Mutual fund investments formed just 6 per cent of an Indian household’s savings in financial assets during FY23, according to RBI data. That’s astonishingly low, but why? Well, it’s majorly because we Indians are a bit too risk-averse and don’t want to mess around too much with our hard-earned money.

This is where index-based investing can help.

What’s that? Well, this type of investing follows an index. For example, NIFTY50 in the stock market, is a tracker of the top 50 companies on the National Stock Exchange. 

So, in index-based investing, mutual fund managers invest in the same stocks as present in the index in the same proportion.

Index funds are of 2 types:

Market Cap Weighted Index Mutual Fund: These funds invest as per the stock’s weight in the index. For example: If HDFC has an 11.21% weightage in NIFTY50 and you are investing Rs. 100, then your Rs. 11.21 will go into HDFC in a Market Cap Weighted Nifty 50 Index Fund.

Equal-Weight Index Mutual Fund: These funds invest equally in all the stocks in the index. For example: If you put Rs 100 in an Equal-Weight NIFTY50 Fund then Rs. 2 will go to each stock of the index.

Of the above two, Market Cap Weighted Index Funds are more popular. But, does that mean Equal Weighted Investing isn’t helpful? Well, that’s not true! Here’s the reason why:

No over-pessimism or over-optimism

Let’s consider this scenario, when there is over-optimism, you will generate great returns but when the market goes down, the fall will be even bigger. A market cap-weighted index reflects all of these inefficiencies. An equal weight index, on the other hand, won’t be affected to the same level due to its equal split.

Equal-weight investing offers good diversification

In equal-weighted index mutual funds, the investment is evenly distributed across all index participants, giving even relatively smaller firms a larger weight. For example, the Nifty Equal Weight Index distributes 2% to each of its participants, limiting the influence of larger firms on the index’s performance.

Therefore, during a time like COVID-19, when the paint and chemical industry wasn’t doing that well, a market cap-weighted index would be affected to a great extent. However, an equal weight index wouldn’t be affected that much due to its equal diversification.

Provides better rebalancing of portfolio

In equal-weight investing, rebalancing happens by selling the stocks that are doing really well and buying ones that aren’t performing as strongly. Thus, this approach can help you make money in the long run.

On the other hand, a market cap-weighted approach would simply let it rise. If that company’s performance and leadership deteriorate, it will decline causing losses.

However, equal-weight investing also has downsides like higher costs because you’re doing it more often and it might be harder to find buyers or sellers for the stocks you want.

Also Read: Are Index Funds good for long-term investment? Find out

Which is better? Equal-Weight or Market-Cap? 

The answer is not that simple. So, to understand which is better we will have to look at the 5-year rolling returns offered by both indexes.

Why rolling returns?

Rolling returns help in highlighting the frequency and magnitude of an investment’s good and bad periods of performance. Therefore, making it an apt indicator.

Here’s a comparison between NIFTY 50 TRI and NIFTY 50 Equal Weight TRI:

Note: NIFTY 50 TRI gives a more realistic picture of the return from the stock market as it includes all the constituents associated with it like price change, interest, and dividend.

As you can see both of them have done equally well. Thus, predicting which is better may not be accurate. Eventually, it depends on the style of investing you want to pursue based on your financial goals.

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Disclaimer: The above content is for informational purposes only. You should consult a SEBI-registered Investment Advisor before finalising your financial planning.