A Simple Way to Beat the Dow?

The Dow Jones Industrial Average (INDEX: ^DJI) is one of the oldest measures of the stock market still in use today. But if the Dow's idiosyncrasies are causing to lose money, then don't you owe it to yourself to think about investing in Dow stocks a different way?

With exchange-traded funds, investing in the Dow has never been easier. But some argue that it emphasizes some stocks unfairly while virtually ignoring others. So I'll take a look at another way to invest in Dow stocks and ask whether it can bring you even better returns. First, though, let's try to understand what it is about the Dow that creates this potentially exploitable opportunity.

The ultimate in simplicity
The beauty of the Dow is that unlike most market benchmarks, it's easy to calculate. You don't need to know what each company's market capitalization is, and you don't need to look at financial statements to figure out earnings, dividends, or any other fundamental information about the company. All you need are 30 share prices and a fudge-factor known as the Dow divisor to figure out the current level of the Dow at any particular time.

But that lack of additional information rubs some people the wrong way. Because price is the only factor it incorporates, the Dow gives high-priced stocks more weight than lower-priced ones. Moreover, when a company decides to do a share split to reduce its stock price, it loses a big part of its influence in the Dow's returns.

Simpler still?
One obvious way to fix the problem would be to use a market-cap-weighted Dow, just as the S&P 500 and many other benchmarks are calculated. But then, some would inevitably argue that the small caps in the Dow were getting ignored.

Many index researchers have argued that equal weighting consistently allows you to outperform market-cap-weighted indexes. With broader-based indexes, equal weighting captures the tendency of smaller-cap stocks to outperform their larger counterparts over the long run. With the narrower Dow, however, there's no guarantee that the same phenomenon will appear -- especially since nearly all of the Dow's stocks are megacap giants.

The truth is out there
When I considered this idea last month and took a look at 10-year returns, the equal-weighted average beat the Dow. But surprisingly, a look at the more recent past reveals the opposite: The Dow has held its own against an equal-weight strategy in recent years and has soundly outperformed it over the past year. Averaging the total returns of all 30 Dow stocks and comparing the result with returns on the Dow-tracking SPDR Diamonds ETF since June 8, 2009 -- the last time changes were made to the Dow's component stocks -- showed almost identical performance with both methods.

Moreover, since last March, equal weighting has actually lagged the Dow by 4 percentage points. Similarly, the Dow's price-weighted measure did better throughout both 2010 and 2011.

What's behind the numbers?
The key to these results is in where the top performance in the Dow has come from recently. Tech behemoth IBM (NYSE: IBM) has outperformed the Dow soundly since mid-2009, as its emphasis on essential information-technology services helped it avoid some of the problems that more equipment-focused companies suffered during the recession. Similarly, although its performance has been less consistent given that it suffered a small loss in 2011, Caterpillar (NYSE: CAT) has had the best returns of any Dow stock over that nearly three-year period. That strong performance has come from two critical strategic decisions: focusing on high return-on-equity investments and being willing to take on significant leverage on its balance sheet to accelerate its growth.

By contrast, the worst performers have had relatively small share prices for a long time. Alcoa (NYSE: AA) has had problems dealing with a glut of aluminum supply at extremely low prices, which has largely kept it from enjoying the fruits of the global recovery over the past few years. And despite its recent advance, Bank of America (NYSE: BAC) suffered extreme losses as a result of its mortgage liabilities, and even since the end of the crisis, B of A in particular has struggled to get enough capital and try to get past its toxic-asset problems. Yet collectively, Alcoa's and B of A's low share prices have sheltered the price-weighted Dow from the worst of its losses -- while an equal-weighted average bears the full brunt of the companies' woes.

Keep searching
Despite its flaws, the Dow serves the valuable purpose of giving the general public a simple, easy-to-understand snapshot of the stock market. The Dow wouldn't have survived as long as it has if it didn't have some value in helping investors reach their financial goals.

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