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How to diversity and reduce concentration risk in passive investments

Investors today have a variety of offerings on the passive side based on S&P BSE Sensex and Nifty 50. Besides the Nifty 50 index, the NSE has also constructed many variations of the broader market index. (Photo: Bloomberg)Premium
Investors today have a variety of offerings on the passive side based on S&P BSE Sensex and Nifty 50. Besides the Nifty 50 index, the NSE has also constructed many variations of the broader market index. (Photo: Bloomberg)

Nifty 50 delivers better returns during consolidation phases, the Equal Weight Index performs well in a bull market. Since both indices behave differently under different market scenarios, investors can reduce the overall portfolio volatility by staying invested across these indices

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Over the last six months, the asset under management of passive offerings has increased by 22%, reflecting an increased acceptance of passive investments among the masses. This is mainly because of the inability of actively managed funds, especially large-cap category funds, to beat their respective benchmark indices. On the other hand, investors today have a variety of offerings on the passive side based on S&P BSE Sensex and Nifty 50. Besides the Nifty 50 index, the NSE has also constructed many variations of the broader market index. The Nifty 50 Equal Weight Index is one such variant.

Nifty 50 Equal Weight Index

The benchmark Nifty 50 Index comprises of top 50 companies listed on the National Stock Exchange. The weight assigned to each company is determined on the basis of its free float capitalisation. So, a company with higher free float capitalisation is given higher weight in the index. The only difference in the case of Nifty 50 Equal Weight Index is that each of the 50 companies is assigned equal weight. As a result, all stocks are treated equally, and even relatively small companies in the Nifty 50 universe are held in the same proportion as any large company, thus avoiding any size or valuation bias.

This Index is rebalanced quarterly to correct any imbalance caused due to the relative price rise/fall of the constituent companies. It is reconstituted every six months in line with the reconstitution of its parent Nifty 50 Index.

How to invest in Nifty 50 Equal Weight Index

The easiest way to take exposure to this index is through an index fund which replicates this index. Presently, there are four fund houses (ICICI Prudential, HDFC, Aditya Birla and DSP) which have an offering based on this index. The NFO of ICICI Prudential is currently underway and is open till September 28, 2022.

Pros and Cons of an Equal Weight Index 

As the weightage assigned differs under Nifty 50 Index and Nifty 50 Equal Weight Index, investors can diversify their investments in the broader market. In the Nifty 50 Equal Weight Index case, there is no company-specific concentration risk as the weights assigned are equal among all the names. For example, under Nifty 50 index, HDFC and Reliance account for 20% weight, while in case of Nifty 50 Equal Weight Index, the weight is reduced to 4%. Furthermore, sector concentration risk too is reduced in an equal weight index. For example, financial services account for 37% of the Nifty 50 index, whereas the weight is reduced to 23.3% in the case of an equal weight index. This reduced concentration risk helps lower volatility while offering a diversified passive portfolio.

Index Performance

Over longer time horizons (10, 15 and 20 years), data shows that the equal weight variant has outperformed Nifty 50. The dividend yield, too, is better with Nifty 50 Equal Weight Index at 2.1% compared to the Nifty 50 at 1.4%. In terms of price-to-earnings and price-to-book, the equal weight index is better placed than Nifty 50, thus offering a higher opportunity to outperform its parent index in the long run.

Historically, while Nifty 50 delivers better returns during consolidation phases, the Equal Weight Index performs well in a bull market. Since both indices behave differently under different market scenarios, investors can reduce the overall portfolio volatility by staying invested across these indices. For those looking to invest in one of the indexes, I believe an investor with a long-term view can consider investing in an equal-weight index.

Tax Treatment Since the fund invests in listed shares of Indian companies, it is treated as equity oriented scheme for tax purposes. Any profits made within 12 months are treated as short-term capital gains and taxed @ flat rate of 15%. Any profits made after 12 months are long-term capital gains and taxed at a flat rate of 10% after initial capital gains of Rs. 1 lakh from all equity products, which is taxed at a zero rate.

Balwant Jain is a tax and investment expert and can be reached on jainbalwant@gmail.com and @jainbalwant on twitter.

 

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