Index Investing: How effective are equal weight strategies?

Index investing is catching fancy nowadays and investors are looking beyond plain vanilla index strategies. Equal weighting is one such strategy.

As you must be aware, Nifty50 is India’s bellwether index. It tracks the stock market performance of 50 highly liquid bluechip companies and accounts for 66% of total float-adjusted market capitalization of all companies listed on NSE. On the other hand, Nifty50 Equal Weight Index also tracks the performance of Nifty 50 companies but assigns them equal weights.

If you haven’t heard of this concept before, you may wonder why one should adopt an equal weight strategy and whether this alternative weighting approach is effective.

Let’s find out.

Why equal weights?

Although the constituents of a plain vanilla index and an equal weight index are the same, alternative weighting makes a significant difference to the portfolio skewness and sectoral allocation. Granular analysis suggests that equal weight indices tend to offer more diversification.

For instance, financial services dominate Indian markets; however, their dominance is more prominent in the plain vanilla index (Nifty50) as compared to that in the equal weight index (Nifty50 Equal Weight).

At present, the Nifty50 Equal Weight Index is significantly overweight (in comparison to Nifty50 Index) on Auto, pharma and metals. But it will give you less exposure (again, in comparison to that offered by Nifty50 Index) to Information Technology and Oil &Gas, besides financial services.

Sectoral allocations: Nifty50 Equal Weight Vs Nifty50

(Source: NSE)

Does that translate into better returns? Well, depends on the market tone and the pace of economic growth.

From the beginning of 2021, the Nifty equal Weight Index has substantially outperformed the Nifty 50 index.  The economy is expected to bounce back in FY22, despite a devastating second wave of COVID-19 infections.

Does equal weight mean more weight?

Data as on May 21, 2021
The graph depicts the performance of Rs 1 lakh each invested in Nifty 50 and Nifty 50 Equal Weight Index on January 1, 2021
(Source: NSE)

Drawing any conclusion based on just Year-to-Date (YTD) returns wouldn’t be an intelligent idea. We should use a rearview mirror to gauge the performance of the equal weight strategy.

Historical performance: plain Vanilla Vs equal weight

Returns are absolute
(Source: NSE)

Observations

• The equal weight strategy works when the stock market rally is broad-base and the economy is thriving or expected to do well. A huge outperformance of Nifty50 Equal Weight Index between 2002 and 2004 and also in 2009 reinforces this belief.
• As against that, plain vanilla indices tend to outperform when the rally is narrow and only a few stocks are driving the index performance. Noticeable underperformance of Nifty50 Equal Weight Index vis-à-vis Nifty50 during 2018 and 2019 substantiates these observations.

Be cautious!

If you prefer to follow the equal weighting strategy, you must understand the underlying indices and their overall representation very well. If you were to apply this strategy to more diverse indices, such as Nifty500, you might end up getting higher exposure to smaller companies, besides to less prominent sectors. In such cases, the volatility of an equal weight portfolio is likely to be greater as compared to that of a comparable plain vanilla index.

You may also like to read: In Conversation with Taher Badshah

Disclaimer: The blog is for information purposes only. We strongly suggest you to consult your financial advisor before taking any decision pertaining to your finances.  Asset allocation becomes extremely relevant.

We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:

We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.