Tuesday, September 10, 2013

A Big Change in the Dow Jones Industrial Average

For passive investors who invests in diamonds, cubes and spiders (see footnote if you don't get this) , the announcement today made by S&P Dow Jones indices should have caught your attention. The index provider has announced that Goldman Sachs (GS), Nike (NKE) and Visa (V)  will replace Hewlett Packard (HPQ), Alcoa (AA), and Bank of America (BAC) in the Dow Jones Industrial Average after the close of September 20th. This is a major component change for the Dow Jones index since 2011. 

Just a brief history on the index, the Dow Jones Industrial Average was created in 1896 when Charles Dow compiled the prices of 12 leading industrial stocks to create a barometer for general business conditions. The index's components increased to 30 by the end of 1928 and numerous revisions were made to the index on a periodic basis. Companies are removed if they no longer considered a leading blue chip company and S&P Dow Jones indices has several methodologies on deciding which company should be added or removed. Out of the 12 original Dow components, GE is the only one that remains.  

What is noticeable about today's change is the addition of two high priced stocks, namely Goldman and Visa. These high priced stock may have a significant influence on how future performance of the Dow Jones Index is calculated given it is a price-weighted index. I have provided a discussion below on price-weighted vs. market-weighted (sometimes called value weighted) indices.

The difference between a price weighted index and market-weighted index:


Price Weighted Example:

A price weighted index is calculated by adding the share price of all the stocks in the index and dividing the sum by the number of components as shown below: 



Stock Price Time t=0
Stock Price Time t=1
Return
Stock A
10
15
+50%
Stock B
20
10
-50%
Index
15 (average A&B price)
12.5
-16.7%

Despite the average return of the two stocks is 0%, the price weighted index suffered a remarkable 16.7% decline because stock B, the more heavily weighted one, dropped 50%. The weakness of a price-weighted index is that the performance of higher priced stocks can have a huge impact on the overall index performance. 


Market-Weighted Example (price assume same at t=0 and t=1 as last table):



Shares Outstanding
Market Cap  t=0 (shares x price) 
Market Cap Time t=1
Return
Stock A
10
100 
150
+50%
Stock B
5
100
50
-50%
Index

200 (sum A+B)
200 (sum A+B)
0%

With a market-weighted index, the result is completely different than the price-weighted index. The index returned 0%, which is the average return of stock A and B (given they have same market-cap).  In a market-weighted index, the individual weights for any stock depends on its market capitalization (share price times shares outstanding) rather than its absolute share price. 

The examples above show the weakness of price-weighted indices. The performance of those indices is highly dependent on the returns of the higher priced stocks. For example, the Dow Jones's highest priced stock is IBM (current at $200), but many Dow components' share price are below $100. Adding higher priced stocks like Goldman Sachs (at $165) and Visa (at $184) to the Dow Jones will skew the index's performance as more weight is given to these new components. The problem with large stock prices is the main reason why blue chip giants Apple (currently priced at $500) and Google (current priced at $900) are not added to the Dow Jones index despite they clearly represent leading blue chip companies. 

Not many major world market indices are price-weighted. For those who are curious, the only other major stock index that is priced weighted is Japan's Nikkei 225 index. The S&P500 and the TSX Composite are all market-weighted indices. 

Implications for the Dow Jones Index going forward:

In the long run, the effect of this change is minor but this change is significant. Goldman and Visa together will represent 15% the Dow's returns, which could distort future price returns of the overall index. Passive investors investing in ETFs such as DIA, should realize that their investment is now more concentrated in the financial sector given that 2 financial companies are added and only one was removed. Also, given the extraordinary high share prices of Goldman and Visa, passive investors are over-weighting financials due to the price-weighted nature of the Dow Index. This is something to keep in mind for passive investors when constructing a portfolio or re-balance their current ones. In addition, for traders using the Dow Theory to predict future prices, the components change will likely alter price patterns of the index and traders need to make the necessary adjustments to minimize price fluctuations due to this components change. 

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Source: http://press.djindexes.com/index.php/goldman-sachs-visa-nike-set-to-join-the-dow-jones-industrial-average/

Footnote: Diamonds, cubes and spiders refer to the classes of Exchange Traded Funds (ETFs) that track the three biggest indices. Diamonds refers to the DIA which tracks the Dow Jones Industrial Average. Cubes refers to the QQQ which tracks the NASDAQ 100. Spiders refers to SPY which tracks the S&P500. ETFs are exchanged traded instruments that is designed to track an underlying index like the Dow Jones or S&P500. ETFs are often lower cost investment products compared to a traditional mutual funds. 

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