Three of the 30 shares held by the Dow Jones Industrial Average will be replaced at the end of this month. Standard & Poor’s, which manages the blue-chip index, announced Monday that current constituencies ExxonMobil (NYSE: XOM), Pfizer (NYSE: PFE), en Raytheon Technologies (NYSE: RTX) is exchanged with Salesforce.com (NYSE: CRM), Amgen (NASDAQ: AMGN), en Honeywell International (NYSE: SHE), respectively.
Updates to Dow components are not uncommon. Excluding changes resulting from mergers and acquisitions, Standard & Poor’s last modified the components of Dow in 2018 when it replaced General Electric May Walgreens Boots Alliance. Like the recently announced restructuring, it was ultimately intended to make the Dow a more accurate cross-section of the US market.
Still, if 10% of all index holdings are planned for replacement in one swipe, it can buy and hold investors who have Dow-based index funds, wondering how much to buy and keep they can really do with those instruments . If that’s who you are, do not worry. The overdue move actually makes it more comfortable for long-term investors to have Dow-based ETFs and mutual funds.
Image Source: Getty Images.
It’s complicated
Standard & Poor’s’ announcement states:
The index changes were requested by DJIA constituency Call The decision of Inc. to share its share 4: 1, which will reduce the weight of the index in the Global Technology Classification Standard (GICS) Information Technology sector. The announced changes will help offset that reduction. They also help diversify the index by removing overlap between companies of similar size and adding new types of companies that better reflect the U.S. economy.
The explanation touches on what is not completely clear within the announcement. Unlike most other indices that assign a “weight” – as a degree of influence – to a holding based on the total capitalization of that company, the Dow Jones Industrial Average is a price-weighted index. For example, stock prices at $ 100 apiece cause more net change for the Dow than shares of a $ 50 stock, even if that $ 100 stock represents a smaller organization. It is quite possible that the smallest name in the Dow (measured by market capitalization) could still have the largest impact on the daily point changes of the index if the share of that company was the highest price in the 30 that it Dow Jones Industrial Average.
In other words, the pricing method used creates a situation where the Dow is not necessarily an accurate, collective reflection of the stock market’s most established names.
Strange circumstances
That has not been the case lately. If anything, the index is skewed for the exact opposite reason. Dow’s largest company (and the world), Apple, also happened to be the longest-running award for a while before its split announcement. The 4-for-1 split will drastically reduce the high impact of Apple’s share on the Dow in the future.
This is a good thing, because it will reduce the overall daily volatility of the index, but that big change alone would also mean a sudden and significant shift in the diversification and reflection of the Dow market. By removing Exxon, Pfizer, and Raytheon and adding Salesforce, Honeywell, and Amgen, Standard & Poor’s is also trying to restore some necessary sectoral balance for the index. This will limit some of the Dow’s impending volatility without necessarily shrinking its performance.
It’s also worth noting ExxonMobil and Raytheon have been two of the Dow Jones Industrial Average’s weaker performers since this time last year – a subparse performance often linked to the COVID-19 pandemic. Regardless of the reason, her predictable future does not look much different than her recent past. Removing these backlogs, the Dow Jones Industrial Average could close the performance gap between it and the S&P 500.
Bottom line
For investors who hold index-based companies like the SPDR Dow Jones Industrial Average ETF Trust (NEW: DIA) as de Vanguard 500 Index Fund (NASDAQMUTFUND: VFIN.X), these major changes raise questions. The underlying strategy of passive, index investing is to own a wide range of the best names in the market for the long term and time let it do the work for you. Now, as noted, 10% of your portfolio is replaced in one fell swoop and you can do nothing to prevent it. The move may mean that you want to continue occupying some of the names you prefer at this time. Maybe you liked the mix of Dow as it was: heavy on Apple, pharmaceuticals, energy and defense, but light on tech, biotech and industry. Maybe you’re not a fan of Amgen, which posted encouraging quarter numbers in July, but otherwise it has not been a very growing machine of late.
The point is that the character of the Dow will change. Perhaps it will not change dramatically, but the sectoral layout has changed in a way that may affect performance going forward.
If that’s your concern, put it off.
If anything, these major changes to Dow’s makeup were actually too late. The Dow has long been less than ideally balanced without most investors realizing it themselves. Apple shares have been trading at unusually high levels for some time now. Energy name Chevron will still be a Dow component, and given that the oil and gas industry may never be what it once was, one such name may suffice. Pfizer will be taken out of the DJIA but drug company Merck remnant. There is currently no biotech / biopharma stake in Amgen’s ilk in the Dow, but there should be some. Raytheon is fired, however Boeing will still be a part of the index. Perhaps most ironically, without Honeywell’s upcoming addition, there would still be no factory-centric industrial name in the Dow Jones Industrial Average.
Standard & Poor’s moves, scheduled for the end of this month, will ultimately make the Dow a better balanced, more diverse index.
