Indian markets have been under pressure due to various global factors, including fears of a looming recession. All of this has weighed down the Indian benchmark indices, which are down by nearly 10% from its all-time high, last seen in December.
One of the major contributors to this correction has been some stocks carrying higher weightages in the banking and the energy (oil and gas) sectors, which account for nearly 12% and 37%, respectively, of the Nifty 50 index universe. Traditional indices such as the Nifty 50 and the S&P BSE Sensex are based on free float market capitalization. Free float means the market value of a company which is not owned by its promoter. So, larger the free float, higher is the weightage of such a company in traditional indices. For example, Reliance industries Ltd has a weightage of 10.5%, while banking majors like HDFC Bank and ICICI Bank carry a weightage of more than 9.2% and 7.8%, respectively. In the case of a sharp correction in an individual stock with a relatively higher market cap, an index such as the Nifty 50 might get weighed down.
The other most prevalent index type globally is the equal-weight index. This follows an alternative methodology, wherein individual stocks are assigned equal weights regardless of the free-float market capitalization. Even in the event of a free fall in an index component, the index itself will be comparatively immune to the correction due to a 2% weightage cap for each company. Here are some aspects which makes this index an interesting investment proposition:
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Overcomes inefficient markets: The equal-weight mechanism ensures the portfolio does not succumb to the inefficiencies created during phases of over-optimism or pessimism. For example, when euphoria is created in a certain pocket, the irrational nature of market/investors will tend to push prices higher. Similarly, during times of negative sentiment, stocks may face sharp correction, and all of these inefficiencies get reflected in a free-float market capitalization-weighted index. An equal weight index will not be impacted to the extent of a traditional index. For example, financial services, which account for 37% weightage in the traditional index like the Nifty 50, accounts for only 23.3% in an equal weight index. So, in the event of a negative development in the financial space, an equal weight index will be less impacted.
No market cap bias: In an equal-weight index, the investment is equally spread across all index constituents, resulting in higher weightage to even comparatively smaller companies. Since the Nifty equal weight index allocates 2% to each of its constituents, the impact created by bigger companies on the index performance stands curtailed.
Index performance: During the pre-pandemic times in calendar year 2019, when a handful of heavyweight names were causing the index to surge, the benchmark indices were polarized in terms of performance. The Nifty 50 TRI delivered a 13.5% return, while the Nifty50 Equal Weight TRI return was just 4.3%. So, in a polarized market, this strategy will be under pressure. While in 2023 (year-to-date basis) the equal weight index has lagged by 0.4%, the performance has been robust when there is a broad-based market uptrend, such as a rally post-covid correction, wherein the equal-weight strategy has outperformed the Nifty 50 TRI in calendar years 2020, 2021 and 2022 by 3.2%, 9.4% and 2.4%, respectively.
Chintan Haria is head of investment strategy, ICICI Prudential AMC.