What are the differences between an equal-weighted NIFTY ETF and a regular weighted NIFTY ETF? Which one is considered better?

 

Understanding the Differences Between Equal-Weighted and Regular-Weighted NIFTY ETFs

 

      Introduction to NIFTY ETFs Investors today have a wide array of options to choose from when it comes to investing in the stock market, and one such popular choice is Exchange-Traded Funds (ETFs). Specifically, NIFTY ETFs have gained significant traction among Indian investors. A NIFTY ETF tracks the NIFTY 50 index, which is a compilation of the 50 largest and most liquid companies listed on the National Stock Exchange (NSE) of India. By investing in a NIFTY ETF, investors gain exposure to the performance of these 50 companies, allowing for a diversified investment with relatively low cost.

 

There are two primary types of NIFTY ETFs:  regular-weighted (market-capitalization-weighted) and equal-weighted. While both track the same NIFTY 50 index, the way in which the stocks are weighted within the ETF significantly influences the risk, return, and overall performance of the investment. Understanding the nuances between these two types of ETFs can help investors make more informed decisions tailored to their investment goals.

 

1. Weighting methodology

 

    Regular-Weighted NIFTY ETF A regular-weighted NIFTY ETF follows a market-capitalization-weighted methodology. This means that each company within the NIFTY 50 index is weighted according to its market capitalization. Market capitalization is calculated by multiplying the company’s share price by the total number of outstanding shares. In a regular-weighted ETF, companies with larger market capitalizations have a higher weightage within the ETF. For instance, if Reliance Industries has a market capitalization that constitutes 10% of the total market cap of all the companies in the NIFTY 50, then 10% of the fund's assets will be allocated to Reliance Industries.

 

      This approach reflects the overall market's sentiment and ensures that the ETF’s performance is closely aligned with the broader market’s performance. Consequently, large-cap companies like Reliance Industries, HDFC Bank, and Infosys have a more significant influence on the ETF's performance.

 

     Equal-Weighted NIFTY ETF An equal-weighted NIFTY ETF, as the name suggests, assigns an equal weight to each of the 50 companies in the NIFTY 50 index, regardless of their market capitalization. This means that each company receives the same percentage of the fund's assets, typically 2% (assuming a total of 50 companies). Therefore, smaller companies receive the same importance in the index as the larger ones.

 

    This methodology provides a more balanced exposure across all companies, ensuring that no single company or a few large companies dominate the ETF's performance.

 

2. Performance characteristics

 

     Regular-Weighted NIFTY ETF A regular-weighted NIFTY ETF is heavily influenced by the performance of large-cap stocks. If a few large-cap stocks perform exceptionally well, the ETF’s value can rise significantly. Conversely, if these large companies underperform, they can drag down the overall performance of the ETF.

 

    Large-cap companies, due to their established market presence, typically offer more stability and lower volatility. These companies are often well-known, with proven business models, stable earnings, and robust financial health. As a result, a regular-weighted NIFTY ETF tends to exhibit less volatility and provides a more stable investment option.

 

     However, this stability comes with a trade-off. Since the ETF is heavily weighted towards large-cap stocks, it may not capture the full potential upside during periods when mid-cap and small-cap stocks outperform. In such scenarios, the regular-weighted ETF may deliver lower returns compared to an equal-weighted ETF.

 

    Equal-Weighted NIFTY ETF An equal-weighted NIFTY ETF, by giving the same importance to each company, tends to have higher exposure to mid-cap and small-cap stocks. This can lead to higher volatility since smaller companies are more susceptible to price fluctuations. However, the potential for higher returns is also present, especially during bull markets when smaller companies tend to outperform.

 

     Over time, equal-weighted ETFs may outperform regular-weighted ones if the smaller and mid-cap companies in the index experience significant growth. However, this also means that the ETF might underperform during periods of market downturns or when large-cap stocks dominate the market.

 

3. Risk and volatility

 

     Regular-Weighted NIFTY ETF The reliance on large-cap stocks in a regular-weighted NIFTY ETF generally translates into lower volatility and reduced risk. Large-cap companies, by virtue of their size and market influence, are typically less prone to extreme price swings. They are often seen as safer investments during times of market uncertainty, providing a cushion against severe downturns.

 

     For conservative investors who prioritize capital preservation and steady returns, a regular-weighted ETF might be more appealing. The relative safety and predictability of returns from large-cap stocks make this type of ETF a suitable choice for those who are risk-averse.

 

     Equal-Weighted NIFTY ETF An equal-weighted NIFTY ETF, with its higher exposure to mid-cap and small-cap stocks, inherently carries more risk and volatility. Smaller companies, while having the potential for higher growth, also face greater challenges and are more susceptible to economic downturns. This results in higher price volatility, making the equal-weighted ETF a more aggressive investment option.

 

    However, for investors with a higher risk tolerance and a longer investment horizon, the potential for higher returns in an equal-weighted ETF can be enticing. This ETF might outperform during periods of economic expansion when smaller companies grow rapidly, but it also carries the risk of sharper declines during market downturns.

 

4. Sectoral and company concentration

 

    Regular-Weighted NIFTY ETF Sectoral concentration is more pronounced in a regular-weighted ETF. For instance, if the banking sector has a significant number of large-cap companies, the ETF may have a higher allocation to this sector, leading to less diversification. Similarly, the performance of a few top companies can dominate the ETF's returns.

 

    This sectoral bias means that the performance of a regular-weighted NIFTY ETF can be disproportionately affected by the fortunes of a few sectors or companies. If the dominant sectors or companies in the ETF face challenges, the entire ETF may suffer, even if other sectors are performing well.

 

   Equal-Weighted NIFTY ETF An equal-weighted ETF offers broader diversification across sectors and companies, reducing the risk of any single company or sector disproportionately affecting the ETF's performance. This approach minimizes the impact of sectoral concentration and ensures a more balanced exposure to the entire market.

 

    However, this also means that an equal-weighted ETF is more exposed to underperforming sectors or companies. Since each company has an equal weight, even the poor performance of smaller companies can have a noticeable impact on the ETF’s overall returns.

 

5. Rebalancing and costs

 

    Regular-Weighted NIFTY ETF A regular-weighted NIFTY ETF typically requires less frequent rebalancing because the weights automatically adjust as the market capitalization of the companies changes. This passive approach to rebalancing keeps transaction costs low and often results in lower expense ratios, making it a cost-effective option for investors.

 

     Since the ETF tracks the natural movements of the market, there is less need for manual adjustments, which reduces management costs and makes the ETF more efficient.

 

    Equal-Weighted NIFTY ETF An equal-weighted ETF requires periodic rebalancing to maintain equal weights for all companies in the index. This rebalancing incurs higher transaction costs, which can lead to higher expense ratios. Investors should consider these additional costs when evaluating the overall performance of an equal-weighted ETF.

 

     The rebalancing process is necessary to ensure that the ETF maintains its equal-weighting methodology, but it comes at the cost of increased management fees and potential tax implications due to more frequent trading.

 

6. Historical performance and preference

 

     Historical Performance Historically, there have been periods when equal-weighted NIFTY ETFs have outperformed regular-weighted ones, particularly during times when mid-cap and small-cap stocks have performed well. For instance, in bull markets where smaller companies see significant growth, equal-weighted ETFs can deliver superior returns. However, in market downturns or during periods of large-cap dominance, regular-weighted ETFs tend to perform better due to their focus on more established companies.

 

     Over the long term, the performance of these ETFs can vary significantly based on market conditions, making it important for investors to align their choice with their market outlook and investment strategy.

 

      Which One is Better? The choice between an equal-weighted and regular-weighted NIFTY ETF ultimately depends on an investor’s financial goals, risk tolerance, and market outlook.

 

     For conservative investors who prioritize stability and lower risk, a regular-weighted NIFTY ETF may be a better option. The focus on large-cap companies provides a safety net, making it suitable for those looking for steady, reliable returns.

 

    On the other hand, for investors with a higher risk appetite and a desire for potentially higher returns, especially over the long term, an equal-weighted NIFTY ETF could be more appealing. The equal exposure to smaller companies offers the potential for higher returns, albeit with greater risk.

 

Conclusion

 

    Both equal-weighted and regular-weighted NIFTY ETFs offer unique advantages and disadvantages. A regular-weighted ETF provides stability and lower volatility by focusing on large-cap companies, making it an ideal choice for risk-averse investors. In contrast, an equal-weighted ETF offers broader diversification and the potential for higher returns, especially during periods of economic expansion, making it suitable for investors willing to tolerate more volatility for the chance of enhanced performance.

 

    The decision between these two types of ETFs should be guided by individual investment objectives, risk tolerance, and the current market environment. Some investors may even choose to diversify their portfolio by including both types of ETFs, balancing the benefits of stability and growth potential. Ultimately, a well-informed choice based on personal financial goals