Q. I am a 33-year-old government employee working as an officer in the state administrative service of Madhya Pradesh, my wife is a government employee too. We have been investing in index mutual funds tracking Sensex and Nifty since the past 10 years. Recently I came across certain mutual funds investing in Nifty Equal Weight Index, can you please elaborate on the differences between Nifty and Nifty Equal Weight Index. I understand that the Nifty Equal Weight Index is more diversified, is that true? Additionally, please elaborate on the pros and cons of investing in the Nifty Equal Weight Index.
An equal weight index is a stock market index that invests an equal amount of money in the stock of each company that makes up the index. For example, the Nifty 50 Equal Weight Index is an index that invests 2% of its portfolio in each of the 50 stocks that constitute the Nifty 50 Index. This means that each stock has the same impact on the index value, regardless of its market capitalization or share price.
The Nifty equal weight index is rebalanced every six months, in March and September, to maintain the equal weights of the stocks. The rebalancing involves buying or selling the stocks in proportion to their deviation from the 2% target weightage.
The companies that are part of the Nifty equal weight index are selected based on the same criteria as the Nifty 50 index. The criteria include liquidity, free-float market capitalization, listing history, impact cost and domicile. The companies must be listed on the National Stock Exchange (NSE) and must be among the top 800 companies by average free-float market capitalization for the last six months. The companies must also have a minimum listing history of six months and a minimum impact cost of 0.5% for 90% of the observations. The companies must be domiciled in India and must not be classified as ADRs or GDRs.
What is the difference between Nifty 50 and Nifty 50 Equal Weight Index?
The Nifty 50 is a market-cap weighted index, which means that it gives more weight to the larger companies based on their market capitalization. For example, as of September 2021, HDFC Bank and Reliance Industries had a combined weight of over 20% in the Nifty 50 Index, while the smallest company had a weight of only 0.2%. This means that the performance of the Nifty 50 is largely driven by a few large companies.
The Nifty 50 Equal Weight Index, on the other hand, gives equal importance to all the companies in the index, regardless of their size. This means that the performance of the Nifty 50 Equal Weight Index is more diversified and reflects the broader market sentiment.
The Nifty equal weight index aims to provide a more diversified exposure to the Nifty 50 stocks, as it reduces the concentration risk of a few large-cap stocks that dominate the Nifty 50 index. The Nifty equal weight index also tends to capture the performance of the mid-cap and small-cap segments better than the Nifty 50 index, as it gives more weightage to the lower-priced stocks.
What are the pros and cons of investing in a mutual fund that tracks the Nifty 50 Equal Weight Index?
Some of the advantages of investing in a mutual fund that tracks the Nifty 50 Equal Weight Index are:
- It reduces the concentration risk and avoids overexposure to a few large companies that may dominate the market-cap weighted index.
- It benefits from the higher return potential of smaller companies that may be undervalued or have higher growth prospects than larger companies.
- It follows a contrarian approach by rebalancing periodically and buying low and selling high, which may enhance returns over time.
Some of the disadvantages of investing in a mutual fund that tracks the Nifty 50 Equal Weight Index are:
- It may have higher volatility and risk than a market-cap weighted index, as smaller companies tend to be more sensitive to market fluctuations and economic cycles.
- It may have higher trading costs and tax implications than a market-cap weighted index, as it requires more frequent rebalancing and turnover of stocks.
- It may underperform a market-cap weighted index when the market rally is narrow and led by only a few large names, as was the case in 2018 and 2019.
How does the historical performance of the Nifty 50 and the Nifty 50 Equal Weight Index compare?
The Nifty 50 Equal Weight Index tends to outperform the Nifty 50 Index when there is a broad market rally, as is often the case after a large market decline. When the market rally is narrow and led by only a few large names, for example in 2018 and 2019, the Nifty 50 Equal Weight Index tends to underperform the Nifty 50 Index.
Conclusion
An equal weight index is a stock market index that invests an equal amount of money in each company that makes up the index. It differs from a market-cap weighted index such as the Nifty 50 by giving equal importance to all companies regardless of their size. Investing in a mutual fund that tracks an equal weight index such as the Nifty 50 Equal Weight Index has its pros and cons. It may offer higher returns and diversification benefits than a market-cap weighted index but also entails higher risk and costs. The historical performance of an equal weight index may vary depending on the market conditions and cycles.
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Note: This is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.
