The conventional approach to index construction for a portfolio relies on market capitalization for weightage of stocks. However, the emergence of ‘smart beta’ strategies that seek to passively follow the indices have introduced a subset of strategies. These include equal weight investing, which assigns equal weights to all components in an index.
This deviation has both pros and cons, as observed in the case of the Nifty 50 Equal Weight Index (EWI) and the Nifty 50 Index. The EWI offers a more diversified and less concentrated portfolio, reducing the risk associated with dominant companies. Additionally, it tends to have a lower price-to-earnings (P-E) ratio, potentially making it attractive for long-term investors.
The main difference lies in the allocation methodology between Nifty 50 and Nifty 50 EWI. The traditional Nifty 50 Index tends to be skewed towards heavyweight stocks, where the top 5 stocks contribute significantly to most of the portfolio. The Nifty 50 EWI allocates an equal 2% weight to each stock, irrespective of its market capitalization. This approach ensures more balanced exposure, mitigating the concentration risk posed by a few dominant companies.
“For instance, consider that we have a 4 stock fund with 25% weightage each for HDFC Bank, ICICU Bank, Yes Bank and IndusInd Bank. Suppose HDFC outperforms and its weightage rises to 30%, ICICI performs a bit better and its weightage goes up to 27%, Yes Bank underperforms and drops to 22% and IndusInd drops to 21%. Now, this EWI fund will at the time of rebalancing sell some portion of HDFC Bank and ICICI Bank and buy more of Yes Bank and IndusInd bank to reset the weights back to 25% each,” says Anish Teli, managing partner at QED Capital Advisors LLP
“Now, there are second-order effects of equal weighting a market cap-weighted index. As Yes Bank and IndusInd underperform, their relative valuation becomes more attractive and they also are relatively smaller than HDFC Bank and ICICI Bank now. This gives the EWI fund exposure to the value factor (a portfolio of cheaper companies outperforms a portfolio of relatively expensive companies) and the size factor (a portfolio of small companies outperforms a portfolio of large companies). This makes an EWI fund relatively more riskier and volatile than a market cap weighted index.” adds Teli
Several asset management firms have launched such funds. SBI Mutual Fund has launched the SBI Nifty 50 Equal Weight Index Fund, currently in its NFO (new fund offer) period, replicating the Nifty 50 EWI. This fund offers equal exposure to all Nifty 50 stocks, with quarterly rebalancing to maintain equal weightage.
“EWI has outperformed its parent index, Nifty 50, in 15 out of 24 calendar years (considering years 2000-2023). This data reflects the potential of the EWI strategy in generating favourable returns over the long term,” says DP Singh, deputy MD & joint CEO, SBI Mutual Fund
To further contextualise this strategy, a comparison with the S&P 500 EWI can provide valuable insights. Over the last 16 years, the S&P 500 has delivered a return of 7.37%, while the S&P 500 EWI has delivered 7.25% (see graphic). This indicates that, during this period, the EWI has slightly underperformed the market-cap weighted index. It’s crucial to note that market conditions and dynamics may vary, and historical performance is not indicative of future results.
Is equal weight a better strategy?
Historical performance suggests that equal weights do not consistently outperform the index. In polarized markets, where only a select few top stocks perform well, traditional indices may prove more resilient. Conversely, during broad-based rallies, equal weights may exhibit superior performance. In the recent 2–3-year rally, almost all Nifty 50 index stocks have risen above their 200 DMA (daily moving average), indicating a broad-based market surge. Initially led by top stocks, the current scenario sees these leaders taking a breather, paving the way for other stocks to gain ground. This shift is a key reason for the outperformance of the EWI
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Market narratives often influence fund houses to tailor their products accordingly. Investors might be drawn to equal weight strategies due to recency basis. Viewing the current equal weight rally as a cyclical play—a flavour of the season—allows for a more balanced perspective. Investors should be prepared for potential shifts, such as a return to a polarized market scenario.
Examining the broader investment landscape, equal weight strategies provide comfort to investors during bullish markets. In scenarios where only a few stocks perform well, market cap investing directs a significant portion of funds to these top companies. In contrast, EWI funds distribute exposure evenly across all stocks, offering a more conservative approach.
On the positive side, the diversification and lower concentration risk of EWI can appeal to risk-averse investors. Additionally, the lower P-E ratio may indicate higher return potential over the long run. However, investors should be mindful of the potential underperformance during market polarization, as seen in scenarios where a few mega-cap stocks dominate the market rally.
Do you need it?
The recent rally may attract investors, but the cyclical nature of these strategies demands caution. The decision to opt for equal weight or market weight strategies should align with an individual’s market view. A study of the past performance of these two strategies is also necessary. It is important to emphasize on considering risk-adjusted returns, a metric crucial for evaluating the success of any investment strategy. Lower valuations alone should not be the reason to invest in an EWI fund. Lower valuations might reflect lower quality, as EWIs expose investors to companies with lower valuations. Investors should refrain from allocating capital solely based on valuation considerations.
“For me it is not convincing; I look at this equal weight rally more like a cyclical play, a flavour of the season. Somebody can get into equal weight while somebody can get into market weight based on what their view is. It is not necessary that equal weight will always do better than market cap. It really depends on market conditions” says Ravi Sarogi, co-founder, Samasthiti Advisors.
In the short time frame of the Indian markets, comparing different investment ideas is tricky. Just because equal weights performed well in the last two years doesn’t necessarily mean they are better than market cap indexes. Figuring out which is superior requires looking at a more extensive data set covering various market cycles.
Right now, equal weight might face challenges if markets take a polarized turn again, while market cap indexes thrive. In a broad-based rally, the equal weight index could do better. Predicting future market behaviour is tough. It’s like a trend of the moment; we’ll have a clearer picture after 10-15 years. The term ‘smart beta strategies’ can be confusing and used for marketing, suggesting alternative weight strategies are better, but it might not be a solid reason to choose EWIs. Market themes change, highlighting the importance of mean reversion in navigating the financial markets.
“EWI funds are often labelled as smart beta or factor funds, and their expense ratios in India typically range from 81 to 96 basis points (bps). In contrast, market weight index funds are available at lower expense ratios, typically ranging from 20 to 30bps. It raises questions as to why one would pay a higher fee for more risk and potentially lower expected returns.” says Teli.
While EWI funds are associated with smart beta and factor strategies, the higher fees raise questions about their attractiveness. Opting for market cap index funds appears more sensible, unless there’s a specific reason for choosing higher fees for potentially lower returns.
While equal weight strategies have demonstrated success in certain market conditions, their cyclical nature requires caution.