Will equal weight index funds change the face of passive investing?

This post was originally published on this site

Representative image | (PC-Shutterstock)

Remember the preferential treatment the academic toppers in your school received? Their strong performances set the benchmark for the entire class, right? But if you were not a part of the front-bench, studious club, wouldn’t you wish for more inclusivity and equality when it came to class representation?

Well, the Sensex and the Nifty, two of the most popular market indices, are no different. If you look at the weights of various sectors in the Sensex as of May 28, 2021, you’ll find that this index is heavily concentrated around Banking and Finance (42.45 percent) and Information Technology (17.92 percent). That’s just two sectors making up around 60 percent, or more than half of the entire index. 

The Nifty follows a similar pattern. An April 2021 report detailing the sectoral weightage of various sectors on the Nifty presented a strikingly identical picture. While Banking and Finance held almost 37.82 percent of the weight, Information and Technology stood at 16.53 percent. Again, that’s almost 55 percent of the index, concentrated amongst two sectors. 

To avoid this, the Nifty50 Equal Weight Index Fund approaches the weighting strategy differently. While the parent index Nifty50 weighs various companies in accordance with their market capitalisation, the Nifty50 Equal Weight Index, consisting of the same 50 companies as its parent index, weighs all the companies equally, irrespective of their market size. 

Taking this approach ahead, Aditya Birla Sun Life Mutual Fund recently launched an open-ended scheme tracking this index. The NFO (New Fund Offer) for this, which opened on May 19, 2021, will close on June 2, 2021. Keeping with the fund basics, each stock will be given a similar allocation of 2 percent.

Opting for an equal approach 

Traditionally, values on the Nifty are determined through the free-float market capitalisation method. This means that the company’s market capitalisation is calculated by multiplying the number of company shares available for trade by the price at which the company’s stock or equity is currently trading at. The higher the market cap value, the greater the weight assigned to it on the index. 

Now, the higher the price of a company’s equity, the more its market capitalisation figures and therefore, the greater the value assigned to its stock on the index.

This often leads to the index concentrating only around a few stocks. Consider this. These are the top five companies on the Nifty, by weightage, as of May 28, 2021: 

Company Index Weightage (In %)
Reliance Industries  10.19
HDFC Bank  9.72
Infosys 7.93
HDFC 6.89
ICICI  6.56

A closer look would tell you that these five stocks have a combined weight of more than 40 percent on the index, an indicator of how weights can be massively disproportionate in the free float method. 

Hitendra Parakh, Fund Manager-Quantum Nifty ETF believes the equal-weighted index provides a solution to this disproportion. “With equal-weighted index funds, you can completely avoid stock concentration, which is generally the case with major indices. Higher diversification also implies lower risk. Also, in the international market, equal-weighted funds have been known to perform similar to and even outperformed their parent benchmarks, which makes for a strong, positive case for this category,” he says. 

Solid Performance

An equal-weighted index, in fact, has a good track record of returns. For instance, the S&P 500 Index has a return rate of 12.18 percent over the last decade. In contrast, The S&P Equal Weight Index delivered around 11.42 percent returns over the same time period. 

The Indian story is a little more encouraging. Take a look at this table, which details the returns of Nifty50 and Nifty100 funds, both equal-weighted and free-float market capitalisation ones, since their inception:

Nifty50 (Returns since Inception) Nifty100 (Returns since Inception)
Free-Float Market Capitalization  Equal Weighted  Free-Float Market Capitalization  Equal Weighted 
11.09 percent  11.57 percent 17.51 percent 18.74 percent 

Game-changer 

The Aditya Birla equal-weighted fund has a threshold of 2 percent, with a provision of quarterly rebalancing.  This means that if any stock’s allocation surpasses 2 percent, the excess percentage will be sold off and the profit thereof will be automatically added to the NAV (Net Asset Value) of the fund. Since the fund will be rebalanced every quarter, periodic and regular profit booking would follow. 

While this sounds very enticing, not many market experts agree if equal-weighted funds are the better of two. Rohit Shah, A CFP, SEBI registered investment advisor, and founder of Getting You Rich, a Mumbai-based personal finance advisory, thinks that equal-weighted funds go against the collective wisdom of the market by not utilising the collective market wisdom of optimally utilising the performance of top market performers. “In fact, equal-weighted funds might mean higher expenses. For instance, a regular mutual fund plan could cost 10 paise per investor, expense-wise. The same plan might have an expense structure of 30-40 paise per investor when it comes to equal-weighted funds. Hence, I would not immediately recommend my clientele to invest in these funds.

According to Shah, the ultimate aim of any fund is to generate increased alpha for its investors. There are many incentives and ways to go about the same, and equal-weighted index funds are just one of the ways to achieve it.

Is there a market for ETFs?

Passive investing in India is still in its nascency, with last year triggering a momentous growth. In 2020, the Indian ETF market had more than $37 billion dollars in assets, marking a Y-O-Y increase of about 171 percent in the sphere.

However, Parekh explains that this growth in AUM (Assets Under Management) in the passive investing sphere is driven majorly by institutional participation and has little to do with retail investors. “The numbers related to passive investing in India are very low, and there is a long way to go before we reach a considerable volume of people who engage in passive investing. 

Hemang Jani, Group Senior Vice President at Motilal Oswal Financial Services Ltd, concurs. “Passive Investing in India is still at a very initial stage. I believe that the public should be made more aware of ETFs (Exchange Traded Funds) since they are an easier investment vehicle as compared to other products like mutual funds and more. Introducing the concept of equal-weighted index funds would be an easier process, then. However, I personally believe that the foremost priority of an investor is the returns generated by the fund, irrespective of whether the fund is free-float or equal weight”, he signs off. 

Related Posts