In the last week of August, the Dow Jones Industrial Average announced that it was making its largest component reconstitution since 2013.  The decision was triggered by Apple's recent stock split announcement, but the management of the index also made changes to sector weighting to reflect the evolving American economy.

Index reconstitutions are interesting events that can impact returns for index funds and influence demand for both new entrants and those stocks exiting.

Digital board with stock price changes in blue

Image source: Getty Images.

Shaking up the Dow Jones

The Dow is comprised of 30 stocks, which are weighted by share price rather than market capitalization. Under this methodology, a $100 billion company with $50 shares could theoretically influence the index performance as much as an identically priced $2 billion company. Apple's 4:1 stock split, effective August 31st, means that its weighting in the Dow was quartered to only 3.4% of the index. It was previously the heaviest-weighted stock. This also reduced the Dow's exposure to the tech sector from 27% to 23%, which has been on fire throughout the COVID-19 recovery. Constituent swaps occur fairly regularly, but the latest is a particularly sweeping change.

The average added (NYSE:CRM), which is trading above $240, making up some of the gap from the split tech giant. Amgen (NASDAQ:AMGN) and Honeywell (NYSE:HON) were also added, while Pfizer (NYSE:PFE), Raytheon (NYSE:RTX), and ExxonMobil (NYSE:XOM) were removed. This increases the Dow's overall exposure to healthcare and industrials at the expense of energy and tech. Chevron is the lone remaining energy company among the 30.

Index funds will be impacted

The rebalancing is going to directly influence future returns of any index funds that track the Dow, which are fairly popular in passive portfolios. Since the announcement, the Dow has lagged the S&P by 160 basis points and Apple by 480 basis points.

Index funds could also incur higher expenses due to trading costs to rebalance and reconstitute, and these expenses are passed along to shareholders. These are likely to be relatively minor, but some return erosion is still likely, especially with changes of this magnitude.

Effects on individual stocks

There is a wealth of academic and industry literature covering the performance of stocks that enter and exit indexes, and there are even trading strategies based on index arbitrage. Theoretically, there are supply and demand ramifications following an inclusion or exclusion event. Index tracking funds are forced to buy or sell according to the reconstitution, impacting the market in the short term, and potentially locking up some supply of a given stock over the long term.

The evidence for this effect is mixed. The performance for individual constituents have varied depending on the index in question, the weighting of a given stock, and the prevalent trading strategies across the time frame studied. For example, entering the Russell 1000 as one of the smallest cap-weighted companies seems not to create a substantial increase in demand. However, inclusion or exclusion from the Russell 2000 is shown to have an larger effect on price returns. There appears to be a similar impact for the S&P 500, but a thorough analysis indicates that any changes in share performance could be attributed to the corporate results and market returns which motivated reconstitution in the first place.

In this specific case, the post-announcement results appear to have been impacted by the Dow's announcements. All the new entrants saw meaningful jumps at the start of trading following the news-Honeywell is up 7.3%, Amgen rose 4.4%, and is up 18.7%, primarily due to a strong earnings report. Meanwhile, Raytheon is up 2.7% after intially falling 1.6%, Pfizer is down 3.9%, and ExxonMobil has lost 10.4%.

The evidence would suggest that these are headline-driven, short-term impacts and that individual company performance is related to a more complicated set of drivers. Pfizer and Raytheon aren't fundamentally inferior to Amgen and Honeywell, but the Dow's price methodology dictated those substitutions. In contrast, ExxonMobil had been part of the average since 1928, and its removal signals the next step in an extended rough patch for energy companies, which have lagged the market substantially over the past five years. Investors should keep this context in mind before reacting to the Dow Jones reconstitution and avoid overreacting to this news as opposed to fundamentals.