We decode if equal-weighted index funds are better than regular ones?

The Story

Index funds are easy to understand and typically cost less than actively managed mutual funds.

The best part is you don’t need to worry about whether your investments generate enough returns compared to market returns. Good all in all, right? But there’s one problem.

When you invest in index funds, a major proportion of your investments goes to a few high-weighted companies in the index because all these indexes are free-float index funds. I know it sounds too technical, so let’s break it down.

Free Float Market Cap Index

The Nifty 50 includes 50 companies, and each company’s market capitalization determines its weighting in the index. Let’s understand this with an example.

Imagine Reliance Industries as a large pie worth ₹17.38 lakh crores (its market value). The Ambani family, the company’s promoters, own half of this pie—about ₹8.7 lakh crores. They are least likely to sell them, meaning this part of the pie isn’t typically available for public trading.

The other half, around ₹8.7 lakh crores, is what’s actually available for the public to buy and sell. This portion is called the free-float market cap, representing the shares actively traded on the stock market.

Similarly, Bajaj Finance’s free-float market cap is ₹1.87 lakh crores. Lower free-float market caps mean companies carry less weight in the index. So, while Reliance has 8.31% weight in the index, Bajaj Finance carries only 1.77% weight.

Here’s a kicker: the top five companies carry 39% weight in the Nifty 50. So if you’re investing in its index fund, about 39% of your money is being invested in those top five companies.

Similarly, the top five companies carry 31.67% weight in the Nifty 100 and 22.71% weight in the Nifty 500 index.

What’s the solution to this problem? The answer is equally weighted index funds.

Equal Weight Index Funds

As the name suggests, rather than weighting companies based on their market capitalization, this index provides equal weight to all the constituents of the index.

For example, in the Nifty 50 equal-weighted index, each company carries 2% weight. Similarly, each company has 1% weight in the Nifty 100.

So, equal-weight index funds offer good diversification compared to market cap led weighting.

Let’s see how they have performed.

The track record shows that equally weighted indices returns have delivered better returns with more or less similar volatility.

To Conclude

If you’re aiming for better diversification and balanced exposure across companies, equal-weighted index funds can be an attractive option.

They allow you to spread your investment more evenly, rather than concentrating a significant portion in a few heavyweights.