Concentrated Exposure to Industry Leaders

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

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

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%.

Individual stocks can have a noticeable impact on the fund's performance because its portfolio is fairly concentrated. The top 10 positions account for just over half the portfolio. Goldman Sachs,

Mirroring its index, the fund excludes utilities and has greater exposure to industrial and consumer cyclical stocks than the S&P 500. Based on Morningstar's sector classification system (which places

Portfolio Construction The fund employs full replication to track the Dow Jones Industrial Average. This index reflects the performance of U.S. industrial leaders, excluding stocks in the utilities and transportation industries. A committee, which includes the managing editor of The Wall Street Journal, selects stocks for the index on the basis of subjective factors, including the strength of each firm's reputation, industry leadership, investor interest, and a history of successful growth. In constructing the index, the committee also takes steps to ensure that the index is representative of the U.S. economy. While the committee doesn't make frequent changes, it reviews the entire index when it replaces any component. Therefore, multiple changes often occur at once.

The index dates back to 1896, when Charles Dow simply took the average price of the index's constituents to calculate the index value. Unlike most indexes, each component in the Dow is weighted by its share price. For example, with a stock price near $160, Goldman Sachs receives a greater weighting in the portfolio than

Fees The fund charges a 0.17% expense ratio, which is comparable to its peers. However, there are cheaper and better-diversified alternatives. The fund offers good liquidity, which makes it inexpensive to trade. During the past three years, the fund lagged its benchmark by 16 basis points annually. Full index replication has kept tracking error low.

Alternatives

Investors can also get direct exposure to stocks with attractive quality characteristics through

Investors looking for similar market-cap exposure to DIA might consider

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