Nifty 50 Equal Weight Index vs Nifty 50: Does equal weight result in more returns?

Published: March 29, 2018 at 10:00 am

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The Nifty 50 Equal Weight Index (N50EW) is one which the 50 stocks with highest market capitalization have equal exposure in the index. Whereas the more commonly used Nifty 50 (N50) has a market cap based exposure. In this post, we consider the impact of equal weights. Does it result in higher returns? What about risk? Should you choose Nifty 50 Equal Weight Index fund over a Nifty 50 index fund?

There are three popular ways of constructing an index: Market capitalization-weighted index; price-weighted index and equal-weighted index. Let us briefly consider each method of index construction.

Market capitalization-weighted index

Market capitalization is defined as total no of shares outstanding x current price per share. The Nifty 50 is a list of 50 stocks having the highest market cap. The nifty 100 has the top 100 in terms of market cap and the Nifty Next 50, the 51st to 100.

Now suppose you calculate the market cap of each of the top 50 stocks and add it up and get Rs. 25,000 Crores. Suppose the highest market cap of an individual stock (say company XYZ) is Rs. 5000 Crores. Then, 20% (5000/25,000) of a market cap weighted index will have XYZ stock and so on.

Price-weighted index

In this case, the stock with the highest price gets the highest allocation. The Dow Jones is an example of this type of index. We will not be considering this type further in this post.

Equal weight index

Here, you take the top 50 stocks by market cap (by example) and give them equal weight in the index. The advantage here is, there is no preferential exposure. If the stock with the largest market cap or price tanks, then the above two types of indices will fall much more than then equal weight index. The essential idea is to provide equal diversification and reduce concentration risk.  This, of course, is using common sense. As we have seen time and time again, common sense does not transform into reality. What about this time? How effective is the Nifty 50 equal weight index is against the Nifty 50 which is capitalization-weighted?

The following picture from the NSE whitepaper on the Nifty 50 Equal Weight index clearly illustrates the weight of each stock. Notice that 60% of Nifty 50 comprises of only 13-14 stocks due to their height market cap.

White paper on Nifty 50 Equal Weight Index

The NSE claims:

Equal weight index benefits from better diversification due to lower stock concentration risk as compared to parent index. One of the major benefits of equal weight index strategy is better diversification by avoiding concentration of portfolio in few big stocks

The purpose of this post is to verify this claim by using rolling returns and rolling risk calculations as recently done to verify the effect of timing the market with the Nifty PE using this tool: Evaluating Volatility in Returns, All indices considered are total return indices with dividends reinvested.

Nifty 50 Equal Weight Index vs Nifty 50: 10 years return and risk

Nifty 50 Equal Weight Index rolling return over 10 years

There are about 1076 10-year rolling return data points in the above curve. The rolling risk shown below is defined in terms of the average deviation from monthly returns over the 10Y period. Higher the value of the standard deviation, higher the risk. Note the NIfty 50 is also a total returns index.

Nifty 50 Equal Weight Index rolling risk (standard deviation) over 10 years

 

The risk of N50EW is only marginally lower than that of N50 and its returns is a bit higher. When the risk difference becomes close to zero, so does the return difference.

Nifty 50 Equal Weight Index vs Nifty 50: 5 years return and risk

Nifty 50 Equal Weight Index rolling return over 5 years

Nifty 50 Equal Weight Index rolling risk (standard deviation) over 5 years

Impression as an analyst: The N50EW does have marginal better return and lower risk benefits. However, when you get such benefits is a matter of potluck. If must choose an index, then an EW index is not a bad idea as long as you do not expect much. The EW50 has higher exposure from lower market cap stocks than the N50. This can cut both ways: more returns (lower risk) sometimes and less returns (more risk) sometimes.

Impression as an investor: The above impressions can also be crudely inferred from the normalized price movement.  During bull markets, N50EW outperforms the N50 because the relatively higher weight from the lower market cap stocks offers the push.

Nifty 50 equal weight vs Nifty 50

When the entire market tumbles down, then the N50EW quickly drops down close to N50. I am not convinced this is an attractive feature.  Also, notice that the EW50 volatility in the last few years seems to be higher.  Perhaps if there is a Nifty Next 50 (NN50) equal weight, I would consider it over the Nifty Next 50: The Benchmark Index That No Mutual Fund Would Touch!

Considering that many active mutual funds easily beat the N50 with good downside protection, I would prefer those than N50EW. DSPBR has a N50EW fund. Sundaram has a Nifty 100 EW fund. Let us close by looking at its performance against Nifty 100 (top 100 stocks in terms of market cap). Nifty 100 = N50 + NN50.

Nifty 100 Equal-weight (TRI) vs Nifty 100  (tri)

Nifty 100 equal weight price movement

Notice that again the N100EW quickly falls down to meet the N100 during times of trouble.

Ten year rolling return.

Nifty 100 10Y returns

Ten year roling risk

Again the risk is not markedly lower, but the extra return is decent.

Five year rolling return

Five year rolling risk

So what is the point of all this? Frustrating as it is, many readers (I pray not too many) do not care much for data and only worry conclusions (assuming that I will not make mistakes  – dangerous!). They scroll down to the bottom of the post and complain they cannot understand. Well, for such readers, here is the gist:

The benefit offered by equal weighting is not dramatic. There is not much point in choosing N50EW or N100EW as most funds comfortably beat these indices in terms of risk (first priority) and return. If there is a Nifty Next 50 Equal Weight index offered, then it can be considered over the base index. However, it should be kept in mind that these so-called smart beta indices are quite new and their backtesting history is longer! We need to give them enough time in the presence of real market forces to decide. So don’t do anything in a hurry.

If you are a DIY investor, read the above linked white paper and critique the above data.

 

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About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
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