The Dow Industrial Price-Weighting Design Skews Performance

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SPDR Dow Jones Industrial Average ETF (DIA) fluctuations are largely a function of price movements in just ten equities. Because of the underlying index design, 33% of the largest 30 companies in America, control an overwhelming 53% of the index value computations daily. When you hear the Dow 30 widely quoted in the newspaper or on the nightly news, you are essentially getting the change in price for just ten companies. Why?

Image Source: SPDR Sector Website

Unlike the typical U.S. index creation that is weighted by the total capitalization size of each company, similar to the S&P 500 or Nasdaq 100 indices, the Dow Jones Industrial Average has always been price-weighted. What does this mean? Basically, the higher the share “price” for each component, the more say it will have on the final index number. When a stock goes through a stock-split, it generates a lower share quote on more shares outstanding. For the DJIA construct, it also translates into a reduced index weighting. The end result is the other 29 companies are reweighted higher in importance.

Dow Divisor Explanation

The formula uses a mathematical “divisor” to account for corporate ownership changes and component substitutions. After the price of all 30 stocks included in the index are added together, you divide the sum by the divisor. The Dow Divisor was invented to make sure the index values would match one day to the next after stock splits, spinoffs, special dividends and substitutions among the Dow constituents are considered. The original masterminds for the Dow Jones averages were Charles Dow, editor for the Wall Street Journal in 1896, and statistician Edward Jones. The Dow Divisor is continually adjusted to offset specific corporate structure events, and generate an accurate daily value for the DJIA. Again, all of this is required because of its price-weighted design. After many decades of use, the Divisor has declined from 16.67 in 1928 to 0.152 (rounded) today.

Image Source: Dow Jones Website

The easy translation is each $1 change in the quote for any stock in the index is equal to a 6.58-point change in the overall index. It doesn’t matter if the $1 comes from a $20 stock or one priced at $150. In practice, the highest-priced equities have the biggest say on index results, as smaller percentage fluctuations have a huge impact on point values. As of Friday’s close (November 20th), the DJIA’s sum of price in the 30 components was roughly $4448, divided by 0.152, giving us the reported value of 29,263.

An example of a stock split’s effect on the index can be found in this year’s Apple (AAPL) ownership dilution. The heralded 4-for-1 stock split in August completely degraded its effect on DJIA index values and the related SPDR ETF calculation. With today’s market capitalization of $2 trillion, easily placing the company at the #1 U.S. equity ranking by dollar-size of shareholder worth, you would think its quote gains and losses would be the most important single factor in this mega-cap index. However, despite being the biggest holding in the S&P 500 or Nasdaq 100 index creations, it controls less than 3.5% of the fluctuations in the DJIA in November, down from roughly 13% pre-split.

Top 10 Higher-Priced Names Drive DJIA Changes

So, which companies control a lion’s share of the Dow Industrial’s underlying performance moving forward? The answer lies in finding the highest-priced names of the 30 components. Below is a list of the Top 10 equity holdings in the SPDR ETF, replicating the DJIA index using high price as the only determinant of importance. They alone account for 53% of index values, as of today’s trade. The list includes, in order of price weighting, UnitedHealth Group (UNH), The Home Depot (HD), Salesforce.com (CRM), Amgen (AMGN), McDonald’s (MCD), Microsoft (MSFT), Goldman Sachs (GS), Visa (V), Honeywell (HON) and 3M-Minnesota Mining & Manufacturing (MMM).

Image Source: Seeking Alpha Database

Below are 12-month trading charts of the Top 10. I have also included some of my favorite momentum indicators of buying and selling pressure. Accumulation/Distribution Line, Negative Volume Index, and On Balance Volume signals are pictured for each company to compare and contrast. To generate the Accumulation/Distribution Line, intraday buying intensity is measured. If the closing quote is nearer the high trade of the session consistently, the line is rising. The Negative Volume Index reviews price and volume trends, but only on falling volume days vs. the previous session. Rising trendlines are good news. It is a terrific record of overhead supply and buying on weakness. On Balance Volume looks at net dollar interest by investors on up vs. down days, multiplying price change by volume. Again, healthy situations, especially in blue-chips, include a nicely advancing line.

Using the above charts as my sole technical window for evaluation (I actually use nine indicators in my Victory Formation momentum sorts), Microsoft, Honeywell, McDonald’s, Home Depot and Salesforce have the strongest looking momentum patterns.

Lastly, I am including the SPDR DIA chart using the same setup and indicators. It is positioned in a fairly healthy setting, technically speaking. The only noteworthy bearish development is the slacking Accumulation/Distribution Line since early September. Without doubt, the U.S. stock market could succumb to a normal 10% correction at any time back to the 200-day moving average, for a variety of reasons. After the super-strong rebound from the coronavirus panic lows in March, a technically-driven breather into the spring may be next for U.S. equities.

SPDR Dow Industrial Statistics and Performance

Versus a Wilshire 5000 total U.S. market capitalization of $37 trillion today, the 30 Dow Industrial names account for nearly $8 trillion. By far, the DJIA is the most concentrated index in the largest-cap companies based in America. The SPDR Dow Jones Industrial Average ETF has an annual expense ratio of 0.16%, slightly higher than the most popular S&P 500 ETFs available to trade. Part of the reason for higher costs is the constant price reweighting design creates extra expense for the fund. DIA holds $25 billion in assets under management.

I have charted some comparisons of the SPDR DIA ETF versus the other popular, major index-replicating ETFs including the Vanguard S&P 500 (VOO), Invesco Nasdaq 100 (QQQ), and iShares Russell 2000 (IWM). I discussed the wonderful characteristics of the VOO product last week here, as the best choice for owning the largest 500 publicly-traded companies in America with one decision. The QQQ ETF tracks the biggest 100 high-technology names, and has been the standout market winner for years. And, the IWM creation is an investment in 2000 smaller cap companies, tracking the economic health trends at mainly American-focused enterprises. The other larger cap ETFs generate significant sales overseas, in general.

The good news for SPDR DIA trust stakeholders is the ETF pays a greater than S&P 500 rate of dividends. Today’s 2.0% annual cash distribution (paid monthly) on a trailing basis is far higher than the S&P 500 number around 1.6%, or 0.6% from the technology sector or 1.2% from smaller cap companies. Against risk-free Treasury yields under 1% on the short-end of the duration curve, DIA’s cash payout is quite desirable. Below is trailing yield chart drawn over the last decade.

Below are charts measuring alpha and beta ideas vs. the S&P 500 benchmark for returns, using a 10-year time period and rolling 1-year stats. Over the last year, the Nasdaq tech stocks have led the way for gains (alpha), while the Dow Industrial and Russell 2000 ETFs trailed behind.

Nevertheless, the SPDR DIA has retained below average beta (volatility) characteristics vs. QQQ and IWM on a regular basis. Plus, the DJIA usually performs better than either the high-flying Nasdaq or lower quality Russell 2000 stocks during recessions and sharp bear market sell-offs.

Total return performance results, including dividends, over the past ten years are pictured below. The Dow 30 have been performing better since the summer, something of a late-cycle phenomenon, when reviewing history. I have time periods from 1-month to 10-years charted. Notice S&P 500 returns are nearly identical to the Dow Industrials over longer-term spans of five or ten years.

Final Thoughts

The SPDR Dow Industrial ETF is a worthwhile choice for any portfolio, if looking for large capitalization exposure in a single trade. A greater than U.S. equity-normal dividend yield, with regular monthly checks, is a real income payout advantage over most equity investments. DIA has largely matched total returns from more diversified indexes, another bullish point to contemplate for long-term investment. At this particular point in time, with record overvaluations for stocks on Wall Street (as measured by all-time high price to trailing sales and GDP output), DIA’s more defensive behavior argues for further research as a 5-year or longer buy-and-hold proposition.

An understanding of the performance skew in favor of the highest-priced participants can be an important characteristic when reviewing shorter-term price swings. This design is far different than other indexed ETFs, but has worked out just as well as the capitalization-focused setups over the long run. If the Top 10 holdings are in strong uptrends or downtrends, their immediate advances/declines in price have an overwhelming pull/drag on Dow Industrial reported values. For those with oversized investment dollars in DIA, tracking and forecasting the latest Top 10 for high price can be a useful endeavor.

Thanks for reading. This article should be a first step in your due diligence process. Consulting with a registered and experienced investment advisor is recommended before making any trade.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DIA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This writing is for informational purposes only. All opinions expressed herein are not investment recommendations, and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity and is not a registered investment advisor. The author recommends investors consult a qualified investment advisor before making any trade. This article is not an investment research report, but an opinion written at a point in time. The author’s opinions expressed herein address only a small cross-section of data related to an investment in securities mentioned. Any analysis presented is based on incomplete information, and is limited in scope and accuracy. The information and data in this article are obtained from sources believed to be reliable, but their accuracy and completeness are not guaranteed. Any and all opinions, estimates, and conclusions are based on the author’s best judgment at the time of publication, and are subject to change without notice. Past performance is no guarantee of future returns.