Equal Weight Index Fund: An alternate style of index investing

The efficient market hypothesis states that any given point in time, share prices reflect all information. This means it will be close to impossible to outperform the market on a risk-adjusted basis since market prices should only react to new information.

On the basis of this hypothesis, it is believed that investors are better-off investing in a low-cost, passive portfolio. This is especially at a time when it is becoming increasingly difficult to beat the indices for say a large cap fund.

Traditionally, indices are based on free float market capitalization. Such a type of index invests in individual stocks in proportion to their relative free float market capitalization. Free Float means the market value of a company which is not owned by the promoter of the company.

However, there is an alternate option of weightage which is “equal weight index”. Such an index follows an index weighting methodology wherein the individual stocks are assigned equal weights regardless of their free float market capitalization. If you are an investor who believes that equity markets hereon are likely to see a broad based market rally, then an equal weighted index fund could help you better. To understand why, let us consider how indices perform under various conditions.

Indices like Nifty50 are constructed on the free float market capitalisation weight basis. Simply put, stocks with a higher free float in their market cap will have a higher weight in the index. For example: In the Nifty 50 index, as on January 8, 2023, Reliance Industries has the highest weight at 10.98% and BPCL has the lowest weight at 0.38%. Such uneven distribution could cause the index to outperform or underperform, depending on the performance of the stocks with the highest weightage.

On the other hand, the Nifty50 Equal Weight Index invests equally across the Nifty 50 Index resulting in higher weightage to even comparatively smaller companies in the index. So, each of 50 names in the Nifty 50 index has roughly 2% weight in the Nifty50 Equal Weight Index. As a result, in case of a broad market rally, an equal weight tends to do better than conventional market capitalization based index since it is not biased toward the largest companies in the index. Moreover, such an index is re-balanced on a quarterly basis such that the weights are not distorted.Consequently, an equal weight index is better diversified and has empirically higher dividend yield. When it comes to sectoral distribution, an equal weight index is more diversified in nature. The weightage of financial services in Nifty 50 is at 37% while in an equal weight index the weightage stands at 23.3%. Similarly, while IT and Oil & Gas enjoys double digit weightage in traditional index, when it is in equal weight index, the weights are in single digit. The impact of the same is reflective in the returns profile generated over the years.

In the year 2020 and 2021, when the market witnessed a broad based rally post the pandemic impact, the return of the Nifty50 Equal Weight TRI was 19.3% and 35% respectively. At the same time, the return of Nifty 50 TRI stood at 16.1% and 25.6% respectively. Alternately, in 2019 when even though the broader markets were under pressure, a rally in few of the highest weighted stocks led the Nifty 50 TRI to deliver a 13.5% return. During such times of anomaly, an equal weight index will not perform well, given the equal weight each company has in the index. Hence, in 2019, the return of a Nifty50 Equal Weight TRI was just 4.3%.

At a time when India is poised to do well, with growth emerging across sectors thanks to the various initiatives of the Government, improved capacity utilization, uptick in credit growth etc., one of the ways to play this broad based trend is through the top companies in the listed universe. For this, you may consider an equal weight index based fund as it is better placed structurally to capture the gains reflective in each of the companies.

(Chintan Haria, Head Investment Strategy,

AMC) (Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)