Three of the 30 stocks that make up the Dow Jones Industrial Average will be replaced at the end of this month. Standard & Poor's, which manages the blue-chip index, announced on Monday that current constituents ExxonMobil (XOM -0.83%), Pfizer (PFE -0.85%), and Raytheon Technologies (RTX 0.82%) will be swapped out with (CRM 1.65%), Amgen (AMGN 0.05%), and Honeywell International (HON -1.71%), respectively.

Updates of the Dow's components aren't unusual. Not including changes stemming from mergers and acquisitions, Standard & Poor's altered the Dow's components most recently in 2018 when it replaced General Electric with Walgreens Boots Alliance. Like the recently announced restructuring, that one was ultimately intended to make the Dow a more accurate cross-section of the U.S. market.

Still, when 10% of an entire index's holdings are scheduled for replacement in one sweeping move, it could lead buy-and-hold investors that own Dow-based index funds to wonder how much buying-and-holding they're really able to do with those instruments. If that's you, don't worry. The overdue move actually makes it more comfortable for long-term investors to own Dow-based ETFs and mutual funds.

Investor sitting at desk examining pie chart of a stock portfolio's diversification

Image source: Getty Images.

It's complicated

The announcement from Standard & Poor's explains:

The index changes were prompted by DJIA constituent Apple Inc.'s decision to split its stock 4:1, which will reduce the index's weight in the Global Industry Classification Standard (GICS) Information Technology sector. The announced changes help offset that reduction. They also help diversify the index by removing overlap between companies of similar scope and adding new types of businesses that better reflect the American economy.

The explanation touches on something not fully clarified within the announcement. Unlike most other indices that assign a "weight" -- or degree of influence -- to a holding based on that company's total capitalization, the Dow Jones Industrial Average is a price-weighted index. For example, constituent shares priced at $100 apiece cause more net change for the Dow than shares of a $50 stock do, even if that $100 stock represents a smaller organization. It's entirely possible the smallest name in the Dow (as measured by market cap) could still make the biggest impact on the index's daily point changes if that company's stock was the highest-priced ticker among the 30 that make up the Dow Jones Industrial Average.

In other words, the pricing methodology used creates a situation where the Dow isn't necessarily an accurate, collective reflection of the stock market's most established names.

Strange circumstances

That's not been the case of late. If anything, the index has been skewed for the exact opposite reason. The Dow's (and the world's) biggest company, Apple, also happened to be the highest-priced component for quite some time before its split announcement. The 4-for-1 split will drastically reduce the high degree of influence that Apple's stock has on the Dow in the future.

That's a good thing in that it will reduce the index's overall day-to-day volatility, but that big change alone would also mean a sudden and significant shift in the Dow's diversification and reflection of the broader market. By removing Exxon, Pfizer, and Raytheon and adding Salesforce, Honeywell, and Amgen, Standard & Poor's is also trying to restore some much-needed sector balance for the index. That will curb some of the Dow's prospective volatility without necessarily crimping its performance.

It's also worth noting ExxonMobil and Raytheon have been two of the Dow Jones Industrial Average's weaker performers since this time last year -- a subpar performance that's perhaps linked to the COVID-19 pandemic. Regardless of the reason, their foreseeable futures don't look much different than their recent pasts. The removal of these laggards may allow the Dow Jones Industrial Average to close the performance gap between it and the S&P 500.

Bottom line

For investors holding index-based holdings like the SPDR Dow Jones Industrial Average ETF Trust (DIA 0.18%) or the Vanguard 500 Index Fund (VFINX -1.20%), these big changes raise questions. The underlying strategy of passive, index investing is owning a broad piece of the market's best names for the long haul and letting time do the work for you. Now, as was noted, 10% of your portfolio is slated to be replaced in one fell swoop and there's nothing you can do to prevent it. The move may mean shedding some names you'd prefer to continue owning at this time. Maybe you liked the Dow's mix as it was: heavy on Apple, pharmaceuticals, energy, and defense, but light on tech, biotech, and industrials. Maybe you're not a fan of Amgen, which posted encouraging quarterly numbers in July, but otherwise hasn't been a high-growth machine of late.

The point is, the Dow's character will change. Perhaps it won't change dramatically, but its sector makeup has changed in a way that could impact its performance going forward.

If that's your concern, put it to rest.

If anything, these sizable changes to the Dow's makeup were actually overdue. The Dow has been less-than-ideally balanced for a while without most investors even realizing it. Apple's shares have been priced at unusually high levels for some time now. Energy name Chevron will still be a Dow component, and given that the oil and gas industry may never again be what it once was, one such name may be enough. Pfizer will be taken out of the DJIA, but drug company Merck remains. There's no biotech/biopharma stock of Amgen's ilk in the Dow right now, but there arguably should be. Raytheon will be shed, but Boeing will still be a component of the index. Perhaps most ironic is that, without the impending addition of Honeywell, there would still be no factory-centered industrial name in the Dow Jones Industrial Average.

Standard & Poor's moves, planned for the end of this month, will ultimately make the Dow a better-balanced, more diverse index.