How equal weight index can assist throughout volatility

Indian markets have been below stress attributable to numerous international components, together with fears of a looming recession. All of this has weighed down the Indian benchmark indices, that are down by practically 10% from its all-time excessive, final seen in December.

One of many main contributors to this correction has been some shares carrying increased weightages within the banking and the power (oil and gasoline) sectors, which account for practically 12% and 37%, respectively, of the Nifty 50 index universe. Conventional indices such because the Nifty 50 and the S&P BSE Sensex are based mostly on free float market capitalization. Free float means the market worth of an organization which isn’t owned by its promoter. So, bigger the free float, increased is the weightage of such an organization in conventional indices. For instance, Reliance industries Ltd has a weightage of 10.5%, whereas banking majors like HDFC Financial institution and ICICI Financial institution carry a weightage of greater than 9.2% and seven.8%, respectively. Within the case of a pointy correction in a person inventory with a comparatively increased market cap, an index such because the Nifty 50 may get weighed down.

The opposite most prevalent index sort globally is the equal-weight index. This follows another methodology, whereby particular person shares are assigned equal weights whatever the free-float market capitalization. Even within the occasion of a free fall in an index part, the index itself might be comparatively proof against the correction attributable to a 2% weightage cap for every firm. Listed below are some points which makes this index an fascinating funding proposition:

Overcomes inefficient markets: The equal-weight mechanism ensures the portfolio doesn’t succumb to the inefficiencies created throughout phases of over-optimism or pessimism. For instance, when euphoria is created in a sure pocket, the irrational nature of market/traders will are inclined to push costs increased. Equally, throughout instances of detrimental sentiment, shares might face sharp correction, and all of those inefficiencies get mirrored in a free-float market capitalization-weighted index. An equal weight index won’t be impacted to the extent of a conventional index. For instance, monetary companies, which account for 37% weightage within the conventional index just like the Nifty 50, accounts for less than 23.3% in an equal weight index. So, within the occasion of a detrimental improvement within the monetary house, an equal weight index might be much less impacted.

No market cap bias: In an equal-weight index, the funding is equally unfold throughout all index constituents, leading to increased weightage to even comparatively smaller corporations. For the reason that Nifty equal weight index allocates 2% to every of its constituents, the impression created by greater corporations on the index efficiency stands curtailed.

Index efficiency: In the course of the pre-pandemic instances in calendar 12 months 2019, when a handful of heavyweight names had been inflicting the index to surge, the benchmark indices had been polarized by way of efficiency. The Nifty 50 TRI delivered a 13.5% return, whereas the Nifty50 Equal Weight TRI return was simply 4.3%. So, in a polarized market, this technique might be below stress. Whereas in 2023 (year-to-date foundation) the equal weight index has lagged by 0.4%, the efficiency has been sturdy when there’s a broad-based market uptrend, resembling a rally post-covid correction, whereby the equal-weight technique has outperformed the Nifty 50 TRI in calendar years 2020, 2021 and 2022 by 3.2%, 9.4% and a couple of.4%, respectively.

Chintan Haria is head of funding technique, ICICI Prudential AMC.

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