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Editors’ Note: Fisher Investments’ editorial staff does not make individual securities recommendations. The below simply represents a theme we wish to highlight.Editors’ Note: Fisher Investments’ editorial staff does not make individual securities recommendations. The below simply represents a theme we wish to highlight.

The Dow Jones Industrial Average just got a makeover, which isn’t unusual. The index, which purports to include 30 of the biggest and best-known US stocks, has had numerous companies rotate in and out over its 135-year life. But the trigger for this rebalance was rather unusual: Apple’s four-for-one stock split, which occurred at August’s end. In Fisher Investments’ view, exploring why Apple’s corporate action prompted the move—and others—shows why the Dow is a poorly constructed index and useless measuring stick for portfolio performance.

Apple’s split didn’t affect its weighting in the S&P 500, MSCI World Index or any other index based on market capitalization—the total dollar value of all outstanding shares. This is logical, because a stock split doesn’t affect the company’s market capitalization, either. It just spreads that market value across a larger pool of shares. The number of shares held by an individual investor changes, but the total dollar value of those shares doesn’t. The Dow, however, doesn’t weight its constituents according to their market size. Rather, it uses their share price. Before Apple split, its share price of $503 as of August 24 made it the Dow’s largest constituent. [i] After the split and the reshuffle, Apple fell to the middle of the pack, greatly reducing its influence on the index’s return—even as its influence on cap-weighted indexes didn’t waver. In Fisher Investments’ view, the latter is more relevant for investors, as portfolio holdings are inherently cap-weighted. An investor’s portfolio performance depends on the percentage of their portfolio, in dollar terms, represented by each company—irrespective of share price.

The main reason for the reshuffle, however, is that diminishing Apple’s influence diminished the Tech sector as a whole within the Dow. One analyst with S&P Dow Jones Indices estimated the split reduced the Tech sector’s price weighting within the index from 28% to 20%. [ii] For comparison, on a cap-weighted basis, Tech is about 28% of the S&P 500. [iii] To address this shortfall, the index added Salesforce, whose $208 share price on August 24 partly offsets Apple’s split. [iv] While the powers that be were at it, they also purged three companies with negative year-to-date returns (Exxon, Raytheon and Pfizer) and added the much pricier (on a per-share basis) Honeywell and Amgen. We don’t have an opinion on whether any of these companies belong in the Dow and, generally, we don’t consider index additions or deletions important. Fisher Investments’ research shows index changes don’t materially influence returns.

But the Exxon decision is more evidence of just how broken the Dow is. Most observers cited Exxon’s diminished share price as the reason for its demotion. When S&P Dow Jones Indices announced the reshuffle, Exxon had the fourth-smallest weighting in the Dow. Yet at the same time, on a market-cap basis, Exxon was the 33rd-largest company in the S&P 500, with a market capitalization of over $175 billion. [v] It is one of the largest companies globally, yet it was too small for the Dow.

S&P Dow Jones Indices’ stated reasoning for adding Salesforce, Amgen and Honeywell offers more insight into the Dow’s limitations: According to the official announcement, they add “new types of businesses that better reflect the American economy.” Fine enough, but a broader index wouldn’t need to make such arbitrary decisions. For instance, this is not Honeywell’s first trip to the Dow during its long life. Similarly, Amgen is the Dow’s first Biotech stock, which indeed improves its reflection of the US economy. But Biotech is not a brand-new field. It has been a key cog in broader indexes for many, many years. That the Dow had a long-running blind spot to such a key industry illustrates the drawbacks of trying to represent the entire US stock market with just 30 stocks. In Fisher Investments’ view, it is simply impossible to diversify adequately with so few holdings.

The selection criteria for the companies’ addition to the index are further evidence of a flawed gauge. Rather than size or profitability or really any quantifiable metric, the index additions are based on the firms’ reputations—and the index provider’s assessment of growth prospects and investor interest. That all seems very squishy to us.

So ditch the Dow. It is a relic of a long-gone era when the US had few publicly traded companies and dividing them into two categories—Transports and Industrials—adequately represented the broader economy, more or less. But it doesn’t capture our 21st-century world or adequately reflect the performance of the companies it chooses to hold.

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.

[i]Source: FactSet, as of 08/25/2020. Apple, Inc. closing price on 08/24/2020.
[ii]Source: FactSet, as of 08/25/2020. Apple, Inc. closing price on 08/24/2020. “Salesforce, Amgen, Honeywell to Join Dow Jones Industrial Average,” Michael Wursthorn, The Wall Street Journal, 08/24/2020.
[iii]Source: FactSet, as of 08/25/2020. S&P 500 and Information Technology sector market capitalization on 08/24/2020.
[iv]Source: FactSet, as of 08/25/2020. Salesforce closing price on 08/24/2020.
[v]Source: FactSet, as of 08/25/2020. Exxon Mobil Corporation market capitalization on 08/24/2020.

The Reuters editorial and news staff had no role in the production of this content. It was created by Reuters Plus, part of the commercial advertising group. To work with Reuters Plus, contact us here.

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