The Dow Jones Industrial Average (DJIA) is one of the most well-known financial indices and this year is celebrating 125 years as it was created all the way back in 1896. The DJIA was the second index that Charles Dow created, the first being a “railroad” index (which was later generalised to transportation). At that time railroads and the industrial sector were considered the two dominant drivers of the economy.
Rich history of the Dow
The index has remained popular and widely followed ever since and it is still quoted prominently in the financial press and data feeds. Financial Indices are taken for granted now but back at its inception over a century ago it was a ground-breaking concept. Charles Dow was a journalist by profession rather than a trader or fund manager and so the motivation for the creation of an index was as a simple way to demonstrate the market direction. This would provide news and data to the investment and business community. The index was initially composed of 12 stocks and this was increased to 30 in 1928 to reflect expansion in the US economy.
The DJIA is a price weighted index which today is an extremely rare choice with the only other major index to use this calculation method being the Nikkei 225 in Japan. A price weighted index takes the sum of the individual stock prices within the index and divides by a pre-determined ratio. This ratio is re-calculated every time there is a change to the index composition or a corporate action to maintain the index value across this event. By contrast, a market capitalisation index takes the largest stocks by market value applies weights in proportion. A third way of calculating an index is to equally weight stocks according to a certain schedule.
Legacy of price weighting
In today’s world, the choice of a price weighted index seems very strange, where the contribution to the index of a company is not determined by its size but the price of the individual share. We should not be overly critical of this methodology which has to be set within the context of being created so long ago. This was a world of limited and very slowly disseminated news, information and data. Financial analysis techniques were in their infancy and mainstream automation of any kind decades away. By contrast the capitalisation weighted index S&P Index was not created until 1923 and only expanded to include 500 stocks in 1957.
A price weighted index is sensitive to the initial stock price level of a company and is also affected when a company undergoes a corporate action. This was shown up in dramatic fashion last year when Apple underwent its 4 for 1 share split. Apple has had a history of relatively frequent share splits in recent years in order to keep its (unit) share price roughly constant, a happy problem caused through its stellar rise over twenty years on the way to becoming the world’s largest company. Such a corporate action is purely cosmetic in terms of the company’s fundamentals and the share price simply adjusts to keep the company total market value constant. This in turn means that its weighting in a market capitalisation (or equally weighted) index is unchanged, and it would also cause no impact for a fund manager with a holding in the company. However for the DJIA under the rules of a price weighted index the proportion in Apple stock was immediately divided by four. This now means that Apple is demoted to the bottom portion of the index and UnitedHealth and Goldman Sachs are the highest constituents in the DJIA, despite their relatively modest placings in the S&P-500.
Apple stock highlights the flaws
This episode caused much comment in the industry and the index committee felt the need to bring in another technology company (Salesforce) in order to restore some sector balance to the index. Exercising their discretion in this somewhat arbitrary manner to compensate for the price weighting mechanism further highlights the drawback of this famous index. Most observers might assume that the main difference between the DJIA and the S&P-500 is the fact that the DJIA is only composed of 30 stocks. Since these stocks are so dominant in the US economy their characteristics are usually similar. The DJIA is generally a little more volatile (20.2% versus 19.3% for the last five years historical volatility) but the two indices are very highly correlated, 97% over that same period. The S&P-500 has shown rather better performance however at 16.4% versus 15.0%, due in part to the higher technology sector weighting it has.
Index still has a place in structured products
The US structured product market has seen significant growth in recent years and in 2020 issuance of products linked to the DJIA totalled USD 8.7 bn, an increase of over 150% on the previous year, (source www.structuredretailproducts.com). While the DJIA remains a less common choice to the wider market index represented by the S&P-500 it is still a popular choice for those seeking exposure to some of the most well known companies in the US and who trust the brand of such a long standing index. Additionally, the slightly higher volatility (and sometimes the dividend yield) makes the DJIA an attractive choice for capital at risk products. Products were issued by many market participants in 2020 and include choices such as auto-callables, callables and contingent coupon notes. The DJIA is a less common choice for ETF issuers compared to the giant funds that track the S&P-500.
On the back of a healthy US structured product market we can expect the usage of DJIA in structured products and the wider market to remain buoyant as interest in this landmark index remains strong.
Image courtesy of:
Gaelle Marcel / unsplash.com