Thursday, August 22, 2013

"What if the Dow Were Market Cap Weighted?"

One of my pet peeves is pseudo-sophisticates who dismiss the Dow Jones Industrial Average out of hand, usually using the word anachronism somewhere in the dismissal.

The DJIA correlates with the S&P 500 92 to 98% of the time which is very close, the index was valuable enough that the CME structured their 2010 joint venture with a distribution to DJ of $607.5 million and finally the top dog on the DJ side, John Prestbo, won the Sharpe Indexing Lifetime Achievement Award (who knew?)

However, over the last 18 months it is not tracking so well...

From Avondale Asset Management:
The Dow is looking to make it seven straight down days tomorrow, and you have to love the symmetry considering that earlier this year we got a streak of 10 straight up days.

Following the recent losing streak, the Dow is now underperforming the S&P 500 by 1.5% year to date (ex-dividends), which comes after trailing the $SPX by a woeful ~600 bps in 2012.  One notable factor contributing to the divergence between the indexes is that the Dow is price weighted, while the S&P 500 is market cap weighted.  In order to take a look at how the Dow is tilted, below is a chart of the current Dow weightings and what they would be if they were weighted according to market cap.

By price weighting, IBM has the largest current weight within the Dow at 9.4% of the index.  If the index were market cap weighted though, IBM’s weight would fall to only 4.8%.  As a market cap weighted index, XOM would be the largest holding at 8.8% vs. 4.4% currently.

Overall if the $DJIA were market cap weighted, the Industrial Average would be a lot less Industrial.  The weighting of the Industrial sector would fall from ~22% to ~10% (depending on how you categorize some of the components).  Even with IBM, Tech would gain much of what the industrial sector lost.  MSFT is currently the most “underweighted” company in the Dow–it would be 6% of the index, but instead is only 1.6%....MORE