When it comes to indices, there are many ways in which an index can be created. Globally, the most popular equity market indices are free-float market capitalization weighted. This type of index invests in individual stocks in proportion to their relative free-float market capitalization. The other most prevalent index type worldwide is the equal-weight index. An equal weighting index follows an alternative index weighting method in which individual stocks are assigned equal weighting regardless of their free-float market capitalization.
Globally, many institutional wealth managers opt for equal weighting in the stocks they wish to invest in. This is largely because it is widely believed that, over the long term, equally weighting a broader universe of stocks outperforms cap-weighted ones. portfolio. Below are the reasons they are often cited:
Calculating Inefficiencies: By having all stocks in a portfolio invested equally, a uniform weighting mechanism ensures that the portfolio does not succumb to inefficiencies created during phases of over-optimism or over-pessimism.
For example, when excitement builds in a certain pocket, the irrational nature of investors will push prices higher. Similarly, during the time of negative sentiment, there may be a sharp decline in stocks. All of these inefficiencies are reflected in a free-float market capitalization-weighted index. On the other hand, a uniform weighted index will not be affected to the same extent as a traditional index.
Diversification: Financial accounts for 37% of the weightage in traditional indices like Nifty 50. In the event of negative growth in the financial sector, the index is bound to weigh heavily. But when the same index is equally weighted such as Nifty 50 Equal Weighted, the concentration of financials is reduced to 23.3%. Therefore, with equal weighting, the issue of concentration risk is addressed to a large extent as the index is better diversified and provides better stability to the overall portfolio.
No market cap bias: In a traditional market capitalization-based index, stocks with smaller market caps receive less weightage in an index. But in the case of an equal-weighted index, the investment is spread evenly across all the stocks in the index, resulting in higher weighting even to comparatively smaller companies. For example: As of August 2022, the heaviest weighted stock was 11.7% and the next two Nifty 50 indexes were each weighted at 8%. Meanwhile, the weights of the same company in the Nifty 50 Equal Weight Index were 1.8%, 1.9% and 1.8% respectively. Since the index is not intended to have any size bias, it tries to minimize the impact of large companies on the performance of the index.
Room for Rebalancing: Unlike a traditional index, an index of equal weight has periodic rebalancing. For example: In case of Nifty 50 Equal Weight Index, NSE rebalances the offering on a quarterly basis. This means that profits will be booked and the weight of the recent winners will be deducted at the time of rebalancing. Because of this mechanism, an evenly weighted portfolio helps an investor lock in periodic gains and also benefit from any mean reversal between rebalancing times.
An equal-weighted index outperforms a market-capitalization weighted index when there is a broad market uptrend. For example: The rally was relatively broad-based, as the markets rallied after the Covid correction. Therefore, the equal-weight strategy has outperformed Nifty 50 TRI in 2020, 2021 and YTD by 3.2%, 9.4% and 2% in 2022 respectively. (Data as on 31 August 2022).
However, in pre-pandemic times, a handful of heavyweight names led to a jump in the index; In such an instance, traditional benchmark indices tend to perform well. For example: In calendar 2019, when the benchmark indices were polarized in terms of performance, Nifty 50 TRI gave 13.5% return. During the same time frame, the Nifty 50 Equal Weight TRI return was just 4.3%. This clearly shows that in a polarized market, an equal weighting strategy is bound to come under pressure. Another example when a strategy can come under pressure is during market consolidation. The last time such a stage was played was during the calendar year 2018. At that time, the Nifty 50 TRI was at 4.6%, while the Nifty 50 Equal Weight Index gave a negative 4.6% return.
Performance shows that different indices perform differently under different market conditions. Therefore, it is prudent to diversify the indices with different weighting methods.
Chintan Hariya is Head, Product Development & Strategy, ICICI Prudential AMC
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