% respectively in the calendar years 2020, 2021 and 2022.
Chintan Haria is the Head of Investment Strategy at ICICI Prudential AMC.
catch all business News, market news, today’s fresh news events and Breaking News Update on Live Mint. download mint news app To get daily market updates.