When it comes to investing in index funds, one important decision you’ll need to make is whether to choose an equal-weighted index fund or a market cap-weighted index fund. Both types of index funds have their own advantages and disadvantages, and the right choice for you will depend on your investment goals and risk tolerance.
Equal-weighted index funds, as the name suggests, give each component of the index an equal weighting. For example, in an equal-weighted index fund tracking the NIFTY 50 index, each of the 50 stocks in the index would have a weight of 2%. In contrast, market cap-weighted index funds give each component of the index a weight based on its market capitalization, or the total value of the company’s outstanding shares of stock. This means that larger, more valuable companies will have a higher weighting in the index.
So which is better, an equal-weighted index fund or a market cap-weighted index fund? To answer this question, let’s compare the performance of the two types of index funds over different time periods using the NIFTY 50 index as an example.
Over a three-year period, the NIFTY 50 Equal Weight Index has outperformed the NIFTY 50 Index (a market cap-weighted index) by a significant margin. From January 2019 to December 2021, the NIFTY 50 Equal Weight Index returned 23.9%, while the NIFTY 50 Index returned 15.7%.
Over a five-year period, the performance of the two index funds is more mixed. From January 2018 to December 2022, the NIFTY 50 Equal Weight Index returned 17.8%, while the NIFTY 50 Index returned 18.2%.
Over a seven-year period, the NIFTY 50 Index has outperformed the NIFTY 50 Equal Weight Index. From January 2016 to December 2022, the NIFTY 50 Index returned 13.7%, while the NIFTY 50 Equal Weight Index returned 12.3%.
Over a ten-year period, the NIFTY 50 Index has again outperformed the NIFTY 50 Equal Weight Index. From January 2013 to December 2022, the NIFTY 50 Index returned 9.6%, while the NIFTY 50 Equal Weight Index returned 8.4%.
Short-term performance: Over a three-year period, the NIFTY 50 Equal Weight Index has outperformed the NIFTY 50 Index (a market cap-weighted index) by a significant margin. From January 2019 to December 2021, the NIFTY 50 Equal Weight Index returned 23.9%, while the NIFTY 50 Index returned 15.7%.
Long-term performance: Over a ten-year period, the NIFTY 50 Index has outperformed the NIFTY 50 Equal Weight Index. From January 2013 to December 2022, the NIFTY 50 Index returned 9.6%, while the NIFTY 50 Equal Weight Index returned 8.4%.
Based on these performance figures, it appears that equal-weighted index funds may offer stronger short-term performance, while market cap-weighted index funds may offer stronger long-term performance. However, it’s important to note that past performance is no guarantee of future results, and it’s possible that the performance of the two types of index funds may vary over different time periods.
One potential reason for the differing performance of the two types of index funds is that equal-weighted index funds are more diversified than market cap-weighted index funds. By giving each component of the index an equal weighting, equal-weighted index funds spread the risk more evenly across the index, which can help mitigate the impact of any single stock’s performance. On the other hand, market cap-weighted index funds are more heavily weighted toward larger, more valuable companies, which can increase the index’s overall risk.
Another potential reason for the differing performance of the two types of index funds is that equal-weighted index funds tend to be more actively managed than market cap-weighted index funds. While market cap-weighted index funds simply track the composition and weightings of the index, equal-weighted index funds require regular rebalancing to ensure that each component of the index continues to have an equal weighting. This active management can add a layer of costs to equal-weighted index funds, which can eat into their overall returns.
Volatility: Over the long term, both equal-weighted index funds and market cap-weighted index funds have had similar levels of volatility. However, in the short term, equal-weighted index funds tend to be more volatile than market cap-weighted index funds. This is because equal-weighted index funds are more diversified than market cap-weighted index funds, and diversification can help reduce the impact of any single stock’s performance on the overall index.
So which type of index fund is right for you? As with any investment decision, it’s important to consider your own financial goals and risk tolerance. If you’re looking for a more diversified index fund with the potential for higher short-term returns, an equal-weighted index fund may be a good choice. However, if you’re more comfortable with a lower-risk, passively managed index fund with a focus on long-term growth, a market cap-weighted index fund may be a better fit.
Ultimately, the best choice for you will depend on your individual financial situation and investment goals. It’s a good idea to consult with a financial advisor or do your own research to determine which type of index fund is right for you.