Indexing with the Dow: Flaws aside, it has appeal

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Ever since changes to the Dow Jones industrial average were announced earlier this week, a number of observers have been giving the blue-chip index a closer look. Turns out, it looks pretty good. But is it good enough to invest in?

We noted in this space that the Dow's five- and 10-year track records are better than the S&P 500's – despite the Dow's narrower diversification, odd weighting (by share price rather than market capitalization) and fallible human oversight.

But Bespoke Investment Group (via Abnormal Returns) takes a longer view and finds that even going back to 1980, the Dow rocks. According to their numbers, the Dow has gained 1,759 per cent over this 33-year period, versus 1,487 per cent for the S&P 500. That's a remarkable 262 percentage point difference in the Dow's favour.

"Traders can't wait to take a shot at the index for being a dinosaur, holding too few names, holding the wrong names (this includes us), or being weighted incorrectly," Bespoke said on its blog. "All of these complaints are mostly true, but if performance is the ultimate arbiter, the Dow wins."

Eddy Elfenbein at Crossing Wall Street goes back even further, to 1957, with a chart from the St. Louis Federal Reserve. But rather than compare simple returns, the chart shows the Dow divided by the S&P 500. This approach shows a remarkable correlation between the two indexes, at more than 98 per cent over the past decade.

While it is hard to see a trend in the fluctuations, he believes the Dow does better versus the S&P 500 during tough times when investors are scared.

Interestingly, though, the Dow is a fading benchmark. For evidence, look at the difference between the two exchange traded funds that track the Dow and the S&P 500, respectively.

The SPDR Dow Jones Industrial Average ETF Trust has a market cap of less than $12-billion (U.S.) and trades an average of 6.1 million units a day. On the other hand, the SPDR S&P 500 ETF Trust has a market cap of $142-billion, or nearly 12-times the size; and trades 106 million units a day, or more than 17 times more.

For small investors with less than a billion dollars to throw around, this makes no difference, of course. But it does show the extent to which the Dow fails to appeal to indexers, who like to track indexes rather than pick individual stocks.

Should they give the Dow a second look? Quirks aside, the long-term performance suggests that the index – by virtue of its blue-chip nature – has something going for it.

Its dividend yield also tends to be superior: Right now, the Dow's yield is 2.44 per cent, which is considerably better than the S&P 500's 2.09 per cent. (The difference is unlikely to change significantly once the Dow drops Hewlett-Packard Co., Bank of America Corp. and Alcoa Co. in favour of Goldman Sachs Group Inc., Visa Inc. and Nike Inc. on Sept. 20.)

But as I see it, the Dow has two big flaws that should give indexers pause – and they both relate to its narrow 30-stock membership. First, it isn't a diverse collection of stocks that is assembled using a methodology, and therefore doesn't really do what indexers should want an index to do.

Perhaps more importantly, the narrow group of stocks encourages investors to focus too much on its individual components, particularly heavily weighted stocks like International Business Machines Corp., Chevron Corp. and Boeing Co. If you start to feel nervous about any of these companies, are you likely to stay put in the index? And if you start jumping in and out of the index based on calls about individual companies, are you really indexing anymore?

Still, if you can overcome these flaws, the Dow has appeal. And given that pure indexing is dull, dull, dull, it might add a little excitement to your portfolio.