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Concentrated Exposure to Industry Leaders

This Dow Jones Industrial Average tracker has an odd weighting scheme that limits its appeal.

Alex Bryan, 08/05/2016

SPDR Dow Jones Industrial Average ETF DIA invests in 30 industry-leading companies that approximate the industry composition of the U.S. stock market. However, it leaves out a broad swath of the U.S. large-cap market and weights its holdings by their share price, which is arbitrary and leads to considerable concentration.

Since its inception in 1896, the Dow Jones Industrial Average has served as a barometer of the U.S. stock market by tracking a select group of the country's industrial leaders. Unlike most indexes, the Dow weights its constituents by their share price, rather than by market capitalization. So, even though Exxon Mobil XOM has a larger market cap than Goldman Sachs GS, it receives a lower weighting in the portfolio because Goldman Sachs has a higher share price.

Price weighting is a relic from the 19th century that was adopted because other weighting options, such as market-cap weighting, were impractical before computers were introduced. This simple price-averaging approach, which gives higher-priced stocks larger portfolio weightings, does not have a sound economic basis. Price weighting also may limit the index committee's selection options. For example, thanks to Alphabet's GOOG high stock price, it would account for more than 20% of the index if it were included, which could distort the Dow's representation of the U.S. market.

There are no firm guidelines dictating how or when the committee overseeing the index will pick new constituents. The committee's selections have placed the fund in the large-value Morningstar Category. Yet, the fund has been highly correlated with the broader, market-cap-weighted S&P 500. Over the trailing 10 years through June 2016, it outpaced the large-blend category average by 1.54 percentage points annually, partially due to its underweighting of the financial-services industry and cost advantage.

All the fund's holdings currently carry wide or narrow Morningstar Economic Moat Ratings, indicating that they enjoy durable competitive advantages that may help protect their profitability in bad times. In fact, about 59% of the fund's assets are invested in companies with wide economic moats. The corresponding figure for the S&P 500 is around 48%. As a result, the fund exhibited slightly less volatility than the S&P 500 during the past 10 years, despite its more concentrated portfolio.

Fundamental View 
The average market cap of the fund's holdings is nearly twice that of the S&P 500, as a result of its concentrated portfolio of industry leaders. These giants tend to be more profitable than the average company in the S&P 500. Over the trailing 12 months through June 2016, the fund's holdings generated a higher return on invested capital (16.9%) than the constituents in the S&P 500 (12.2%).

Historically, highly profitable firms have outperformed less profitable companies with similar valuations. The market may not fully appreciate the long-term sustainability and predictability of highly profitable firms' earnings because many investors have relatively short investment horizons. Long-term investors may benefit from this myopic focus when these stocks are trading at reasonable valuations. This portfolio exhibits a value tilt, which is not surprising because many of the industry leaders it targets have relatively mature businesses. But it tends to look very different from its peers in the large-value category because it does not explicitly target stocks with low valuations. And it focuses more narrowly on mega-cap stocks than most of its peers.

The fund's focus on industry leaders gives it a modestly defensive posture that can help it weather market downturns a little better than the broad market. For instance, during the bear market from October 2007 through March 2009, the Dow Jones Industrial Average cumulatively lost 51.5%, while the S&P 500 dropped 55.0%.

Alex Bryan is an ETF analyst with Morningstar.

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