A magic formula for wealth creation: An equal-weighted index

The Nifty 50 Equal Weight Index has outperformed in 11 out of 17 calendar years. NSEBSEHDFC bankLoading data…





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    By Anil Ghelani

    As the captain of your cricket team -two of your best bowlers are getting badly hit today, your star spinner is not able to perform his magic due to a finger injury, and your best fielder in the slips has slipped a simple catch and given up a couple of boundaries. With a reasonably low target to defend, what you want now is hope for a miracle! Or what you really want is to get your other players in greater focus.

    You will use your calm mind and give a chance to that fresh bowler waiting to get his kill with a few wickets, motivate other fielders and activate the Jhonty Rhodes in them to jump on each ball passing by and suddenly, the match is looking very different and team sees a positive victory. Often not just the heavyweight stars, but all players performing equally can win matches.

    Moving from cricket to the world of investments, an index fund using equal weight strategy is something similar to this concept. Simply put, the fund following such a strategy allocates an equal weight to all the stocks in the portfolio instead of following a market cap weighted approach where the larger stock gets a higher allocation.

    One of the core principles of investing would suggest investments in strong companies that are leaders in their sectors, large in size and can ride through business cycles. One such good compilation of such companies would be companies in the Nifty 50 index. However, the weights of the companies in the Nifty 50 index are heavily tilted to those having higher market capitalisation, effectively betting more on larger companies.

    This results in undue concentration risk on a few stocks, say HDFC Bank at 9.5 per cent, which then also translates into higher concentration at a sectoral level, say financial services at 36 per cent.

    While retaining the core principle of investing in the large leaders of India’s strongest 50 companies, if we make a small change and simply weigh each stock equally, then we can achieve a good stock and sector level diversification as well. In this case, HDFC Bank will be equally weighted at 2 per cent and such a change will also bring down exposure to financial services sector to 20 per cent.

    The concept of an equal weight index was introduced in 2003 in the US with the S&P 500 Equal Weight Index. Following this there have been many new developments globally.

    Historically, the S&P 500 and other equal weight indices have outperformed their market capitalisation weighted equivalent indices over longer time periods with some interim periods of both, outperformance as well as underperformance.

    In India, we have observed that the Nifty 50 Equal Weight Index has a similar outperformance over longer periods of time against the Nifty 50 Index.

    During the historical data available period from 1999 onwards, the Nifty 50 Equal Weight Index has outperformed in 11 out of 17 calendar years.

    The level of outunder performance has also varied considerably under different market conditions, where often the equal weight index tend to outperform during starting of a market rally or just at the turn leading to a correction.

    The attractiveness for an individual or HNI investor would be gain access to a portfolio which meets the two basic principles of investing in leaders and diversification across companies and sectors, a smart strategy which has potential to outperform marketcap indices as seen in the past.

    On the other hand, for a sophisticated institutional investor like a corporate treasury or an exempt PF Trust, the added reason to invest other than potential to outperform would be that equal weighting creates a different set of risk exposures and return potential when compared to market cap weighting and hence it offers a good diversification.

    Often the most powerful investment ideas are simple.There is no complex formula or theory applied here. A very simple logic -let all players work equally hard to make you win -let all companies play equal role in the longterm wealth creation for you.

    (The author is Anil Ghelani, Senior Vice President, DSP BlackRock Mutual Fund. Views expressed in the article are personal.)

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