Is the NSE 20 Share Index top heavy? Sure, it is. When you have one counter accounting for 40 percent of the market capitalisation, it means the bullish/bearish significance of this counter affects the final print of the index.
It doesn’t help when most of the indexes (NSE 20 Share Index, All share Index) are market-cap weighted including the recently launched; NSE 10 Share Index.
Same problems face the FTSE Kenya Index series (FTSE NSE Kenya 15 Index, FTSE NSE Kenya 25 Index) as they also share similarities - they are free-float based.
So, whenever these divergences between the index and individual stocks rise to the surface, they are always a reminder of the limitations of the headline number and to take the data with a grain of salt.
If this is an issue, would an equal-weighted index be the answer? Let's further understand why price or cap-weighted indexes are less ideal.
Besides the above-stated handicap of occasional massive performance divergences, the industry push for more structured products such as exchange traded funds (ETFs) means allocators will be subject to too much market risk.
With these shortcomings, only an equal-weighted index would help avoid large positions in a handful of stocks while gaining a relative overweight to the smaller constituents of the index.
It further serves to protect against bubble bursting - if something goes wrong with a single company, it’s only a small part of the portfolio. Versus a market-cap-weighted approach, the result is less weight in large companies and more weight in smaller firms.
That said, equal-weighted indexes have one major flaw - they tend to tilt toward companies with lower prices to fundamentals, commonly known as value companies.
This bias assumes that value stocks will outperform growth stocks and allocates more to mid-sized companies, which typically come with more volatility and sometimes, bags of governance issues.
It makes no sense why a tiny company with negative earnings and a weak balance sheet should receive the same weight as the largest company in the market.
Therefore, treating all companies the same, ignoring prices and fundamentals, isn’t likely the best way to address concerns with the current market concentration “problem.”
As someone said, “ignoring prices is never a good idea when buying anything”. Same applies to investments. Bad news for a company will push down its price, but an equally-weighted portfolio will completely ignore this information.
Nonetheless, it’s best to have both in my view for only one reason; comparative analysis of past performances of an equal-weighted index to the cap-weighted NSE 20 Share index may indicate potential future trends.
In other words, the different index designs could potentially provide better insights to market trends. More importantly, for an industry that’s embracing more structured products, availing the two options only serves to deepen the market further.
If we believe that a healthy market is one in which large cap stocks do not overshadow the smaller ones, then an equal-weighted index should be introduced for the sake of balance.
Mwanyasi is MD, Canaan Capital
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