A Closer Look at the Dow, With GE Out
Investing in a Dow-tracker hasn't been a disastrous bet, but better options for passive core equity exposure abound.
It's hard not to see it as the end of an era. Until yesterday, General Electric (GE) was the only original Dow component left of the 30 stocks that comprise the Dow Jones Industrial Average. It was the sole remainder from a time when the Dow consisted of mostly "smokestack" companies, according this Wall Street Journal article that provides a brief look at the index's components during historical periods (subscription required).
What long-term or short-term effect, if any, its exclusion from the Dow will have on GE is unclear. Even before the announcement was made that GE would be replaced in the index by Walgreens Boots Alliance (WBA) effective June 26, there was wide speculation that it would be removed. Though the requirements for inclusion in the Dow have always struck me as a bit fuzzy, there is a general understanding that if a firm's shares fall more than 50% over the trailing 12-month period and it cuts its dividend twice, it might be on the way out.
Some market observers, such as MarketWatch's Mark Hulbert, speculate that GE's ejection from the Dow could be the best time to buy the beleaguered stock, citing IBM's (IBM) exclusion from the Dow from 1939 to 1979--a 40-year stretch during which IBM's stock outperformed the U.S. market.
Whenever I hear about reconstitutions to the Dow Jones Industrial Average, though, I can't help but think about how wonky the index is.
The committee that oversees the Dow issued this statement about GE's removal.
“General Electric was an original member of the DJIA in 1896 and a member continuously since 1907,” says David Blitzer, Managing Director and Chairman of the index committee at S&P Dow Jones Indices. “Since then the U.S. economy has changed: consumer, finance, health care and technology companies are more prominent today and the relative importance of industrial companies is less. Walgreens is a national retail drug store chain offering prescription and non-prescription drugs, related health services and general goods. With its addition, the DJIA will be more representative of the consumer and health care sectors of the U.S. economy. Today’s change to the DJIA will make the index a better measure of the economy and the stock market.”
This seems reasonable. Even though General Electric's market cap is twice that of Walgreens Boots Alliance ($119 billion versus $63 billion), the Dow's weighting in the industrials sector was almost twice that of the S&P 500. Adding a consumer defensive firm and removing an industrial one would help bring its sector weightings better in line with the U.S. market. (The image below compares the sector weightings of SPDR Dow Jones Industrial Average ETF's (DIA) portfolio with the S&P 500's updated through Monday, pre-GE-removal.)
But the statement goes on to discuss how the change makes sense in terms of the index's weighting method, which sounds a lot less reasonable:
“The DJIA is a price-weighted index, and the range of prices among its 30 constitutes matter. The low price of GE shares means the company has a weight in the index of less than one-half of one percentage point. Walgreens Boots Alliance’s share price is higher, and it will contribute more meaningfully to the index. It will also help the index better represent the U.S. market and economy.”
I'm certainly not the first person to say this, but weighting an index by stock prices doesn't make sense. A company's share price represents the firm's market capitalization divided by the number of shares outstanding, but relative to another firm's share price, it tells you nothing. Companies have all different market caps; their earnings per share are different as well.
The statement also says the index divisor will be recalculated, so as to prevent distortion in the measurement of the components' stock price movements resulting from dropping GE and adding Walgreens Boots Alliance.
When I read this I thought that it sounded like an attempt to make the index sound like it uses a transparent, logical, rules-based approach. But it doesn't--it comprises hand-picked components that are weighted according to price. Perhaps at one time, the mystique of the index's inclusion methods was one reason it held sway, but times have changed. As my colleague Alex Bryan, director of passive strategies research, writes in his article "6 Traits of the Best Indexes":
“It goes without saying that a strategy should be sensible, but it's not always obvious which strategies clear that hurdle. Price weighting, the approach that the Dow Jones Industrial Average employs, is a prime example of a process that falls short. There is no viable economic theory to support price weighting, which assigns larger weightings to higher priced stocks. Dow Jones simply adopted it because limited computing power rendered alternative approaches impractical when it first calculated the index in the late 1800s. While there are other such indexes that fail this basic sensibility test, there aren't many of them and most do not attract much money.”
Nonetheless, the Dow remains relevant in many market performance conversations, and for a surprising number of investors, too: The SPDR Dow Jones Industrial Average ETF (DIA), which we rate Neutral, has over $20 billion in assets.
The good news is that even though the index isn't very attractive from an investing strategy standpoint, its performance has been within a few percentage points of both the S&P 500 Index and the Wilshire 5000 over both short- and long-term periods.
This is actually sort of surprising, because there aren't any explicit rules for aligning the Dow's sector exposures with the U.S. market's other than the index committee's desire to make the index representative of the U.S. economy. However, as you can see from the DIA portfolio data above, its sector weightings can and do differ from those of the U.S. market at large.
The table below shows the percentage-point margin by which the index on the left has outperformed or underperformed the Dow over various time periods (three- to 15-year performance is annualized).
So while investing in a DJIA tracker hasn't been a disastrous bet to make, if you're looking for core equity index exposure, better choices abound.
Karen Wallace does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.