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Globe and Mail columnist David Berman.

The Globe and Mail

The Dow Jones industrial average is capturing the attention of headline writers as it nears the 20,000-point milestone, but something far more interesting is going on with the blue-chip index than a lengthy flirtation with a big, round number: It is beating the S&P 500.

Over the past three months, the Dow has risen nearly 9 per cent, versus 6 per cent for the S&P 500 – a remarkable difference over a short time period and one that raises questions about what's driving the outperformance, how long it will persist and whether investors should pay more attention to the Dow as an investment.

The Dow, of course, gets plenty of attention as an index, given its long history and snappy name. But it consists of just 30 stocks, selected by human hands and weighted using share prices rather than market capitalization.

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This archaic approach has left it ignored by most index investors, who prefer the broader, market-capitalization-weighted and rules-driven S&P 500.

You can see the snubbing in the size of mainstream exchange-traded funds that track the two indexes.

The Dow-tracking SPDR Dow Jones Industrial Average ETF Trust (symbol: DIA) has a market capitalization of just $15.4-billion (U.S.). By comparison, the SPDR S&P 500 ETF Trust (SPY) has a market cap that is nearly 15 times larger.

The difference between comparable iShares ETFs is even more extreme: The iShares Core S&P 500 ETF is 92 times larger than the iShares Dow-tracking ETF – making the Dow look as if it's a fringe investment.

But it is now getting a closer look. At least one observer – RBC Dominion Securities' chief equity strategist, Jonathan Golub – is recommending index investors turn their attention to funds that track the Dow rather than the S&P 500.

"We're generally not big fans of the Dow," Mr. Golub said in a note. "At present, however, there is one big benefit to [its] antiquated construction. The Dow has a huge bias toward financials and industrials and little exposure to bond proxies (telcos, utilities, staples, and real estate investment trusts)."

In other words, the Dow is benefiting from a trend over the past three months – largely coinciding with the November victory of Donald Trump in the U.S. presidential election – that has seen key areas of the stock market diverge.

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Financials are getting a lift from higher bond yields and a widely held belief the incoming Trump administration will relax financial regulations, while industrials are rallying over hopes for stronger economic activity and greater spending on infrastructure.

However, stocks that tend to lag when bond yields are rising – making dividends less appealing – are indeed performing poorly.

This divergence is working well for the Dow. Mr. Golub pointed out the Dow's exposure to industrial stocks is 9.4 per cent higher than the S&P 500's exposure to the sector. The Dow's exposure to financials is 3.3 per cent higher and Goldman Sachs Group Inc. is the top-weighted stock in the index, given its triple-digit share price.

But the Dow is relatively underexposed to consumer staples, REITs and utilities, which are now struggling.

The Dow has outperformed the S&P 500 before, of course. Given its tilt toward older, bigger companies, the Dow tends to do better when markets are turbulent, which is why it beat the S&P 500 by 12 percentage points from 2000 to 2010 (not including dividends).

It underperforms during ripping bull markets, when smaller, nimbler companies are doing better than the lumbering behemoths. For example, the Dow lagged the S&P 500 by 10 percentage points between 2014 and October, 2016 (prior to the U.S. elections).

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At the very least, the spread between the performance of the Dow and the S&P 500 should provide an indicator of how the market is digesting the policies of the Trump administration, Mr. Golub suggested.

If the past three months is any indication, the Dow is on side with the Donald.

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