The Index That Started It All

How could you summarize the movement of markets in just one number in the days before computers? Charles Dow and Edward Jones faced such a challenge and came up with a pretty good solution that is still in use today. They simply summed up the prices on 12 leading stocks, which eventually led to what we now know as the Dow Jones Industrial Average. In its time, it was a radical innovation. Dow's publication simplified complex financial information and put it in the hands of the individual investor.

Nowadays, computers and economic theory have combined to create better indexes, but the simple approach still has some merit. What's more, it has withstood the test of time without radical change, aside from occasionally replacing waning companies with emerging industry leaders. Interestingly, the Dow Jones and Standard & Poor's have merged their index businesses, so changes might be in store for the Dow. But for the time being, what better way to capitalize on the historic Dow than through a low-cost exchange-traded fund? While these blue-chip stocks are all high quality, we feel that valuations do not justify an overweighting at this time.

The Dow has several quirks that investors should keep in mind. Instead of market-capitalization weighting, the index uses share-price weighting. So although  Microsoft (MSFT) has a larger market capitalization than  IBM (IBM), its low share price means that Microsoft makes up less than 2% of the index, while IBM, with its high share price, makes up a whopping 12% of the index. Meanwhile,  Apple (AAPL), currently the largest United States company by market cap, is not even included. The index also excludes transportation and utility stocks and has an underweighting in financials but an overweighting in industrials relative to the S&P 500. The index-construction methodology does not follow mechanical rules, so there are no firm guidelines dictating how or when the committee overseeing the index will pick new constituents. Despite these idiosyncrasies, the index has had a 0.97 correlation to the S&P 500 over the past 10 years and lower risk.

The effects of the share price weighting can be illustrated by a comparison of the largest 13 stocks in the S&P 100 with their weight in the DJIA. 

 SPDR Dow Jones Industrial Average (DIA) replicates the Dow Jones Industrial Average, an index of 30 stocks maintained by a committee that considers subjective factors such as the strength of each firm's reputation, industry leadership, and the degree to which the business is representative of the U.S. economy in deciding which stocks to include. The odd weighting scheme and small number of holdings result in a concentrated portfolio, with the top 10 holdings accounting for 56% of assets. This would be unacceptable were it not for the fact that these companies are conglomerates with low volatility. The corporate behemoths in the DJIA generate a large percentage of revenues internationally, giving this ETF considerable international exposure, despite being composed of U.S. companies. The fund is structured as a unit investment trust, although dividends are paid monthly, there is nearly a one-month lag between the ex-date and pay date.

Role in the Portfolio
SPDR Dow Jones Industrial Average can serve as a core equity holding because of its fairly diverse allocation to top-quality companies and also because it is based on an index with a proven performance track record. However, it is difficult to recommend as the primary core U.S. equity holding because it lacks exposure to all but the largest mega-cap stocks, and it does not complement other indexes to provide complete market coverage without overlap. However, investors can rest assured that this fund holds only the most well-established, iconic multinational firms. Many index providers have created a separate carve-out of mega-cap stocks, which tend to exhibit low growth and are less responsive to valuation or momentum factors but at the same time have low volatility.

Fundamental View
After strong performance in the late 1990s, U.S. large-cap equities have provided meager returns with gobs of volatility over the past 12 years. It is easy to see why investors have poured new money into bonds rather than stocks since the financial crisis. Over the past five years, the Dow has returned 1.60% per year while the S&P 500 has eked out just 0.36% per year. Part of the outperformance of the DJIA relative to large-cap stocks in general can be explained by the fact that the index is managed and contains a tilt toward value, quality, and multinational companies and away from financials.

Morningstar analysts cover each of the 30 stocks in the index, and in aggregate, they see the stocks as slightly undervalued, trading at a price/fair value of about 0.96--basically fair value. They see 70% of the index's weighting in stocks with a wide economic moat, which is a Morningstar measure of the quality and defensibility of a firm's competitive economic advantage. This compares with 43% for the S&P 500, which trades at a price/fair value of 0.95. Of the stocks in the Dow, Morningstar analysts are most concerned with  Verizon (VZ),  Home Depot (HD), and  Procter & Gamble (PG). They see these firms as slightly overvalued.

They see better opportunities in  Alcoa ,  Hewlett-Packard (HPQ), and  Cisco Systems (CSCO). Significant scale advantages, meaningful customer switching costs, and a reputation as the go-to provider of enterprise-class networking equipment give Cisco a durable competitive advantage in its core markets of routing and switching. However, Cisco currently faces pressure on two fronts. Demand is slack due to the global economic slowdown and government austerity measures. Meanwhile, lower-priced technology could erode CSCO's moat over time.

According to Morningstar equity analyst Bridget Freas, the biggest challenge for Alcoa is the price of aluminum, which averaged just over $1,900 per ton in the most recent quarter, well below her long-term projection of $2,600 per ton. Even if demand growth for aluminum holds steady and operating costs provide support, we think a stronger global economy is required for the price of aluminum to accurately reflect these fundamentals. Alcoa is likely in store for another tepid year in 2013, but she continues to believe the shares represent an attractive value for long-term investors.

At a 4% weight in the index,  Boeing (BA) may be a concern to investors worried about the impact of defense spending cutbacks. But Morningstar analyst Neal Dihora sees the stocks as fairly valued. Boeing's production rate increases planned for the next several years will drive strong sales. However, he believes commercial airplane sales will come with little profitability as the delayed 787 Dreamliner is delivered. His $73 fair value incorporates a difficult military spending environment combined with strong aircraft deliveries.

If You Like DIA, You May Also Like
SPDR Dow Jones Industrial Average ETF charges a 0.17% expense ratio, while this is cheaper than the 1.11% average for large cap open-end mutual funds, there are cheaper ETF options. Vanguard, SPDRs, and iShares each offer broader U.S. large-cap index tracking for lower fees.

For investors focused on quality,  Vanguard Dividend Appreciation ETF (VIG) provides a suitable alternate to the Dow's high-quality portfolio with more diversification, exposure to mid-cap names, and weightings in proportion to market capitalization. Whereas DIA tilts slightly toward value, VIG tilts slightly toward growth. With an expense ratio of 0.13%, it focuses on companies that have a 10-year track record of increasing dividends.

Investors who want just giant-cap companies should consider  Guggenheim Russell Top 50 (XLG) (0.20% expense ratio),  iShares S&P 100 Index (OEF) (0.20%), or  Vanguard Mega Cap 300 Index ETF (MGC) (0.12% expense ratio). These funds market-cap-weight the largest 50, 100, and 300 stocks, respectively. Those looking to invest in a diverse set of large-cap U.S. companies should look at  iShares Core S&P 500 ETF (IVV), while investors looking for exposure to the broad U.S. market should consider  Vanguard Total Stock Market ETF (VTI) with its full coverage of small- and mid-cap stocks and rock-bottom expense ratio of 0.06%.

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Disclosure: Morningstar, Inc. licenses its indexes to institutions for the creation of ETFs and ETNs. Morningstar receives fees that are mainly based on fund assets under management. AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Scottrade, and Van Eck currently license Morningstar Indexes. These ETFs and ETNs are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on the Morningstar Indexes.