scorecardresearchHow equal weight index funds are different from conventional market cap funds?

How equal weight index funds are different from conventional market cap funds?

Updated: 16 Oct 2022, 02:00 PM IST
TL;DR.
Equal-weighted index funds divide the pooled money equally across all the equities in the underlying index while investing in stocks of publicly listed corporations. As a result, the performance of the index fund is equally affected by each stock's performance.
Equal-weighted index funds divide the pooled money equally across all the equities in the underlying index while investing in stocks of publicly listed corporations. 

Equal-weighted index funds divide the pooled money equally across all the equities in the underlying index while investing in stocks of publicly listed corporations. 

In the stock market, an equal-weighted index is one that assigns equal weight to all of the stocks in its portfolio. As a result, while determining the index's value, each stock that makes up the index will be treated equally. This is regardless of whether the listed firm is large or small, or the stock valuation of the company.

In contrast to a capitalization-weighted index, an equal-weighted index puts all of the stocks in it on the same level when calculating the index's value. With a capitalization-weighted index, larger firms and higher-value stocks are given more weight in the index's composition, which has the effect of dictating the index's performance.

Now that we understand what an equal weight index is, let’s move towards equal weight index funds.

What is an equal weight index fund?

Similar to an index fund or ETF, an equal-weighted index fund invests largely in the companies that make up the underlying or benchmark index. Equal-weighted index funds divide the pooled money equally across all the equities in the underlying index while investing in stocks of publicly listed corporations. As a result, the performance of the index fund is equally affected by each stock's performance.

For instance, the top 10 companies that make up the Nifty 50 index account for the bulk of the index's value. This fact makes it clear that the index's weight has a significant impact on how its value is computed and that an equal-weighted index will be very different from a conventional market cap weighted index. Let us understand this in detail.

How is an equal weight index fund different from market cap weight funds?

Most people believe that market-cap-weighted indices and equal weight indexes reflect various investing strategies. According to conventional wisdom, market-cap-weighted indices are driven by the momentum style of investing, whereas equal weight indexes are founded on the value approach to investing.

This argument has some validity. After all, Equal Weight Indices do include a good mix of assets with high and low prices. Additionally, the goal of rebalancing is to increase shares of firms whose prices are falling while decreasing shares of companies whose prices are rising. A market-cap-weighted index, on the other hand, keeps adding to its holdings in businesses whose prices have climbed, which supports the momentum approach.

Comparatively speaking, equal-weighted indices provide greater diversification than capitalization-weighted indexes. These therefore have a somewhat reduced risk. However, these funds are more susceptible to a dramatic and abrupt decline in bear market circumstances. In contrast, market-cap-weighted funds are less likely to encounter volatility during weak markets since they invest disproportionately in large-cap firms.

Equal-weighted index funds might be a reasonable substitute for exposure to the overall market value. It all boils down to an investor's financial objectives, level of risk tolerance, and investment portfolio structure when deciding between equal-weighted index funds and standard market capitalization-weighted index funds.

Article
Index funds are mutual funds that replicate the portfolio of an entire index like Nifty50. 
First Published: 16 Oct 2022, 02:00 PM IST