Understanding equal weight index investing and its many benefits

Globally, many institutional money managers opt for equal weights in the stocks they choose to invest in. This is largely because there is a widely held belief that, over the long term, equally weighting a broad universe of stocks tends to outperform a cap-weighted portfolio. Given below are the reasons they often ascribe to:

Counting inefficiencies: By being equally invested in all the stocks in a portfolio, an equal-weight mechanism ensures the portfolio does not succumb to inefficiencies created during phases of over-optimism or over-pessimism.

For example, when euphoria is created in a certain pocket, the irrational nature of investors will tend to push the prices higher. Similarly, during times of negative sentiment, stocks may face sharp correction. All of these inefficiencies get reflected in a free-float market capitalization-weighted index. On the other hand, an equal weight index will not be impacted to the extent as that of the traditional index.

Diversification: In a traditional index like the Nifty 50, financials account for 37% of the weightage. In the event of a negative development in the financial space, the index is bound to be heavily weighed down. But when the same index is equal-weighted such as the Nifty50 Equal Weight, the concentration of financials is reduced to 23.3%. So, by equal weighting, the issue of concentration risk stands largely addressed as the index is better diversified and renders better stability to the overall portfolio.

No market cap bias: In a conventional market capitalization-based index, stocks with smaller market cap get lower weightage in an index. But in the case of an equal-weight index, the investment is equally spread across all the stocks of the index resulting in higher weightage to even comparatively smaller companies. For example: As of August 2022, the heaviest weightage stock was at 11.7% and the next two were weighted at 8% each in the Nifty 50 index. Meanwhile, the weightage of the same company in the Nifty50 Equal Weight Index was at 1.8%, 1.9% and 1.8%, respectively. Since the index intends to have no size bias, it tries to reduce impact of bigger companies on the index performance.

Room for Rebalancing: Unlike a traditional index, there is periodic rebalancing in an equal-weight index. For example: In the case of the Nifty50 Equal Weight Index, NSE rebalances the offering on a quarterly basis. This means profits will be booked and the weights of the recent winners will be trimmed at the time of rebalancing. Because of this mechanism, an equally-weight portfolio helps an investor to lock in gains time to time and also benefit from any mean reversal playing out between rebalancing times.

An equal-weighted index tends to outperform a market-capitalization weighted index when there is a broad market uptrend. For example: Post the Covid correction, as the markets rebounded, the rally was relatively broad-based. Hence, the equal-weight strategy has outperformed the Nifty 50 TRI in 2020, 2021 and YTD 2022 by 3.2%, 9.4% and 2% respectively. (Data as on 31 August 2022).

However, during pre-pandemic times, a handful of heavyweight names caused the index to surge; at such instance, traditional benchmark indices tend to perform well. For example: In calendar 2019, when benchmark indices were polarised in terms of performance, the Nifty 50 TRI delivered 13.5% return. During the same timeframe, the Nifty50 Equal Weight TRI return was just 4.3%. This clearly shows that in a polarised market, the equal-weight strategy is bound to come under pressure. Another instance when the strategy could come under pressure is during times of market consolidation. The last time when such a phase played out was during calendar year 2018. At that time, the Nifty 50 TRI was at 4.6%, while the Nifty 50 Equal Weight Index delivered a negative 4.6% return.

Performance shows different indices perform differently under varying market conditions. So, it is prudent to diversify across indices with different weighting methodologies.

Chintan Haria is head, product development & strategy, ICICI Prudential AMC