Over its storied lifetime, the Dow Jones Industrial Average has matured into one of the world’s most widely quoted stock indexes. While its strong track record as a balanced, cross-sector representation of the U.S. market is a key feature, the index also provides global perspective, with a significant portion of the component companies’ revenues derived outside the United States.

John Prestbo, editor and executive director of Dow Jones Indexes, provides a look at the ubiquitous index and how it reflects the evolution of U.S. equity markets.

Some people might inaccurately associate a centenarian with diminished usefulness. Consider the Dow Jones Industrial Average (DJIA), which turns 115 years old this year. It would be flawed logic for one to assume the index is outmoded. To the contrary, the DJIA’s central strength has been its ability to evolve with economic trends and globalization.

The DJIA is as relevant and vibrant today as it has been for the past 115 years, a track record unequaled by any other cross-sector index. The DJIA is the most quoted measure of the U.S. stock market globally, and it continues to answer the question, “What did the market do today?”

So while the DJIA exhibits a strength of continuity, it is likewise an example of the elegance of simplicity drawn from components that are immediately recognizable. By using highly liquid components that trade frequently it is able to accurately incorporate new, recent pricing to measure market movements while providing a diversified sector view.

The DJIA is price-weighted, which means the market price of each stock determines how much weight it carries in the DJIA. Price was about all that Charles H. Dow had to work with in the late 19th century to compute an index value on a daily basis. He constructed his index so that a $1 move in any component stock has the same influence on the index value.

With the evolution of markets, the DJIA’s weighting method is less unusual. Hundreds of indexes boast “alternative” weighting – by a component company’s sales, or dividend payout or various blends of “fundamental” factors such as earnings growth, cash flow and so on. Some of these are methodologies intended to beat the market, while others profess a whole new way of viewing and tracking the market.

What can 30 stocks tell us?

With 30 component companies, the DJIA is able to remain vital on the global stage by offering visibility across industries. This remains at the heart of the index just as it was at its inception. The basic concept behind the DJIA is to use a relatively few stocks of big, stable, prominent companies as a microcosm of the broader market. This stability is also what keeps the DJIA relevant. After all, if the index were based on a poor design, I would not be writing about its 115 years of existence.

With 30 stocks, the DJIA’s coverage is significant – accounting for 24 percent of the total U.S. market value today, having gained
7 percentage points since 1996. (The high point over the past 15 years was 27.5 percent during the market collapse of 2008.)

Companies whose stocks are in the DJIA have their roots deep in the economic soil not just of the United States, but the rest of the world as well. Nothing of economic consequence can happen without these stocks – these stocks’ prices – feeling it. Approximately 43 percent of the DJIA companies’ revenue is generated outside the United States, and that includes two, AT&T Inc. and Verizon Communications Inc., which essentially have no non-U.S. sales. At the other end of the scale, Intel Corp. has the most non-domestic revenue, 85 percent, followed by Coca-Cola Co. and Caterpillar Inc., both at 68 percent.

Indeed, there is much to be said for the discipline that the 30-stock limit imposes on those who do the choosing. Each stock must be evaluated and considered carefully, on an individual basis in addition to how it works in conjunction with other stocks to reflect the market.

The DJIA has components representing virtually all of the major sectors, and all the component companies are major factors in their respective industries, with their stocks being held by institutional investors and individuals alike. The only one not represented is utilities, for which there is a separate Dow Jones Utilities Average.

While the DJIA has fewer components than its peers, the results that it produces are very consistent with larger indexes. We typically think in terms of correlation – or whether or not the indexes move in the same direction at the same time. The table below reports the correlation of several major market indexes.

The DJIA’s decreasing correlation to the other indexes is explained by the increasing number of small stocks that are included. There are not any small stocks in the DJIA, but there are hundreds in the S&P 500 Index and thousands in the Russell 3000 Index and the Dow Jones U.S. Total Stock Market (TSM) Index. They influence the overall market to a limited degree – and there are periods when small stocks are much in favor, such as the period from 2009 to 2010 – but they do not move the DJIA.

So, the DJIA lags a bit when small stocks are in ascendancy, but then excels as big stocks take center stage. When the market heads south, small stocks typically receive the worse battering, which means the DJIA falls less than the other indexes. In 2000-2003, for example, the DJIA dropped 37.85 percent while the S&P 500 lost 46.98 percent; in 2007-2009, the DJIA sank 53.78 percent vs. the S&P 500’s 56.78 percent decline.

These differing performances even out over time. Over the past 24 years, which is the life span of the youngest comparative index, the DJIA’s annualized return is 8.02 percent compared with 7.26 percent for the S&P 500, 7.41 percent for the Russell 3000 and 7.45 percent for the Dow Jones U.S. Total Stock Market Index.

Happy birthday, Dow Jones Industrial Average!

Keep up the good work.

For more, visit www.cmegroup.com/magazine to watch an exclusive interview with John Prestbo.

John Prestbo is editor and executive director of Dow Jones Indexes, and chairman of the Dow Jones Index Oversight Committee. Prestbo, who joined The Wall Street Journal as a food, agriculture and commodities reporter in 1964, has co-authored or edited several books over the past 30 years and writes the MarketWatch
column, “Indexed Investor.”

Gaining Exposure to an Iconic Index

Market participants looking to include the Dow Jones Industrial Average’s (DJIA) focused, large-cap U.S. equity perspective in their portfolios, or simply take a view on the index’s direction, have a number of options for executing their strategy. Dow Jones first licensed its benchmark index in 1997 when futures on the DJIA were introduced. Today, approximately 2,600 products track this storied, blue-chip benchmark. This array of products includes mutual funds, exchange-traded funds (ETFs), futures and options.

“The growth of the DJIA suite of products speaks to the vitality of the index and the level of client interest in the index,” notes Scot Warren, managing director, equity index products and index services at CME Group. “Products that track the DJIA, which come in a wide range, provide market participants with flexible, efficient methods for executing their strategies.”

Futures offer a capital-efficient way to gain exposure to or take a view on the DJIA. The first Dow Jones futures contract was launched in October 1997. Since then, the Dow Jones Index suite has expanded to include a mini-sized Dow $5 and a Big Dow DJIA $25 contract, enabling small and large market participants the opportunity to take a position based on the performance of the DJIA.

For those looking to track the DJIA, ETFs are a popular option. Among the largest is the SPDR Dow Jones Industrial Average ETF (DIA), which has about $9.6 billion in assets, as of the end of April 2011, and an average daily volume of more than 10 million shares. Those who wish to take a short-term view on the DJIA often use leveraged or inverse ETFs. These funds seek a return that corresponds to a multiple of, or the inverse of, the index’s daily performance.

Several investment products take a twist on the DJIA. In the early 1990s, money manager Michael O’Higgins, author of Beating the Dow, began advocating an investment strategy based on holding the 10 DJIA stocks with the highest dividend yield. Over the years, a number of investment vehicles were launched which followed this philosophy. Indeed, this investment strategy proved so popular that in 2001, Dow Jones Indexes launched the Dow 10 Index.