ETF Investing

A good collection of high-quality stocks is the basis for this historic yet odd index.
By Michael Rawson | 08/11/12

How could you summarize the movement of markets in just one number in the days before computers? Charles Dow and Edward Jones faced such a challenge and came up with a pretty good solution that is still in use today. They simply summed up the prices on 12 leading stocks, which eventually led to what we now know as the Dow Jones Industrial Average. In its time, it was a radical innovation. Dow's publication simplified complex financial information and put it in the hands of the individual investor.

About the Author
Michael Rawson, CFA, is an analyst covering equity strategies on Morningstar’s manager research team. He covers offerings from Vanguard, Fidelity, and iShares, among others. In addition, he researches asset flows, active versus passive investing, and trends in expense ratios. Before joining Morningstar in 2010, he worked as a quantitative equity analyst for PNC Capital Advisors and Harris Investment Management. Rawson holds a bachelor’s degree in finance from the University of Illinois and a master’s degree in finance from the University of Wisconsin. He also holds the Chartered Financial Analyst® designation.

Nowadays, computers and economic theory have combined to create better indexes, but the simple approach still has some merit. What's more, it has withstood the test of time without radical change, aside from occasionally replacing waning companies with emerging industry leaders. Interestingly, the Dow Jones and Standard & Poor's have merged their index businesses, so changes might be in store for the Dow. But for the time being, what better way to capitalize on the historic Dow than through a low-cost exchange-traded fund?

The Dow has several quirks that investors should keep in mind. Instead of market-capitalization weighting, the index uses share-price weighting. So although Microsoft MSFT has a larger market capitalization than IBM IBM, its low share price means that Microsoft makes up less than 2% of the index, while IBM, with its high share price, makes up nearly 12% of the index. Meanwhile, Apple AAPL, currently the largest company in the United States by market cap, is not even included. The index also excludes transportation and utility stocks and has an underweighting in financials but an overweighting in industrials relative to the S&P 500.

The index-construction methodology does not follow mechanical rules, so there are no firm guidelines dictating how or when the committee overseeing the index will pick new constituents. The committee considers subjective factors such as the strength of each firm's reputation, industry leadership, and the degree to which the business is representative of the U.S. economy in deciding which stocks to include. Despite these idiosyncrasies, the index has had a 0.97 correlation to the S&P 500 over the past 10 years and lower risk, as measured by standard deviation.

The effects of the share price weighting can be illustrated by a comparison of the largest 13 stocks in the S&P 100 with their weight in the DJIA.

BMO Dow Jones Industrial Average Hedged to CAD ZDJ is the only ETF listed in Canada that replicates the Dow Jones Industrial Average. The index's odd weighting scheme and small number of holdings result in a concentrated portfolio, with the top 10 holdings accounting for more than 55% of assets. This would be unacceptable were it not for the fact that these companies are conglomerates with low volatility. The 30 corporate behemoths in the DJIA generate a large percentage of their revenues internationally, giving this ETF considerable international exposure, despite being composed of U.S. companies. The fund, which charges 0.23% in management fees, hedges its U.S. dollar exposure back to Canadian dollars.

The U.S.-listed alternative is the US$10 billion SPDR Dow Jones Industrial Average DIA. That fund charges 0.17% but it exposes investors to currency risk via fluctuations in the Canadian/U.S. dollar exchange rate. Moreover, DIA is structured as a unit investment trust, and although dividends are paid monthly, there is nearly a one-month lag between the ex-dividend date and the pay date. The Canadian-listed ZDJ pays its distributions monthly.

Role in the portfolio

The BMO ETF can serve as a core equity holding because of its fairly diverse allocation to top-quality companies and also because it is based on an index with a proven performance track record. However, it is difficult to recommend it as the primary core U.S. equity holding because it lacks exposure to all but the largest mega-cap stocks, and it does not complement other indexes to provide complete market coverage without overlap. Nonetheless, investors can rest assured that this fund holds only the most well-established, iconic multinational firms.

Fundamental view

After strong performance in the late 1990s, U.S. large-cap equities have provided meagre returns with gobs of volatility over the past 12 years. It's easy to see why investors have poured new money into bonds rather than stocks since the financial crisis. Over the past five years, the Dow has returned 1.60% per year while the S&P 500 has eked out just 0.36% per year, in U.S. dollar terms. Part of the outperformance of the DJIA relative to large-cap stocks in general can be explained by the fact that the index is managed and contains a tilt toward value, quality and multinational companies, and away from financials.

Morningstar analysts cover each of the 30 stocks in the index, and in aggregate, they see the stocks as slightly undervalued, trading at a price/fair value of about 0.96. They see 70% of the index's weighting in stocks with a wide economic moat, which is a Morningstar measure of the quality and defensibility of a firm's competitive economic advantage. This compares with 43% for the S&P 500, which trades at a price/fair value of 0.95. Of the stocks in the Dow, Morningstar analysts are most concerned with Verizon VZ, Home Depot HD and Procter & Gamble PG, which they see as slightly overvalued.

They see better opportunities in Alcoa AA, Hewlett-Packard HPQ and Cisco Systems CSCO. Significant scale advantages, meaningful customer switching costs, and a reputation as the go-to provider of enterprise-class networking equipment give Cisco a durable competitive advantage in its core markets of routing and switching. However, Cisco currently faces pressure on two fronts: demand is slack due to the global economic slowdown and government austerity measures, while lower-priced technology could erode its moat over time.

The biggest challenge for Alcoa is the price of aluminum, which averaged just over $1,900 per ton in the most recent quarter -- well below our long-term projection of $2,600 per ton. Even if demand growth for aluminum holds steady and operating costs provide support, we think a stronger global economy is required for the price of aluminum to accurately reflect these fundamentals. Alcoa is likely in store for another tepid year in 2013, but we continue to believe the shares represent an attractive value for long-term investors.

At a 4% weight in the index, Boeing BA may be a concern to investors worried about the impact of defense spending cutbacks, but we see the stock as fairly valued. Boeing's production rate increases planned for the next several years will drive strong sales. However, we believe commercial airplane sales will come with little profitability as the delayed 787 Dreamliner is delivered. Our US$73 fair value incorporates a difficult military spending environment combined with strong aircraft deliveries.

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