Equal Weight Investing Might Show Results During Good Times But Do Not Ignore Risks

The normal mode of investing in passive funds is to select one that tracks a particular index and the weights of the holdings in the portfolio will match the weights of the stocks in the index. This will lead to a mirror image of the performance of the index being tracked. The overall returns of the index depend to a large extent on the performance of the index heavy components. This might not reflect the true picture and hence one of the alternatives suggested in such a situation is to look at equal weighted investing. There are risks in this field too and one has to be aware of these before an investing decision is taken.

Equal weight investing, as the name suggests, ensures that there is equal weightage given to all the holdings that are present in the portfolio. For example, if there are 50 stocks in an index, then under the normal index investing the weights will be dependent on the weight of the stock in the index and this will vary. However, in equal weight investing all the 50 stocks will have the same weightage of 2% each and hence, a movement in any of the companies will have a similar impact in terms of the movement of the index. Equal weight investing tries to ensure that the changes in a lot of the holdings are not ignored and that the investor is able to gain from the situation.

Equal weight investing is easy to understand because the investor on their own is likely to have started off by investing an equal amount in several of their holdings. One of the best ways to follow this investing style is to select a mutual fund that manages its funds in this particular manner. There are a lot of passive funds that follow the equal weight investing style and hence, the investor can access this at a low cost, without much of a problem. Such equal weight funds are normally based on a leading index like the Nifty 50.

The normal approach of investors is that they think of the upside when they make an investment decision in terms of the potential gains. A similar thing happens with equal weight investing too, as the investor thinks about the fact that in a bull run a larger number of companies are rising. This broad based rally might not be translated into gains on an index because many of these companies have a lower weightage and hence the impact is lesser. In such a situation, the equal weight index will outperform the normal index.

But the reverse can also turn out to be the case, as if there is a fall in the market and there is widespread selling. Here, the investor will find that the equal weight index is falling more because a large number of companies within it that are getting impacted. This is one factor that should not be ignored because the investor is likely to end up with bigger losses than the overall market and it could wipe out a large part of the earlier gains.

The other factor that will impact the result is the time period when the rebalancing takes place. This is important because once the equal weights have been set up, there will be changes depending on the movement of the prices of the companies. In such a situation, there has to be a rebalancing after a certain point of time to ensure that the weights remain equal over the longer run. If this is done quarterly, then it is a reasonable time when the reset would be done but longer time periods can dilute the impact of the whole concept. This becomes another aspect of the risk control that will ensure that the concept works as it is intended to.

Arnav Pandya is founder Moneyeduschool