That’s one reason why the Dow Jones Industrial Index now appears outdated, and doesn’t merit its place alongside other more modern and better constructed investing benchmarks.
A succession of more advanced aircraft have replaced the Wright brothers flyer as a means of air travel — but the Dow Jones Industrial Index is still a prominent part of financial summaries the world over.
That’s too bad. The Dow is a fairly expensive index to track with ETFs, as I’ll show you, there are other ETFs available that track 100x the companies for almost a quarter of the cost.
In this undated file photo, Orville and Wilbur Wright test their airplane on a beach. The Wright brothers have long been credited as the first to achieve powered flight. But in June, 2013, Connecticut Gov. Dannel P. Malloy signed a law giving German-born aviator and Connecticut resident Gustave Whitehead the honor of being first. On Thursday, Oct. 23, 1013 Ohio state Rep. Rick Perales and North Carolina state Sen. Bill Cook held news conferences to dispute Connecticut’s action and reassert the Wright Brothers were first in flight. (AP Photo/File)
Dow Jones themselves now offer many better indices than the Dow Jones Industrial Average. The Dow’s advantage is its iconic status. However, there are vastly better things to use for both investing and benchmarking.
There are several issues with the Dow. It’s a poorly diversified benchmark even though it’s expanded to 30 stocks in 1928 from 10 when it first launched. Historical analysis suggests that holding at a minimum of 100 stocks is helpful to really diversify a portfolio. Even then, counting the number of stocks is a crude measure of diversification. If you held stocks in 100 different US regional bank stocks, you wouldn’t be diversified. The Dow has the following selection criteria that their committee consider for periodic adjustments:
A stock typically is added to The Dow® only if the company has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors. Maintaining adequate sector representation within the indices is also a consideration in the selection process
Only the final point here is likely to help diversification, the others mean that the Dow is comprised of larger US companies. That selection bias can hurt returns, because studies show that over the longer term having a bias to owning smaller and cheaper companies rather than larger and more expensive ones can improve absolute performance. Not only is the Dow too small in terms of its membership, it also may be using criteria that undermine investment returns.
The Dow’s constituents are weighted based on price rather than market capitalization. Weighting components based on price is actually pretty medieval compared to the rest of finance.
Visa is currently the largest component of the Dow. Why? Because its stock at the time of writing trades at over $200, though a stock split is imminent that will change that. Next up is Goldman Sachs with a price of just under $200. Meanwhile, Exxon Mobil trades at less than $100 and gets a smaller weight, despite being more than double the size of Visa by market cap.
Apparently one of the reasons that Apple was able to join was because it split its stock last June, which doesn’t change the value of the company, but enables more shares to be traded at a lower price. For the Dow, it means Apple will take up less of the index trading around $100 than it would have when it was around $700.
A screen above the trading floor shows the closing number for the Dow Jones industrial average, at the New York Stock Exchange, Monday, Oct. 13, 2014. Stocks are ending sharply lower after a late-afternoon slide. The losses extended a downturn in the market last week which gave indexes their worst weekly performance in more than two years. The Dow slumped 222 points, or 1.4 percent, to close at 16,321.07 Monday. (AP Photo/Richard Drew)
Price weighting is a curious thing.
What do you think should happen to the Dow, given current prices, if GE had an incredibly bad day and fell -30% and on that same day Goldman Sachs stock rises +5%, and all the other Dow components stay flat? Surprisingly, because Goldman has a higher stock price than GE the Dow would actually rise for the day in this scenario. That’s true even though Goldman is a much smaller company by market cap than GE, about a third the size. These examples are theoretical, but you can see that as a barometer of the financial markets, there are much better processes for constructing indices.
Because of its small membership and large cap focus, the Dow Jones also has more turnover than it needs to which is generally bad for investors because of the costs associated with trading and the tax consequences.
A handful of stocks enter and leave the Dow Jones every 1 to 3 years. But when you only have 30 constituents, changing just 3 stocks can easily mean 10% turnover. That’s especially inefficient when you compare it to a model where you track hundreds or thousands of stocks.
So with more stocks and looser criteria, the need to enter and leave is less likely, and even if they did due to an IPO or a delisting, any given stock would be a much smaller proportion of the index. If the collection of stocks you are holding are more stable over time, then for most investors that’s going to be cheaper both from a trading cost standpoint and potentially more tax efficient.
The Dow also highlights the problem of home bias in investing.
Globally, investors tend to hold the vast majority of the assets within their home country. Investors have become more global in past decades, but the fundamental domestic bias remains. That’s not a great move, since investing globally can smooth and sometimes even increase returns depending on where you’re starting from.
Having such a prominent index like the Dow include only US stocks is old fashioned. Of course, you can argue that stocks such as Apple are international, and that’s true to some extent, but there is still a US bias in where they make their profits. Overall, the evidence is persuasive that international investing is a better course, and yet indices such as the Dow prompt people to think too domestically when it comes to investing.
So investors can do better than tracking the Dow Jones Industrial Index. There are low-cost ETFs out there that enable you to do it. For example, for tracking the Dow Jones Industrial Average, DIA from State Street has $12B in assets; a similar product from iShares IYY is somewhat smaller. Both are tracking a poor index in my view, and also charge relatively high fees at just under 0.20%.
As an alternative, you could track over 100 times more US stocks with Vanguard’s Total Stock Market ETF, VTI and pay a quarter of the fees, at 0.05%. That appears an unambiguously good move. The Dow Jones Industrial Index should be part of history — and not part of your portfolio.