Risk-tolerant, long-term investors may hold these in satellite portfolio

Mirae Asset Nifty 50 Equal Weight (EW) Exchange Traded Fund’s (ETF’s) new fund offer closed on May 6. Several fund houses, including SBI, HDFC, ICICI, Kotak, Nippon, DSP, and Motilal Oswal already offer schemes based on EW indices.

 

USP of these funds

 

In market capitalisation-weighted index funds, larger companies receive greater weight. “An EW index-based fund assigns the same weight to each stock in the index, regardless of their market cap size,” says Chintan Haria, principal–investment strategy, ICICI Prudential Mutual Fund. In market cap indices, large companies dominate performance.

 

These funds are value or contrarian oriented, whereas market cap-weighted funds follow momentum. “When rebalancing, EW index funds buy more shares of a company with a declining share price and sell shares whose prices have risen. On the other hand, in a market cap-weighted index fund, when share prices of a company increase, the index allocates more weight to it,” says Satish Dondapati, fund manager–ETF, Kotak Asset Management Company. Abhishek Kumar, Sebi reg­ist­ered investment advisor and founder, SahajM­oney.com inf­o­r­ms that an EW index fund tends to undergo more frequent rebalancing.

 

Diversified exposure

 

EW index-based funds reduce concentration risk. “They offer better diversification as no single stock dominates the index’s returns,” says Dondapati.

 

The strategy has built-in discipline. “During the scheduled rebalancing, exposure to outperformers is trimmed while laggards are purchased,” says Inderbir Singh Jolly, chief executive officer, PL Wealth Management. This embeds a value-style tilt in these funds. Jolly adds that they tend to do well in mean-reverting cycles, when underperformers recover.

 

EW indices also outperform during broad-based rallies. “In 2020 and 2021, as markets experienced a broad-based rally, the Nifty 50 EW Total Return Index (TRI) delivered 19.3 per cent and 35 per cent, respectively, while the Nifty 50 TRI delivered 16.1 per cent and 25.6 per cent,” says Haria. 

 

Higher volatility

 

EW index-based funds can be more volatile due to exposure to smaller companies. “The absence of a defensive tilt towards larger, stable companies can increase drawdowns,” says Jolly.

 

The strategy tends to underperform when the market becomes polarised. “In 2019, a few heavyweight stocks drove the market rally. This resulted in a significant performance gap, with the Nifty 50 TRI gaining 13.5 per cent while the Nifty 50 EW TRI delivered only 4.3 per cent,” says Haria. The regular rebalancing these funds undertake can lead to underperformance in trending markets, due to the strategy cutting exposure to winners.

 

Kumar highlights that EW index funds usually carry high­er expense ratios than market-cap-weighted funds. Dondapati points out that frequent rebalancing can result in higher tra­ns­action costs.

 

Higher risk tolerance required

 

EW funds are best suited for investors with higher risk tolerance, a long investment horizon, and those comfortable with value-oriented strategies, according to Kumar. They are less suited for those seeking stable, benchmark-like returns.

 

Hold these funds in the satellite portfolio. “While they provide diversification and possi­ble outperformance during cer­tain market phases, they la­ck the stability often associa­ted with core holdings like market cap-weighted index funds or largecap strategies,” says Jolly.

 

Kumar recommends allocating 0 to 20 per cent of the equity portfolio to them, depending on risk appetite. He suggests sele­cting an EW fund based on criteria like tracking error, expense ratio, rebalancing frequency, fund size, liquidity, and the benchmark index tracked.