Over the past few weeks, we have tested investment ideas and compared the performance against the bellwether indices such a Nifty 50.
In some of my previous posts, I have
- Compared the performance of Nifty Next 50 against Nifty 50.
- Considered the data for the past 20 years to see if the Price-Earnings (PE) multiple tells us anything about the prospective returns. It does or at least has in the past.
- Tested a momentum strategy to shift between Nifty 50 and a liquid fund and compared the performance against a simple 50:50 annual rebalanced portfolio of Nifty index fund and liquid fund.
- Compared the performance of 2 popular balanced funds against a simple combination of an index fund and a liquid fund.
In this post, let us test the performance of another interesting investment idea, Nifty 50 Equal Weight Index vs Nifty 50 Index
Before compare the past performance, let us first look at the difference between market cap-weighted indices and equal weighted indices.
Nifty 50 is a market-capitalization weighted index.
Nifty 50 Equal Weight is an equal weighted index.
Market-Cap Weighted Index vs Equal Weighted Index
In a market cap weighted index, the larger companies (by market capitalization) will get a greater weightage. For instance, as on May 31, 2020, Reliance Industries had weightage of 11.88% while the HDFC and HDFC Bank had combined weightage of 17.24% in Nifty 50. The top 5 stocks had over 40% weightage and the top 10 stocks had over 60% weightage in the Nifty 50 index.
If a stock does better than the index, its weightage increases in the index.
In an equal weighted index, all the companies will have equal weightage. Of course, the weightage can change between the two rebalancing dates. However, on the rebalancing date, the weights will again be set to equal. For instance, on the date of rebalancing, the weights of all the stocks in Nifty 50 Equal Weight index will be set to 2%.
In the weightage table, the weights are different from 2% because we are between rebalancing dates. On the next rebalancing date (or the reconstitution date), the weights will again be reset to equal weights (2% per stock).
Note: Nifty 50 gets reconstituted every 6 months in March and September. You can check the rebalancing schedule here. Nifty 50 Equal Weight (Nifty 50 EW) also gets reconstituted every 6 months in March and September. In addition, it gets rebalanced every quarter. During rebalancing, the constituents do not change but weights are adjusted back to target levels (equal weightage). During reconstitution, even the stocks can change along with the weights.
At the first glance, the equity-weight index looks better diversified. Financial services companies have the highest weightage in both the indices. However, Nifty 50 has 33.33% allocation to financial services while the Nifty 50 Equal Weight (Nifty 50 EW) has only 12.73% allocation to financial services. Thus, there is reason to believe that the market-weighted indices are not sufficiently diversified.
Fair enough. Does the better diversification Nifty 50 Equal Weighted portfolio translate to better returns or lower volatility as compared to Nifty 50?
Let us see what the data tell us.
Nifty 50 Vs Nifty 50 Equal Weight
We compare the performance for the last 20 years.
Nifty 50 Equal Weight TRI: Rs 100 grows to Rs 1,513.92. CAGR of 13.84% p.a.
Nifty 50 TRI: Rs 100 grows to Rs 1,108.77. CAGR of 12.16% p.a.
Now, to the rolling returns.
What about volatility?
Not much difference between Nifty 50 and Nifty 50 Equal Weight index. Had some issues with the plot on DataWrapper. Hence, not showing the chart.
Nifty 50 Equal Weight does not reduce volatility in a meaningful way. It is also evident from Point-to-Point and rolling returns charts.
Not much surprise here because both are Indian equity indices. Moreover, the two indices hold the same stocks. The difference is only in the weights.
What should you do?
Deep down, we always track the bellwether indices such as Nifty and Sensex. If you use any alternative investment strategy (equal-weighted or any other active strategy) and if it underperforms the Nifty or Sensex for an extended time, you might start feeling uncomfortable. And you might shun the strategy at the worst possible time.
While we can see in the first chart that Nifty 50 EW has given better returns in the last 20 years, we must also see when those excess returns have come. Here is the calendar year return chart.
In the first decade (2001-2010), Nifty 50 grew 472% in absolute terms. Nifty Equal Weight 50 grew 815%.
In this decade (2011-till date), Nifty 50 has grown 81% while Nifty 50 Equal Weight Index has grown only 47%. You can attribute this to the recent outperformance of the largest stocks, but that does not change the fact.
Nifty 50 Equal Weight won the race in the first decade.
Nifty 50 is so far ahead in this decade.
This is also evident from the 3-year and the 5-year rolling returns chart.
When it comes to investments, no strategy works all the time. Thus, you need to believe in your strategy. By the way, even the most stupid of strategies will work some time. Hence, you need to exercise discretion.
In my opinion, investing in equal Weight indices (at least for the large cap index like Nifty) is a fine approach. At present, you might also see this as value play. However, be prepared for long stretches of underperformance compared to Nifty 50.
At the same time, if you believe in momentum investing, a market-cap based index is a better play. I am more comfortable investing in market capitalization-based indices.
Nifty 50 Equal Weight index gets rebalanced every quarter and reconstituted every 6 months (when Nifty 50 constituents changed). I just wonder what the results would have been if the rebalancing had happened every six months (and not every quarter).
The Usual Caveats
I have used the Total Returns Index fund. However, you cannot take exposure to the index directly (Well, you can, but it is messy and tax-inefficient). You must invest through index funds. And index funds will have costs and the tracking error. Hence, your returns will be lower than what I have shown in the charts.
We have many Nifty 50 index funds and ETFs. The expense ratio is between 5 bps and 20 bps. There is just one Nifty 50 Equal Weight index fund from DSP Mutual Fund. The expense ratio for the direct plan is ~40 bps.
It is also possible that the Equal weight index fund may also have a higher tracking error than the market-cap weighted index fund. This can happen since the bigger stocks may have better liquidity and lower impact cost. We noted above that 20-year CAGR is 12.16% p.a. for Nifty 50 and 13.84% p.a. for Nifty 50 Equal Weight index. This difference in cost and tracking error can bring them closer.