Most index investors who want exposure to a basket of U.S. stocks look no further than an exchange-traded fund that tracks the S&P 500. But should they be betting on the Dow Jones industrial average instead?
While you might expect the two indexes to deliver comparable results to indexers, the facts suggest otherwise. Over the past 10 years, to the end of 2010, the Dow has risen a total of 7.3 per cent, while the S&P 500 has fallen 4.7 per cent - a substantial 12-percentage-point difference.
Add in dividends and the performances diverge even more: The Dow has beaten the S&P 500 by more than 21 percentage points. Over the past five years, the numbers tell a similar tale - which makes the Dow look strangely compelling.
Curiously, though, the Dow has been virtually ignored as an investable index among retail and institutional investors alike. The most popular ETF tracking the Dow, SPDR Dow Jones Industrial Average ETF , has just $8.9-billion (U.S.) in assets. That's less than a 10th the size of the popular SPDR S&P 500 ETF .
True enough, the two indexes are constructed in very different ways. The Dow is composed of just 30 stocks, picked by fallible human beings and weighted according to stock price.
The S&P 500 has 500 stocks, picked by methodology and weighted according to market capitalization. So International Business Machines Corp. has by far the biggest weight and impact within the Dow because the stock trades at more than $150 (U.S.).
"Yet in the S&P 500, IBM moves differently," said Howard Silverblatt, senior index analyst at Standard & Poor's. "If they had put Apple and Google in the Dow, this thing would have been at 15,000" - given the similar high dollar value and enormous impact of those two stocks. (The Dow closed at 11,980.52 Monday.)
Bear Market, Bull Market
But John Prestbo, editor and executive director of Dow Jones Indexes, believes the Dow and the S&P 500 simply behave differently during different market conditions. That is, the Dow tends to do better than the S&P 500 during down markets - an observation that certainly proved true during the bear markets that followed the dot-com bust in 2000 and the financial crisis of 2008.
That's because the S&P 500 is composed of the 300 largest U.S. companies, along with 200 smaller companies - and smaller stocks tend to be more volatile. On the other hand, the Dow's components are heftier and the index has a bigger dividend yield, providing a softer cushion when things get rough.
"The two indexes have different purposes," Mr. Prestbo said. "The Dow is constructed to be a blue-chip signal of the market. The S&P 500 was originally constructed to be a benchmark, to represent at that time the investable part of the U.S. market."
It's The Financials
Vikash Jain, portfolio manager at ArcherETF Portfolio Management, points out that another factor has given the Dow's recent performance a boost: It has had less exposure to large financial companies than the S&P 500.
This helped the Dow during the most recent bear market, given that financials tanked 84 per cent between 2007 and 2009. While both indexes fell hard during the downturn, the S&P 500 fell harder.
Still, for John DeGoey, certified financial planner and investment adviser with Burgeonvest Bick Securities, the S&P 500 is still the best choice between the two indexes, recent performance differences aside - mostly because it does a better job of doing what an index is supposed to do.
"An index is trying to replicate a broad market," he said. "If you can cherry-pick the market like the Dow and outperform over the short term or medium term, well bully for you. But it's like buying a lottery ticket and winning."
Nonetheless, the Dow represents an intriguing and largely overlooked alternative for index investors. And if markets turn wonky again, the Dow's defensive characteristics might give it another edge over the broader market.