Typically, a 500-stock index is expected to offer broad diversification to investors, but the Nifty 500 index has a bias towards large-cap stocks. However, a recently launched rule-based fund (the Nippon India Nifty 500 Equal Weight Index Fund) aims to provide broader diversification across large-cap, mid-cap and small-cap stocks.
How it works
Instead of market-cap weightings, the fund will maintain equal weighting across the 500 stocks in the index. Each stock will therefore have a weighting of 0.2%. This would result in an index composition with 20% exposure to large-cap companies, 30% to mid-cap companies and 50% to small-cap companies.
This is quite different from the regular Nifty 500 index, where 72% of the index is exposed to large-cap stocks (top 100 stocks by market capitalization).
The equal-weighted index reduces the concentration in the financial services sector to 18%, compared to 27% in the traditional Nifty 500 index, allowing for greater exposure to other sectors. The large exposure to financials in the regular index is due to the dominance of this sector in terms of market capitalisation in Indian equity markets.
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“For an investor looking for a passive approach to investing in equity markets, with a well-diversified portfolio across market capitalisations, this can be an alternative,” said Arun Sundaresan, head of exchange-traded funds at Nippon Life India Mutual Fund.
Risk vs. profitability
The equal-weighted Nifty 500 index has generated an annualised return of 30% over the past five years, compared to 22% for the regular Nifty 500 index. Over a three-year period, the equal-weighted index has generated an annualised return of 25.9% compared to 21% for the Nifty 500 index.
Last year, the equal-weighted index returned 56%, compared with 39% for the Nifty 500 index.
However, this recent notable outperformance can be attributed to mid- and small-cap stocks outperforming during these periods.
But over longer periods (seven and ten years) returns have been in line with the regular 500 index.
“Although this is a index fund, “Investors need to understand that it is slightly riskier than a regular index fund as it has an equal weighting in a broad-based index like the Nifty 500,” said Deepak Chhabria, CEO, Axiom Financial Services. “As equal weighting leads to reduced exposure to large-cap companies, it increases exposure to mid-caps and small-caps. If you had an equal weighting in the Nifty 100 or the Nifty 200, the exposure would still be restricted to large-caps and mid-caps.”
What doesn’t work
While the equal-weighted index has outperformed the regular index in recent periods, the index may experience greater volatility than the regular index.
Over a one-year period, its standard deviation is 16.86, while that of the regular Nifty 500 index is 13.7. Over a five-year period, the equal weight has a standard deviation of 19.09, while that of the regular Nifty index is 18.67.
“Given its large exposure to mid- and small-cap stocks, the fund’s performance could be more cyclical and volatile in nature,” said Rushabh Desai, founder of Rupee at Rushabh Investment Services.
“As the index has only 0.2% share in individual stocks, there may be limitations to the extent to which it can capture the upside in individual stock performance. On the other hand, this would also mean that the impact of individual stocks falling is limited, due to the lower weights,” Chhabria said. To be sure, the weights would only be rebalanced on a quarterly basis.
“The fund could lose out when sector-specific rallies occur, as it will maintain an equal weight regardless of the sector,” he added.
Should you invest?
Investors looking for broad and diversified exposure to equity markets without a bias towards large caps can consider the Nifty 500 Equal Weighted Index Fund. However, as a smart beta fund, it falls somewhere between active and passive investing, and adheres to a set of rules (in this case, equal weighting). Therefore, one needs to keep an eye on how it performs against a Nifty 500 index fund, which is a purely passive investment strategy.
Read also: Is there room for both active and passive index funds in your mutual fund portfolio?
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