A momentous reshuffling that comes into effect on Aug. 31 is aimed at bringing the Dow Jones Industrial Average more in line with the U.S. economy, but largely exposes the limitation of its price-weighted methodology.
Before trading begins on Aug. 31, Exxon Mobil Corp., Pfizer Inc. and Raytheon Technologies Corp. will be removed from the Dow's listing of 30 stocks and replaced by salesforce.com inc., Amgen Inc. and Honeywell International Inc., S&P Dow Jones Indices announced Aug. 24. The changes were made chiefly due to Apple Inc.'s stock split, which would have thrown the Dow's share price weighting into disarray, but also as part of a push to modernize the index.
The Dow, the second-oldest U.S. index after the Dow Jones Transportation Average, is taking some bold steps in removing Exxon Mobil, which was the largest company in the world just six years ago and had been in the index for 92 years. The revamped DJIA continues to exclude some of the mega-cap tech stocks that have helped push the Nasdaq Composite and S&P 500 to record highs this month.
Meanwhile, the Dow remains about 3.6% below its Feb. 12 high. This year, the S&P 500 has outperformed the Dow by 8.4%.
"The key problem with the price weighted index is that companies with high share prices but are extremely influential like Amazon.com Inc. and Google are being excluded specifically because of the share price," said Mike O'Rourke, chief market strategist with JonesTrading. "Likewise, it appears they are shying away from influential, but low share priced companies."
Set to celebrate its 125th birthday next year, the Dow was supplanted some time ago by the S&P 500 as the index of choice for institutional investors.
S&P Dow Jones Indices' 2019 survey of indexed assets found that $11.2 trillion was indexed or benchmarked to the S&P 500 at the end of last year, compared to $31.5 billion for the Dow.
S&P Dow Jones Indices and S&P Global Market Intelligence are both divisions of S&P Global, which also owns S&P Global Ratings.
The changes "help diversify the index by removing overlap between companies of similar scope and adding new types of businesses that better reflect the American economy," S&P Dow Jones Indices said in its Aug. 24 statement.
"These are two different types of indices," said Howard Silverblatt, senior index analyst with S&P Dow Jones Indices. "Over time they correlate well, shorter term they do not."
The S&P 500 is broader and market weighted, utilized more by money managers and complicated by index shares with float adjustments and divisors inaccessible to the average investor, Silverblatt said. The Dow, meanwhile, is simply price weighted, widely understood and offers a quick view of the market, he said.
Exxon Mobil Corp.'s removal was particularly jarring considering it had been listed on the Dow 92 years ago when it was known as Standard Oil of New Jersey and served as another blow this year for America's fossil fuel industry, which has struggled under stagnant prices and plummeting demand.
"It is more about Dow makeup, but I find it an interesting coincidental sentiment indicator for the historic level of apathy towards the [energy] sector," said Eric Nuttall, a senior portfolio manager with Ninepoint Partners. "To have a company that has been included since 1928 removed in favor of a tech company is such a classic sign of the times."
The reshuffling of the Dow shows that index construction has become far more active than it was just a few years ago, said Peter Cecchini, CEO and founder of AlphaOmega Advisors LLC.
"Eliminating a company like ExxonMobil and replacing it with a tech company that investors afford a much higher multiple will likely help index performance," Cecchini said. "The major large cap indices have little to do with the real economy now and this is just part of that continued trend."
Despite it including a greater number of companies and representing a broader swathe of the large-cap universe, the S&P 500's stellar performance in recent months has only driven home its growing detachment from the mainstream U.S. economy as it has become increasingly dominated by a small handful of technology companies.
The top five companies by market capitalization — Apple, Microsoft, Amazon, Facebook and Alphabet Inc. — make up more than 20% of the weighting of the S&P 500.
By comparison, the top five companies by weight in the DJIA are UnitedHealth Group Inc., Home Depot Inc., Amgen, Microsoft and McDonald's Corp.
"From a practitioner's perspective, the S&P 500 tends to be more useful for a number of reasons, though this does not necessarily mean the 500 is better or only for the more sophisticated, but that it is a better proxy for the large cap U.S. equity market than the Dow," said Chris Bennett, director, index investment strategy at S&P Dow Jones Indices. "The S&P 500 is more representative of the option set available to investors in large cap U.S. equities than the Dow."