One of the “bigger” pieces of news this morning is that Amazon (AMZN) has joined the Dow Jones Industrial Average (INDU). I used quotation marks in the preceding sentence because even though it is indeed noteworthy that a key megacap technology stock has joined a flagship market measuring tool, the significance is considerably less than one might imagine. Its construction is anachronistic – a feature of the computational power of the late 19th century – and as a result, it captures only a modest fraction of passively indexed funds.
Note that the title includes the word “average”, not “index”. Therein lies the key to today’s piece.
I have long asserted that despite INDU’s ubiquitous status as a market benchmark, that relevance is mostly historical. Before Charles Dow created its predecessor in 1884, there was no obvious way to measure the broader market’s performance. In a precursor to the Wall Street Journal, he averaged the prices of nine railroad and two industrial stocks. (Bear in mind that in those days railroads were analogous to today’s megacap technology stocks, a key, expanding component of the country’s economic development.). In 1886, Dow changed the construction to 12 railroad stocks and renamed it the Dow Jones Transportation Average, a measure that persists to this day. Ten years later, he created the 12-stock Dow Jones Industrial Average.
Over time, the number of components has risen to 30, with none of the original components remaining among today’s constituents, but INDU’s methodology has not. Remember that it is an average. When the original measures were created, computations were manual. Adding up 12 prices and dividing by 12 was well within that era’s technological standards. This is not meant to be dismissive of Mr. Dow’s inventions. There were no established methods for measuring the market’s overall performance, and he created a framework that worked extremely well at the time and for the decades that followed.
But an average creates an element of randomness. The higher a stock’s price, the higher its weight in INDU. In theory, there is an element of logic that must have appealed to Mr. Dow. The better a company does, the higher its price. But only makes perfect sense if the companies have similar amounts of shares outstanding. If one company A has twice the number of shares as company B, but the two have similar earnings and dividends, it is reasonable to expect that the company A would have roughly half the share price of B, since that would equalize their market capitalizations. But while INDU’s divisor periodically changes to account for splits and corporate actions, it doesn’t fully reflect the differences in market capitalizations between companies.
In 1923, the predecessor to Standard and Poor’s began calculating a 233 stock index in 1923 on a weekly basis. It became a 90 stock index, calculated daily in 1926, and by 1957 it became the 500 stock index that we know today as the S&P 500 (SPX). Their methodology weighs its components by market capitalization, which balances out price differences by utilizing the total value of the company. It is no coincidence that SPX has become the key market benchmark for most professionals.
The current composition of INDU reflects a degree of randomness. UnitedHealth Group (UNH) has the heaviest weight in the average, at just under 9%. Meanwhile, Verizon (VZ) has the lowest weight with about 0.7%. Yet UNH has roughly 3x VZ’s market cap. Should it have about the 12-13x the relative importance?
Consider now the reason that AMZN was able to join INDU. Walmart decided to split its shares 3:1. While I have also asserted that stock splits are the market’s equivalent of making change, say two fives for a ten-dollar bill, they have a profound effect on a price weighted average like INDU. WMT was consigning itself to cutting its relevance in INDU by 2/3. That gave it a similar relevance to Walgreens Boots Alliance (WBA), which then became superfluous. In a happy coincidence, it turned out that AMZN sported a price similar to WMT, so the keepers of the average were able to kick out WBA and insert AMZN, keeping things relatively hunky-dory.
But bear this in mind: as a broad market measure, a 30-stock average is no match for a 500-stock index. And the amounts of money indexed to each reflects that. DIA, the SPDR Dow Jones Industrial Average ETF, has total assets of about $33.4 billion, while its sister product, the SPDR S&P500 ETF Trust (SPY) has about 15X the assets. That preference for SPX over INDU doesn’t reflect the multitude of other ways that money indexed to SPX, including the similarly sized Vanguard S&P 500 ETF (VOO), and many billions or even trillions residing in passively managed pension and mutual funds.
The markets have spoken. INDU is widely reported and remains an important market measure for many. But serious investors and active traders know that SPX is the far more relevant metric.
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