The keepers of the Dow Jones Industrial Average decided the Dow needed a big change, so as of Nov. 1, in come four new companies representing the "new economy" and out go four standards of the "old economy." The changes to the Dow gave me a chance to review the theory and objective of market indices. Despite the criticism that I hear, the Dow does not have enough representation in the innovative companies leading the economy into the next century, the Dow's performance leads the S&P 500 1999 through Oct. 31. However, both trail the technology driven NASDAQ Composite by a wide margin.
Each of the four new stocks entering the Dow ranked within the 25 largest stocks in the S&P 500 as of Sept. 30. Microsoft, ranked number 1 and Intel, ranked number 3, give the Dow its first two stocks that do not trade on the New York Stock Exchange. I feel Home Depot, ranked 23rd along with Wal-mart, are the two most innovative and dominant retailers of the 1990s. SBC Communications, ranked 24th, adds to the telecommunication exposure of the index. Leaving the index are Sears, Goodyear, Chevron and Union Carbide.
Because some investors are uncertain as to what is the market and how do we measure it, I would like to take a moment to explain. The Dow Jones Industrial's Index is one of many domestic equity (stock) benchmarks. I see indices having two main purposes to calculate the change in the aggregate value of securities and also to serve as a benchmark for evaluating investment management performance. The first purpose is to answer the question: "How did the market do over a certain time period?" while the second purpose is to answer the question: "How did the manager (fund) do in comparison to the market over a certain time period?" The Dow is certainly the most popular measure to answer the second question. The Dow is generally not considered an institutional quality benchmark to judge investment manager performance.
The first thing to understand about any index is that the index is just a sample of the universe of equities. Because it is a sample, some set of construction decision rules must be specified regarding the number of stocks, the weight of each stock and how stocks will enter or be removed from the index. The Dow is the oldest and most famous benchmark. The editors of The Wall Street Journal determine the constituents of the Dow. They have chosen 30 stocks with the objective that the index should have low turnover, a cross-section of economic sectors represented, and stable companies with a long-term record of business achievement. The Dow's 30 companies historically have been a good long-term indicator of market movements and returns.
The Dow is not used for the investment manager performance attribution for two main reasons, the lack of breadth in the holdings and the calculation methodology. With thousands of stocks to choose from and only 30 in the Dow, the index is not able to effectively determine the investment manager's stock-picking skill. The second main criticism is the construction methodology. The Dow is priced-weighted, as opposed to the more common capitalization-weighted or equal-weighted. In a price-weighted index, the prices are added up and then divided by a factor called the Divisor (to maintain comparability for changes to holdings and adjust for stock splits). The easiest way I can explain it is to construct a portfolio of 100 shares of each of the holdings, with regard to the price of each stock or how big the company is.
The Dow and the S&P 500 have one thing in common; large cap stocks dominate their performance. In the Dow's case, the 30 stock limit restricts the index to having large companies. For the S&P 500, the return is a result of the capitalization-weighted methodology. A sharp run-up in the market the last week of October gave the Dow Jones Industrials a 1999 year-to-date performance of 18.36 percent, through the end of October The Dow's return is 6.30 percent better than the 12.06 percent of the S&P 500 cap-weighted. The equal-weighted S&P 500 is still in single digits for 1999, with a 7.78 percent return. The NASDAQ composite return of 35.23 percent is nearly double the Dow's return and triples the S&P 500's return. Despite the lack of the exposure to the newer technology companies, the Dow has outperformed the S&P 500 over most of the decades as they have both benefited from the market's large cap dominance.
The editors of the Wall Street Journal believe they have recast the Dow Jones into an index that will represent the market's behavior in the new decade. While they have increased the exposure to higher growth areas, they have also increased the index's valuations and any risk associated with higher valuations. They could have maintained a lower valuation index that would not suffer if the higher growth stocks fell in a style shift, but to maintain market credibility, I think the index had to be repositioned. For more information, call me, Bill Creekbaum, CFP, at 689-8720. Have a great weekend!
William Creekbaum, MBA, CFP, a Carson City resident, is vice president-investments of Salomon Smith Barney, a financial services firm serving Northern Nevada.