Taking stock: What you should know before investing in equal-weight indices

No single stock can heavily influence overall performance of such indices, leading to more diversified industry exposure

Equal-weight indices are increasingly popular, with several new index funds being launched by asset management companies (AMCs). Here’s a look at some of the key advantages and disadvantages of equal-weight indices.

Cap-based indices versus equal-weight indices

In a market cap-based index (such as Nifty 50, Sensex, Nifty Next 50, or Nifty Midcap 150), stocks with higher free-float market capitalisation receive greater weightage. In contrast, an equal-weight index assigns equal weight to all constituent stocks, although weights may change with performance. For example, the Nifty 50 Equal Weight Index rebalances all stocks to 2 per cent on a scheduled date, usually in March and September.

In a market cap-based index, the weight of a stock increases or decreases with its performance, allowing rising stocks to gain higher allocation. This also happens in an equal-weight index but weights reset to equality during rebalancing.

As a result, in an equal-weight index, money shifts from better-performing to underperforming stocks during rebalancing, making it more of a “value” play, whereas cap-based indices follow “momentum”.

Diversification

A market cap-based index may deliver higher returns if a few top-performing stocks dominate. However, the underperformance of a few large stocks can affect the entire index. This is less likely in an equal-weight index, as no single stock can significantly influence overall performance, leading to more diversified industry exposure. On the diversification front, equal-weight indices have an advantage over cap-based indices.

Liquidity

Stocks with higher free-float market caps generally have better liquidity, making it easier to buy and sell with minimal price impact. This helps fund managers who need to manage purchases and redemptions. In a cap-based index, the manager buys in proportion to the market cap.

In an equal-weight index, however, the manager must allocate equal amounts to all stocks. While this may not pose liquidity issues in Nifty 50 Equal Weight, other indices like Nifty 500 Equal Weight could face challenges. For instance, stocks ranked between 450 and 500 may not have the same liquidity as top companies like Reliance Industries or Infosys.

Cap-based indices address such issues by design, as bigger stocks naturally receive higher allocations, while smaller stocks get less. Thus, it’s important to monitor tracking differences when investing in equal-weight indices.

Exposure

A Nifty 500 index fund offers exposure to the entire market spectrum, covering large-cap, mid-cap, and small-cap stocks, based on Sebi’s classification:

Largecap: Top 100 stocks by market cap

Midcap: 101st to 250th stocks by market cap

Smallcap: 251st to 500th stocks by market cap

Although both Nifty 500 and Nifty 500 Equal Weight indices track the same 500 stocks, the allocation differs significantly:

Nifty 500: Largecap 72 per cent, midcap 17 per cent, small cap 10%

Nifty 500 Equal Weight: Large cap 20%, Midcap 30%, Small cap 50% (data as of July 31, 2024, Nippon AMC presentation).

Nifty 500 resembles a largecap or multicap fund, whereas Nifty 500 Equal Weight is more like a mid and small-cap fund. While both indices provide different market exposures, their performance can vary based on market conditions. When mid and small-cap stocks outperform, Nifty 500 Equal Weight is likely to perform better. Conversely, during large-cap outperformance, Nifty 500 may lead.

Should you invest in equal-weight indices?

Before investing in equal-weight index funds, consider the following:

Don’t rely solely on presentations from AMCs. Understand the exposure offered by the equal-weight index.

Focus on the expense ratio and tracking difference when choosing index funds and ETFs.

Assess whether the equal-weight index fund adds sufficient value to your portfolio to justify its inclusion.

The writer is a Sebi-registered investment advisor.