Not Your Average Jones

Change is in the air. After nearly 100 years, Exxon Mobil is being removed from the Dow Jones Industrial Average, along with Pfizer and Raytheon Technologies. Newcomers are biotech giant, Amgen, manufacturing conglomerate, Honeywell, and enterprise software giant, These index changes are fairly common, however this one is particularly interesting and brings into question why the heck the Dow became so popular in the first place.

Apple Inc., added to the Dow in 2015 as a replacement for AT&T, is splitting their stock 4:1 next week.  This simply means that for every share you hold of Apple today, you will receive three new shares, and the value of each share will be cut in four.  Zero, Zilch, Nada is fundamentally changing with the company or its valuation; however, this will materially change the industry characteristics of the Dow Jones Index.

Why is that?

The Dow Jones is what is known as a price weighted index, which means that of the 30 companies in the index, the companies with higher prices will have a greater impact on the index.  Because Apple’s price is being divided by four, when the stock begins to trade post-split, it will affect the index by 75% less even though the company isn’t changing at all!  Riddle me that…

However, because of the reduction in tech representation due to Apple’s split, Dow Jones is adding to keep the technology weighting of the index reflective of the overall economy.  Honeywell for Raytheon as well as the Amgen for Pfizer are simple sector substitutions. for Exxon Mobile will reduce Energy’s exposure in favor of beefing up the tech sector weighting after Apple’s impending split reduces it.

So, now that this is starting to make more sense about why they need to make this change, we can highlight the obvious deficiency in having a price weighted index.  The price of a stock should not matter because it is not representative of that company’s value.  For example, if you have 10 shares of a $1,000 stock or 1000 shares of a $10 stock, you still own $10,000 of that company stock.  What really should matter is that company’s fundamental attributes and its impact on the economy, right?  A bigger company should affect the stock market more, because it also has a greater effect on the economy, so most indices are market cap weighted. Market Capitalization represents the size of companies, multiplying total shares by the price of each share. Well-built stock indices should be representative of future earnings expectations for our economy, but basing that on share price alone, is quite antiquated, like saying ($1,850/share and $75billion market cap) is more important than Walmart ($130/share and $370billion market cap).

The S&P500, the tech-focused Nasdaq and the small cap Russell 2000 are all market cap weighted indices.  This inherently makes more sense, however there can be arguments for having equal weighted indices as well.  All companies start somewhere, right? The biggest companies need to become the biggest companies somehow.  Equal-weighted ETFs can add value in portfolios to help add diversification by avoiding overconcentration to the largest companies in an index and making sure you own an equal share of the smaller companies rising to the top.

It will be interesting to see how the Dow’s facelift impacts future performance. Since news channels usually quote daily market returns in terms of “Dow points” this index will continue to be in the spotlight. Stay tuned.