Equal-weight funds: Pick broader universe if risk appetite, horizon permit

Beware that funds with higher exposure to mid- and smallcaps are likely to be more volatile

Axis Mutual Fund recently launched a Nifty 50 Equal Weight Fund. Equal-weight smart-beta funds currently have assets under management (AUM) of ₹11,313.4 crore. Investors must understand how the index is constructed and select the appropriate underlying universe based on whether it fits their risk-reward return profile.

 

How equal weight index works 

An equal weight index contains the same companies as a conventional market cap-based index. The difference lies in the weight assigned to each constituent. 

A market cap-based index gives companies with a larger free-float market capitalisation a higher weight. The equal-weight version assigns the same weight to every constituent. 

This shifts the focus from company size to broader participation within the same universe. Companies that have smaller weights in the conventional index get greater representation here. This methodology for constructing the index significantly alters stock and sector exposure. In the Nifty 50 index, for instance, HDFC Bank has a weight of about 11.5 per cent, and financial services account for about 36 per cent. Equal weighting reduces HDFC Bank’s weight to about 2 per cent and financial services exposure to about 20 per cent. 

Concentration risk mitigated 

In a market-cap-weighted index, a small number of megacap stocks exert an outsized influence on returns. “An equal weight index reduces dependence on a few dominant stocks. Investors get to capture opportunities from a wider set of businesses instead of relying primarily on the largest companies,” says Anil Ghelani, Head, Passive Investments & Products, DSP Mutual Fund. 

“Equal weighting lowers concentration risk by giving every stock a similar allocation,” says Mahavir Kaswa, Head – Passive Research, Axis MF. 

Periodic rebalancing of the index trims stocks that have appreciated and restores the weights of those that have underperformed. “This creates a built-in buy-low, sell-high mechanism,” says Ghelani. 

An equal-weight fund can complement conventional index investing by offering a differentiated return profile.

 

Higher turnover raises costs 

The rebalancing mechanism also creates disadvantages. “More frequent rebalancing compared to a Nifty 50 index can raise transaction costs,” says Sadiya Khan, chief investment solution officer, Mirae Asset Sharekhan. It can also contribute to higher tracking error. 

Equal weighting gives relatively larger weights to companies at the lower end (by market capitalisation) of the base index. “This may raise volatility,” says Khan. This is because the strategy depends more heavily on the performance of the smaller constituents within the universe. 

The buy-low, sell-high mechanism does not always work in investors’ favour. “Quarterly rebalancing means systematically trimming recent winners and adding to laggards. This approach is disciplined but it can drag if laggards keep lagging instead of reverting,” says Rohan Goyal, investment research analyst, MIRA Money.

 

Performance moves in cycles 

Equal-weight indices tend to outperform when market gains are broad-based and participation extends beyond a few largecap stocks. “Such strategies often perform well when market leadership broadens, sector rotation increases, or relatively smaller constituents within the Nifty 50 deliver stronger earnings growth and stock performance than the index heavyweights.,” says Kaswa.

 

Economic recoveries can favour the strategy when a wider set of companies contributes to market returns. 

The reverse applies when the market rally is narrow. Market-cap-weighted indices tend to perform better when a handful of megacap companies dominate returns. Equal-weight strategies lag during such polarised rallies. 

Investors should avoid selecting these funds merely because of recent outperformance. They should also be cognizant of the fact that these funds can experience periods of underperformance. 

Check suitability 

Equal-weight funds can suit long-term investors who wish to avoid excessive dependence on a few megacap stocks. Individuals seeking diversification across companies and sectors may also take exposure to them. These funds may also be used to obtain risk exposures and return potential that differ from those of market-cap-weighted indices. 

“Investors seeking to benefit from a disciplined rebalancing mechanism may also consider these funds,” says Abhishek Kumar, Sebi-RIA and founder, SahajMoney.com. 

These funds are not for everyone, however. “Those seeking to participate in momentum-led rallies may find them unsuitable because equal weighting systematically trims outperforming stocks,” says Kumar. Investors primarily seeking low expense ratios should also check before entering. Higher turnover and tracking slippage can affect the returns from these funds.

 

Avoid duplication 

Before investing, check whether the scheme would duplicate the holdings of an existing fund. Investors should also compare the total expense ratio and tracking error across fund houses. 

“Investors choosing an exchange-traded fund (ETF) should assess secondary-market liquidity to ensure efficient trading and minimal impact costs,” says Khan. The ETF’s AUM should also be examined. An illiquid ETF can trade at a premium or discount to its underlying value, thereby increasing the cost of entry and exit. 

Investors who do not wish to deal with exchange liquidity may find an index fund more convenient. Even in these funds, they should compare expense ratio and tracking error.

 

Select the right universe 

Equal-weight schemes can be based on a variety of underlying market-cap-based indices: Nifty 50, Nifty 100, BSE 200 and Nifty 500. 

The Nifty 50 represents the 50 largest companies and provides largecap exposure. The Nifty 100 includes the top 100 largecap companies. A BSE 200 Equal Weight strategy adds midcap exposure, raising both return potential and volatility. A Nifty 500 Equal Weight fund extends further into smallcap companies.

 

Broader equal-weight universes place significant portfolio weight in midcap and smallcap stocks. “This increases volatility and drawdown risk,” says Kumar. 

Investors with a lower risk appetite may prefer the Nifty 50 or Nifty 100 universe. Those seeking broader exposure and willing to accept higher volatility may consider the BSE 200. The Nifty 500 Equal Weight universe is suitable only for investors with a high risk appetite and a long investment horizon.

 

Role in portfolio 

A largecap equal-weight fund based on the Nifty 50 can serve as a core equity holding for investors seeking to reduce top-heavy concentration. 

Equal-weight variants of broader indices such as the Nifty 500 are better suited to satellite allocations because of their higher exposure to volatile midcap and smallcap stocks. “he wider the underlying universe, the more the fund behaves like a diversification and alpha-seeking bet rather than a core large-cap holding,” says Goyal. 

Investors should allocate to these funds based on their risk appetite. “Conservative investors may allocate 5–10 per cent of their total equity exposure, moderate investors 10–15 per cent and aggressive investors up to 20 per cent to equal-weight funds,” says Kumar. 

He adds that investors should have a minimum horizon of five to seven years and should use systematic investment plans (SIPs) to smooth entry costs. 

Investors should not expect equal-weight strategies to beat market-cap-weighted indices in every phase of the market. Finally, avoid switching out of these funds prematurely when the market is witnessing a narrow rally led by heavyweights.