Concentrated exposure to U.S. industry leaders

The Dow Jones Industrial Average has an odd weighting scheme that limits its appeal.

Alex Bryan 10 August, 2016 | 5:00PM

The Dow Jones Industrial Average is an index made up of 30 industry-leading companies that approximate the industry composition of the U.S. stock market, excluding stocks in the utilities and transportation industries. A committee selects stocks for the index on the basis of subjective factors, including the strength of each firm's reputation, industry leadership, investor interest and a history of successful growth.

Since its inception in 1896, the Dow has served as a barometer of the U.S. stock market by tracking a select group of the country's industrial leaders. Unlike most indexes, the Dow weights its constituents by their share price, rather than by market capitalization. So, even though  Exxon Mobil (XOM) has a larger market cap than  Goldman Sachs (GS), it receives a lower weighting in the portfolio because its share price -- about US$87.50 at the time of this writing -- is lower than that of Goldman Sachs at US$162.

Price weighting is a relic from the 19th century that was adopted because other weighting options, such as market-cap weighting, were impractical before computers were introduced. This simple price-averaging approach, which gives higher-priced stocks larger portfolio weightings, does not have a sound economic basis. Price weighting also may limit the index committee's selection options. For example, thanks to  Alphabet's (GOOG) high stock price, it would account for more than 20% of the index if it were included, which could distort the Dow's representation of the U.S. market.

There are no firm guidelines dictating how or when the committee overseeing the index will pick new constituents. The committee's selections have placed the index in the large-cap-value section of the Morningstar Style Box. Yet, it has been highly correlated with the broader, market-cap-weighted S&P 500.

All the index's holdings currently carry wide or narrow Morningstar Economic Moat Ratings, indicating that they enjoy durable competitive advantages that may help protect their profitability in bad times. In fact, about 59% of the index's assets are in companies with wide economic moats. The corresponding figure for the S&P 500 is around 48%. As a result, the Dow exhibited slightly less volatility than the S&P 500 during the past 10 years, despite its more concentrated portfolio.

The average market cap of the index's holdings is nearly twice that of the S&P 500, as a result of its focus on industry leaders. These giants tend to be more profitable than the average company in the S&P 500. Over the 12 months through June 2016, the index constituents generated a higher return on invested capital (16.9%) than those in the S&P 500 (12.2%).

Historically, highly profitable firms have outperformed less profitable companies with similar valuations. The market may not fully appreciate the long-term sustainability and predictability of highly profitable firms' earnings because many investors have relatively short investment horizons. Long-term investors may benefit from this myopic focus when these stocks are trading at reasonable valuations. This portfolio exhibits a value tilt, which is not surprising because many of the industry leaders it targets have relatively mature businesses. But it tends to look very different from many funds in the U.S. Equity category because it does not explicitly target stocks with low valuations. And it focuses more narrowly on mega-cap stocks than most of its peers.

BMO Dow Jones Industrial Average Hedged to CAD (ZDJ) is the only ETF listed in Canada that replicates the Dow Jones Industrial Average. The fund, which charges a 0.26% management-expense ratio, hedges its U.S.-dollar exposure back to Canadian dollars. The U.S.-listed alternative is the US$12.5-billion SPDR Dow Jones Industrial Average (DIA). That fund charges 0.17% but it exposes investors to currency risk via fluctuations in the Canadian/U.S. dollar exchange rate. Moreover, DIA is structured as a unit investment trust, and although dividends are paid monthly, there is nearly a one-month lag between the ex-dividend date and the pay date. The Canadian-listed ZDJ pays its distributions monthly.

The fund's focus on industry leaders gives it a modestly defensive posture that can help it weather market downturns a little better than the broad market. For instance, during the bear market from October 2007 through March 2009, the Dow cumulatively lost 51.5%, while the S&P 500 dropped 55% (when measured in U.S. dollars).

Individual stocks can have a noticeable impact on the fund's performance because its portfolio is fairly concentrated. The top 10 positions account for just over half the portfolio. Goldman Sachs,  IBM (IBM) and  3M (MMM), all leaders in their respective industries, are among the largest holdings. As the market evolves and industry leadership changes, the index oversight committee will update the portfolio. Most recently, it replaced  AT&T (T) with  Apple (AAPL). AT&T is still a market leader, but the committee made this change to boost the index's exposure to the technology sector and ensure that it continued to be representative of the broader U.S. market. The index still has exposure to the telecom sector with  Verizon (VZ). Turnover here is generally fairly low.

Mirroring its index, the fund excludes utilities and has greater exposure to industrial and consumer cyclical stocks than the S&P 500. Based on Morningstar's sector classification system (which places  Visa (V) in the financial-services industry), this portfolio also gives an overweighting to financial-services stocks and an underweighting to technology stocks. However, under the GICS classification system, Visa is considered a technology firm. In this light, the fund's financial-services and technology stakes are comparable to the S&P 500's.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
3M Co170.68 USD0.08
Alphabet Inc Class C1,315.46 USD-0.40
Apple Inc266.29 USD-0.30
AT&T Inc38.00 USD-4.11
Exxon Mobil Corp67.82 USD-1.02
Goldman Sachs Group Inc220.04 USD0.14
International Business Machines Corp134.52 USD0.16
Verizon Communications Inc59.50 USD0.10
Visa Inc Class A182.77 USD1.73

About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.