Posted by on Sep 16, 2013 in Blog, Columns, Featured |

By Jason Zweig | Sept. 13, 2013  7:32 p.m. ET
Image credit: Christophe Vorlet

This coming week, the dowager gets a makeover. The Dow Jones Industrial Average, which turned 117 years old this summer, will get three new members as Nike, Visa and Goldman Sachs Group replace Alcoa, Hewlett-Packard and Bank of America.

Should you care? There will be no immediate impact on the level of the Dow, which finished this week at 15376; the three stocks getting the boot have barely budged in price. But the inner workings of the average, which have changed little since its inception, hold some important lessons for investors — most notably that things on Wall Street are seldom as simple as they seem.

The changes to the Dow “were prompted by the low stock price” of Alcoa, H-P and Bank of America and by the “desire to diversify…the index,” S&P Dow Jones Indices, which oversees the Dow, said in a statement. Dow Jones, publisher of The Wall Street Journal, owns a stake in the index company, which is a unit of McGraw Hill Financial.

Wall Street professionals, who regard the Dow as antiquated and cumbersome, mostly sneered. “High priced stocks totally skew this horribly constructed index,” tweeted Kid Dynamite, a trader who runs a popular blog. The way the Dow is put together, he later told me by email, “makes no sense at all.”

The Dow consists of 30 stocks; the higher its share price, the more a stock influences the level of the index. At its recent price of $192, International Business Machines has the largest weight in the Dow, at 9.6% — while Alcoa, at $8, makes up just 0.4%. A 1% rise in IBM’s share price would add roughly 15 points to the value of the Dow, while a 1% jump in Alcoa’s price would add only 0.6 point.

That method of building an index, called price weighting, differs from “value weighting,” in which stocks with a greater total market value (regardless of their per-share price) loom larger. The market value of IBM’s shares totals $209 billion — but that gives it only the 12th largest position in the value-weighted S&P 500, at 1.32% of the index. Instead, Apple — total market value, $429 billion — has the biggest weight in the S&P 500, at 2.92%.

Even so, the Dow has delivered. Over the past 20 years, it has returned an annual average of 9.8%, while the S&P 500 has earned 8.6% annually.

A $10,000 investment in the Dow two decades ago would have risen to more than $64,300 by the end of last month, while the same amount invested in the S&P 500 would have amounted to less than $51,800. The Dow also is ahead of the S&P for the past five, 10 and 15 years.

I asked Rabih Moussawi and Denys Glushkov, finance researchers at the University of Pennsylvania’s Wharton School, to analyze this. Since 1981, they found, the price-weighted Dow returned an average of about one percentage point more per year than it would have if it had been value-weighted. And a price-weighted S&P 500 would have beaten the actual S&P 500 by an average of one point annually. So, even though price weighting seems clunky and nonsensical, it appears to have helped rather than hurt returns.

The twists don’t stop there. You should be skeptical of these results, too — and you shouldn’t be tempted to dump your S&P 500 or other broad-market index fund for a less-diversified Dow fund.

Since the beginning of 1930, according to analyst Jeffrey Yale Rubin of Birinyi Associates, the S&P 500 has returned 9.6% annually, counting dividends—ahead of the Dow’s 9.4% by a hair. So, while the price-weighted Dow has prevailed in recent years, it lagged behind earlier—as it did “hugely” in the late 1970s, says Antti Ilmanen, a managing director at AQR Capital Management in Greenwich, Conn.

Because these differences in long-term returns are too small to be statistically significant, “there is no way anyone should confidently say the expected return on the Dow [is] higher than the expected return on the S&P,” says Kenneth French, a finance professor at the Tuck School of Business at Dartmouth College. “Any differences you observe are almost certainly noise,” or random variations in the data.

So don’t chase marginally higher returns just because someone is marketing them. All told, FTSE Group, MSCI, Nasdaq and S&P Dow Jones—four of the leading index providers—say they calculate returns on more than two million separate indexes. Any apparent advantages offered by most index funds based on these wildly proliferating benchmarks are probably just random noise.

Finally, whenever “everybody knows” something about investing, it probably is wrong. One of the best questions you can ask any professional investor is this: “How do you know that?”

In the wise words of the late British biologist Peter Medawar: “The intensity of the conviction that a hypothesis is true has no bearing on whether it is true or not.”


Source: The Wall Street Journal