Betting on the Right Index Funds

The Equal Weight Index diverges from conventional indices by assigning equal weight to each constituent, in contrast to the market capitalization weight assigned in typical indices. This article explores the distinctions between the two approaches and evaluates whether opting for an equal-weighted index makes sense compared to a market-cap-weighted one. 

If we were to prompt you to guess the bestperforming Large-Cap fund in the past year, chances are that most of you might not correctly identify the top performer. Surprisingly, the leading funds in the large-cap fund category over the last year were all equal weight index funds. The HDFC Nifty 100 Equal Weight Index Fund-Direct Plan emerged as the top performer, delivering a remarkable 37.57 per cent return. Following closely was the Sundaram Nifty 100 Equal Weight Fund-Direct Plan, which achieved a return of 33.54 per cent during the same period.[EasyDNNnews:PaidContentStart]

In contrast, the average return for the large-cap category over the past year was 28.3 per cent, with the best actively managed fund generating slightly over 30 per cent. There has been an ongoing debate about the outperformance of large-cap index funds compared to actively managed large-cap funds. According to the SPIVA India Scorecard, which evaluates the performance of actively managed Indian equity mutual funds against their benchmark indices across one, three, five and ten-year investment horizons, the majority of Indian equity large-cap funds failed to outperform their benchmarks in the latest study, extending until the first half of 2023. 

For example, the S&P BSE 100 gained 7.1 per cent in H12023, and a significant 58.1 per cent of active managers underperformed the benchmark during that period. This underperformance trend persisted over three and five-year periods, with rates of 86.2 per cent and 92.9 per cent, respectively. The underperformance observed in the aforementioned study is attributed to benchmark indices with market capitalisation weighting, where companies with larger market capitalisation carry more weight in the indices. Market capitalisation-weighted indices give greater significance to movements of companies with larger market capitalisation, influencing the overall index to a greater extent. 

In contrast, equal weightage indices provide a level playing field, granting every company an equal opportunity to impact the indices’ performance. To illustrate this concept with a recent example, consider the events following the release of HDFC Bank’s results on January 16. The stock, initially priced at ₹1,673 per share, experienced an 8.44 per cent decline the following day, closing at ₹1,542 on January 17. This decline had a substantial impact on indices with significant weightage, such as Nifty 50 and Sensex. 

The Sensex closed at 71,501, dropping 1,628 points or 2.2 per cent, marking the most significant decline since June 13, 2022. Similarly, the Nifty 50 concluded the session at 21,572, down by 460 points or 2.1 per cent, marking the most substantial drop since June 16, 2022. HDFC Bank’s shares contributed to over half of the losses for both the Sensex and Nifty, holding weightings of 14.7 per cent and 12.7 per cent, respectively. In contrast, in the case of an equal-weighted index, the impact was less severe, as every company carries a mere 2 per cent weightage. 

On the same day, Nifty 50 Equal Weight experienced a fall of less than 0.5 per cent. The equal weight index remained flat due to positive contributions from its other equal weight constituents. On the flip side, if indices rise due to the ascent of a particular stock, as seen on January 29 with Reliance Industries gaining 6.8 per cent, the market capitalisationweighted index gained 1.8 per cent, while the equal weight index rose by a modest 1.6 per cent. It is a common belief that equal-weighted indices exhibit characteristics aligned with the value investing approach, while market capitalisation-weighted indices tend to resemble the momentum investing approach. 

In Comparative Terms
In the Indian equity market, there are not many options when it comes to equal weight equity indices. There are only two equity indices (Nifty 50 Equal Weight and Nifty 100 Equal Weight) where we have both market capitalisation weightage and equal weightage indices. Besides, we do have index funds following these indices. Since funds have a limited history (with a few exceptions) as they are index funds, we can safely assume that they will mimic the index itself with very little variation and hence we have studied the index to understand what is better. We will take Nifty 100 TRI and Nifty 100 Equal Weight TRI as the benchmarks for the index funds. 

Let’s examine the key statistics for different indices in the above table, focusing on the Nifty 100 TRI and Nifty Equal Weight TRI. Over the period from the start of 2003 to January 20, 2024, the total returns for Nifty 100 TRI and Nifty 100 Equal Weight TRI were 2,866.18 per cent and 4,462.36 per cent, respectively. This indicates that the Nifty 100 TRI, which represents market capitalisation-weighted index, has underperformed the Nifty 100 Equal Weight TRI in terms of total returns. 

When considering risk measures, the maximum drawdown for Nifty 100 TRI and Nifty 100 Equal Weight TRI were –61.08 per cent and –63.00 per cent, respectively. In these statistical data, the market capitalisation-weighted index has performed slightly better than the equal weight index with lower drawdown. The yearly volatility is also higher for the equalweighted index. 

Let’s check the risk-reward trade-off, as represented by the Calmar ratio. This was 0.32 for Nifty 100 Equal Weight TRI and 0.29 for Nifty 100 TRI. The Calmar ratio indicates how well the index generated returns relative to its maximum drawdown, with higher values suggesting a better risk-adjusted performance. Now the winner in this case is also the equal weight index. Examining the annualised returns, the compound annual growth rate (CAGR) for the Nifty 100 TRI and the Nifty 100 Equal Weight TRI were 17.44 per cent and 19.87 per cent, respectively. 

Overall, the Nifty 100 Equal Weight index has delivered better return than Nifty 100 TRI. 

The above analysis is more about trailing and point-to-point returns. Going one step ahead, we tried to analyse the calendar year returns in which we found that the Nifty 100 Equal Weight TRI outperformed its market capitalisation-weighted counterpart Nifty 100 TRI in 11 out of the 21 years, and hence could not draw any conclusion. 

What is important to note is that equal weight dominated in the bull markets of 2012 (40 per cent versus 32 per cent) and 2014 (42 per cent versus 35 per cent), but also held its own in years like 2020 (17 per cent versus 16 per cent) and 2023 (30 per cent  versus 21 per cent. The only clear underperformance came in 2018 (negative 8 per cent versus 3 per cent) – a year marked by significant volatility where we saw HDFC Twins and Bajaj Twins dominating the market with larger market capitalisations. Hence, the Nifty TRI (market-weighted) generated better returns as these companies carried higher weightage. 

Rolling Returns
Taking it further, we analysed the rolling returns of these two indices. Upon scrutinising the median rolling returns of Nifty 100 TRI and its equal-weighted counterpart, Nifty 100 Equal Weight TRI, a consistent and noteworthy trend emerges. Across various investment horizons, the Nifty 100 Equal Weight consistently outperformed the market capitalisation-weighted Nifty 100 TRI. In a one-year timeframe, the Nifty 100 Equal Weight demonstrated its superiority in over half (52 per cent) of the observed periods, yielding higher median returns at 10.62 per cent as compared to 10.24 per cent for the Nifty 100 TRI. 

As we extend the horizon to three years, the outperformance becomes more pronounced, with Nifty 100 Equal Weight surpassing Nifty 100 TRI in a substantial 55 per cent of the observations, delivering median returns of 10.23 per cent versus 9.18 per cent. This trend persists over a five-year period with Nifty 100 Equal Weight consistently outshining the Nifty 100 TRI in 60 per cent of the observations. However, the median returns of Nifty 100 TRI were greater than the Nifty 100 Equal Weight TRI. These findings suggest that the Nifty 100 Equal Weight holds the potential to provide investors with superior returns, particularly for medium-term to long-term investment horizons. 

Nifty 50 Study
Now let’s analyse the concentrated index, Nifty 50, to understand how it stands against its equal weight counterpart. We do have a longer history for Nifty 50 and hence we will analyse the data since 1999. The picture below clearly shows that the Nifty 50 TRI has underperformed Nifty 50 Equal Weight TRI. Every ₹1,000 invested at the start of 1999 in Nifty 50 Equal Weight would have become ₹44,547 while the same amount in the same period would have become ₹27,048 if you would have invested in Nifty 50 TRI. 

When we analyse the calendar year returns of the Nifty 50 Equal Weight TRI and Nifty 50 TRI, it reveals an interesting dynamic. While both indices delivered positive long-term returns, Nifty 50 Equal Weight TRI consistently outperformed its market capitalisation-weighted counterpart in 15 out of the 23 years. This edge was particularly evident during the bull markets just like the Nifty 100 index as seen in 2003 (109.4 per cent versus 76.6 per cent), 2009 (100.6 per cent versus 77.6 per cent) and 2021 (35 per cent versus 26.6 per cent). 

However, the Nifty 50 Equal Weight TRI wasn’t immune to the bear markets, experiencing steeper declines in 2008 (negative 49.6 per cent versus negative 51.2 per cent) and 2011 (negative 25.5 per cent versus negative 23.9 per cent). Overall, the Nifty 50 Equal Weight TRI offered investors potential for higher returns and consistent outperformance, albeit with slightly amplified volatility during both upswings and downturns. 

On a daily rolling returns basis, the Nifty Equal Weight index has once again outperformed the Nifty 50 index across various investment timeframes. The chart below shows the daily rolling returns’ analysis of the indices. 

Choosing the Right Fit 
Based on the preceding analysis, it can reasonably be concluded that an equal-weighted index exhibits potential for outperformance compared to a market-weighted counterpart, especially in times of market volatility. The inherent balance provided by an equal-weighted index ensures that each stock contributes proportionately to the overall index movement, avoiding the bias towards larger companies typical of marketweighted indices. Furthermore, the equal distribution of weights acts as a safeguard against the unpredictable impact of corporate governance issues that can significantly influence market dynamics without prior warning. 

Corporate governance concerns, unlike Quarterly Results, are challenging to anticipate, making the equal-weighted approach a prudent choice. Recent market events underscore the potential risks associated with relying on heavyweights in an index, emphasising the resilience of an equal-weighted index in such scenarios. It operates akin to a team of equally talented players, where each member plays an equal role in achieving collective goals. 

While an equal-weighted index provides diversified exposure across numerous stocks, investors seeking heightened exposure to the largest and most established companies may still prefer market capitalisation-weighted indices. Striking a balance is pivotal in both life and investing, where equilibrium between risk and reward is crucial. In recent years, sophisticated investors have leaned towards value-oriented equal weight indices, favouring a balanced approach over momentumfocused market capitalisation-weighted indices.

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