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ETF Specialist

The New Dow Jones Industrial Average

The iconic index is about to experience some big changes, but its quality tilt remains firmly intact.

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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. Earlier this week, S&P Dow Jones Indices announced that  Visa (V),  Nike (NKE,) and  Goldman Sachs (GS) will replace  Hewlett-Packard (HPQ),  Alcoa (AA), and  Bank of America (BAC) in this iconic index, effective Monday, Sept. 23. Because the index weights its constituents by their share price, rather than by market capitalization, these changes will have a significant impact. Both Visa and Goldman Sachs currently trade above $150, which will make them two of the index's top three holdings. They will also help take some of the weight out of  IBM (IBM), which currently represents more than 9% of the index. In contrast, the three departing stocks account for less than 2.5% of the index combined.

Price weighting is a relic from the 19th century that was adopted primarily because limited computing power made alternatives impractical. This simple price averaging approach that gives higher-priced stocks larger portfolio weights does not have a sound economic basis. Price weighting also limits the index committee's selection options. Although  Apple (AAPL) and  Google (GOOG) are leaders in their fields, if either company were included in the index it would account for more than 15% of the portfolio, which would distort the Dow's representation of the U.S. market. 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 Dow was 0.97 correlated with the market-cap-weighted S&P 500 Index over the past 10 years.

Alex Bryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.