What Are Equal Weight Index Funds?
Equal weight index funds negate the preference given to large-cap stocks in any mutual fund. It's worth knowing how the balance helps.
Equal weight index funds have been good performers in recent times, and the leading three in the category of large-caps have been equal weight funds. Specifically, the DSP Equal NIFTY 50 Fund was a top performer, with a 75.3% return annually. This was followed by the Principal NIFTY 100 Equal Weight Fund with 65% yearly returns, and Sundaram Smart NIFTY 100 Equal Weight Fund with 64.5% returns yearly. This comes as a surprise to analysts and investors considering that, so far, the domination has been by market cap-weighted index funds and actively managed funds. If you wish to make the most of your investment, it's well worth delving deeper into equal weight index funds.
So, the question arises: what is an equal weight index fund? Internationally, the most common index used is the market-cap weighted index. This serves the purpose of primary indices all over the globe. Such indices lend more weight to companies with a larger market capitalization, while giving less weight to smaller firms. For example, the NASDAQ Composite, the S & P 500, many Asian and European indices, and even the NSE NIFTY 50 and BSE SENSEX are all clear examples of indexes of market capitalization.
Nonetheless, just because the major stock exchanges favour indexes with market-cap weightage, it doesn’t mean that this is a more superior index. A well known alternative to the weightage of market-cap is the equal weight index. This refers to an equal allocation of capital that is invested in stocks of every company that is part of the index in question.
The Difference between Equal Weight Index Funds & Market Cap Weighted Index Funds
If you wish to grasp the difference between equal weight index funds and market cap weighted index funds, you must first consider the NIFTY 50 index, acting as a benchmark.
Plainly put, the NIFTY 50 consists of stocks in a range of domains within the Indian economy. However, the truth of the matter is that the index is largely focused on information technology, banking, and financial stocks. HDFC Bank and Reliance Industries alone make up in excess of 15% of the NIFTY 50. Clearly, the NIFTY 50’s performance relies heavily on the performance of some 4 or 5 top stocks.
Whichever way you look at it, this is preferential treatment. Therefore, the NIFTY 50 Equal Weight Index Fund, for example, bases its premise on equal weightage. The index allocates an equal amount of weight to each of the 50 entities of the parent index regardless of the market cap size. Hence, in the NIFTY Equal Weight Index Fund, both Coal India and Reliance Industries have the same weightage - at 2%.
A Tabular Representation
What is an equal weight index fund will probably be clearer to you now that you have understood its basic way of functioning with relation to companies listed in indexes. To make the picture clearer, here is a table that highlights the performance of equal weight index funds vs. market-cap weighted index funds. The table shows the weightage of the leading 10 companies in the NIFTY 50 Index and NIFTY 50 Equal Weight Index:
|Company||NIFTY 50 Index - Weight in %||NIFTY 50 Equal Weight Index - Weight in %|
|Housing Development Finance Corporation||7.08||2|
|Tata Consultancy Services||5.18||2|
|Kotak Mahindra Bank||4.05||2|
Advantages of Investing in Equal Weight Index Funds
Investing in equal weight index funds gives you some real advantages in terms of balancing your equity portfolio. Mentioned below, are some of the perks you get with investing in equal weight index funds:
- Diversification - With equal weight index funds, the risk in your portfolio is equally spread between all stocks, and not just focused on large-caps. During corrections and sectoral rotations, over-achieving stocks may get caught off-guard and make you lose out unless some small-caps are prevalent to balance risk.
- Value Investing - The practice of value investing is a key strategy that equal weight index funds are an aspect of. This is in contrast to momentum investing with only large-cap equity.
- No Unfavourable Dominance - No single stock can drive the value of the index on its own. All stock values are considered equal and this is a fair way of dealing in indexes.
Disadvantages of Investing in Equal Weight Index Funds
Although equal weight index funds offer a fairer valuation in an index, there are some disadvantages to investing:
- Transactions Charges - Charges for transactions may be high, leading to an increased expense ratio.
- Volatility - When market volatility strikes, equal weight index funds suffer. Bluechip funds can withstand volatility, but if they are weighted to equal small and mid-cap stocks, they lack the strength to tackle volatility.
- Anomalies - During mergers and stock splits, certain anomalies occur with equal weighted index funds. For instance, if two large-cap companies merge, there is no consideration of this in an equal weight index fund, and values would be assigned in the same proportion as is the usual way with such funds.
Who should invest in equal weight index funds?
Equal weight index funds are suitable for those investors who seek a simple, yet smart way of investing in the leading 50 companies that constitute the NIFTY 50 Index, allocating an equal amount of weightage to every stock in the index. If you have a high tolerance for risk, an investment horizon that is sufficiently long (at least 5 years), and your investment goals are aligned with the fund, you can invest in any given equal weight index fund.
- Do equal weight index funds need rebalancing?
They do need to be rebalanced on a regular basis as they have a higher portfolio turnover relative to market-capitalisation weight funds. In equal weight index funds, fund managers have to see that each stock in the fund has the identical percentage in any given portfolio.
- What is a portfolio that is “equally weighted”?
An investor who holds a portfolio that is equally weighted holds an equal rupee value spread across each of the stocks that make up the index.
- How are equal weight indexes different from market-cap indexes?
In equal weight indexes, as the name suggests, all stocks of constituent companies in the index are assigned a value that is equal. In market-cap indexes, this is not the case.
- Is the NIFTY an equal weight index?
The NIFTY 50 Equal Weight Index is an alternative weighted index compared to its parent index, the NIFTY 50, which is a market-cap weighted index.
- Are equal weight indexes better than market-cap indexes?
Whether they are better or not depends on a matter of opinion. However, equal weight indexes represent more diversified indexes than market-cap indexes, and consequently, might carry less of a risk for investors.