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When it comes to equity investing, the benchmark often used is the Nifty 50 index. If you are an investor looking to invest into the Indian equity space, it is often said that the Nifty 50 index fund is a good starting point. With the growth of the passive landscape and the various innovative product offerings, there are multiple ways in which an investor can take exposure to the same universe of the Nifty 50 stocks.

Option 1: Free Float Based Approach
The Nifty 50 index is a free float based index, also known as a market capitalization-weighted index. It is constructed based on the market capitalization of each stock. Market capitalization is calculated by multiplying the stock’s price by the number of shares outstanding, and it represents the total value of a company in the stock market.

In a free float index, the weight of each stock is determined by its market capitalization relative to the total market capitalization of all the stocks included in the index. Essentially, larger companies with higher market capitalizations have a greater impact on the index performance. For instance, the top 5 names in the Nifty 50 index form 38.83% of the index. Widen the coverage to the top-10 stocks and you have 57.81% of the index.

Advantages
– Reflects the market value of each stock accurately
– Highly liquid stocks have a greater impact on the index, which can be beneficial for investors interested in large-cap companies.
– Better representation of the overall market sentiment.

Disadvantages
– Overweight large-cap stocks, can potentially lead to a concentration of influence from a few companies
– Smaller companies with lower market capitalizations have less impact on the index performance

Option 2: Equal Weight Approach
In this approach, as the name suggests, an equal weight is assigned to all the stocks in an index, regardless of its free-float market capitalisation. In this methodology, every stock included in the index has the same impact on the index performance. For example: In the Nifty 50 Equal Weight Index, each of the 50 names is assigned a 2% weightage. This index is re-balanced on a quarterly basis and is if required reconstituted on a semi-annual basis. This means even if any stock rallies heavily during the period, its weightage would be restricted to the original equal-weight index levels.

Advantages
– No single stock can inordinately influence the index movement as all stocks get similar representation
– Smaller companies have the same impact on the index performance as larger companies, allowing for broader exposure across the market.
– The index has empirically higher dividend yield as it allocates funds equally to its components
– The index is less concentrated and helps in providing stability to the portfolio
– The index tends to provide better downside protection.

Disadvantages
– Less reflective of the actual market capitalization and market sentiment
– During narrow market rallies, this type of index tends to lag

Index Performance
Over the past five years, the Indian equity markets have withstood some extreme volatile times. Starting calendar year 2019, when a few index heavyweights were leading the market rally, there was sharp polarisation seen in the market. For the year, the Nifty 50 TRI delivered a return of 13.5% while the Nifty50 Equal Weight TRI return was at 4.3%. This clearly shows that in a polarised market, the equal weight strategy will be under pressure.

However, in the year 2020, after the sharp correction at the onset of the pandemic, the indices recovered on the back of a broad market rally, a trend which continued well into calendar year 2021 and 2022. Given the broad based market uptrend, the equal-weight strategy outperformed the Nifty 50 TRI in calendar years 2020, 2021 and 2022 by 3.2%, 9.4% and 2.4%, respectively. On a year-to-date basis (as on May 31, 2023), the Nifty 50 TRI index has delivered 2.78% while the Nifty 50 Equal Weight TRI index has delivered 4.57%.

To conclude, from a portfolio perspective, given the variation in performance under variable market conditions, it is prudent to diversify across indices with different weightage methodology. While the exposure in both the strategies is to the Nifty 50 stocks, the investment outcomes can be diametrically different.  Each index weightage strategy has its unique pros and cons which should be taken into consideration when making a choice.

The author is Head Investment Strategy, ICICI Prudential AMC. Views are personal.

(Disclaimer: Stocks recommendations by experts or brokerages are their own and not those of the website or its management. Money9.com advises readers to check with certified experts before taking any investment decisions.)