You Would Never Construct A Portfolio Like the Dow

It will come as news to exactly no one with any sort of markets experience that the Dow Jones Industrial Average is an “idiot’s” index.   What I mean when I say that is that when constructing a portfolio, one would never use “price weighted” methodology like the Dow does.  “Price Weighted” means that the index owns an equal number of shares of each stock – so that the stocks with the largest price have the largest weight in the index.   Moronic?  Yes.   So why do we still use the Dow as a benchmark?

Anyway, today it was announced that $AAPL will replace $T in the index after the close on March 18th, to coincide with the split of Dow Component $V.

I find it somewhat unusual that the Dow is removing a titan like AT&T, but what’s also noteworthy is how they structure the index change around Visa’s 4-1 stock split.  As I wrote previously, the Dow, in all its price-weighted idiocy, requires indexers to actually rebalance when one of its components splits.     When Visa splits 4-1, indexers now own “too many” shares of V, so they’d have to sell V and buy all of the other 29 components.   Instead, by combining this “event” (not an event, really – a stock split is meaningless for any properly constructed index: you just own more shares at a lower price: same notional, so there should be no weight change) with the removal of $T and addition of $AAPL, the Dow can “minimize” trading impact (compared to if they’d done the events separately*): now indexers will buy $AAPL instead of buying all of the other index names.

I don’t have a rebalance calculator handy, but I’d guess that they’ll still have to buy small amounts of the other names to offset the cash raised from selling Visa and T. (quick math:  V = $274, $T = 33.51, $AAPL = $129.  If you sell roughly 3/4 of your V and all of your T, you have more than enough cash for the AAPL you need to buy: so you will buy the other index names too (and sell slightly less than 3/4 of your V)

The Dow Jones Industrial Average is an index that uses a methodology that no one would ever use to construct a portfolio.   For that reason, it doesn’t deserve to persist as a “benchmark” for “The Market” – it does so only because of inertia and ignorance.

related:

Dow Jones Industrial Average Is a Horribly Constructed Index

Apple’s Stock Split Should Remind Us How Horribly Constructed the Dow Is

-KD

* in other words, if the Dow didn’t do the AAPL for T trade at the same time as the Visa split, the flows would look like this:

1) Visa Split Day:  indexers sell V, buy the other 29 components

2) APPL add, T, delete day:  Indexers sell T, sell smaller amounts of the other 29 components, buy AAPL

instead, they do it all at once:

1) Sell V, Sell T, buy a little of the other 28 components, buy AAPL

In this scenario, the turnover is minimized compared to the “separate” scenario

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postscript: I like this explanation from a commenter on my previous post as to how the Dow’s weightings came about originally:

“It is of course a ridiculous index as you say, but there is a reason it ended up the way it did.  While I can calculate several thousand index values per second today, back when the DJIA was first created 115 years ago, it was really really hard to do a weighted average.

For anything with a weighting other than 1.0 for each equity (i.e. any kind of sensible index), you need to multiply the closing price of each component times a weight value.  While we take that for granted today, it was a real pain to multiply 30 values times 30 coefficients (updated however infrequently) and add those fractional values all together…”

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