Index Investing - Better Off With Dow Or S&P 500?

• By Ron DeLegge
• On 12:22 pm EST, Monday December 8, 2008

SAN DIEGO (ETFguide.com) - Which is the better measure ofU.S. stocks? Is it the Dow Jones Industrial Average (DJIA) or is it the Standard & Poor's (S&P 500)?

Before we get to the answer, here's a short history lesson on how each of these majorU.S. stock benchmarks came to be:

The DJIA was created by Charles Dow on May 26, 1896. The original DJIA was a simple average of stock prices, but today's it's price-weighted. This means that the highest priced stocks will have a greater impact on the Dow's movement.

John A. Prestbo, Editor and Executive Director, Dow Jones Indexes says, 'The role of the Dow Jones Industrial Average is to measure theU.S. stock market and by extension theU.S. economy.' Prestbo continues, 'The Dow 30 include some of the largest, established and well-known companies in American business and that are leaders in their respective industries.'

Stocks within the DJIA are selected by editors of the Wall Street Journal. There are no pre-determined criteria except that components should be establishedU.S. companies that are leaders in their industries. 

Some of the 30 blue chip companies contained within the Dow are Kraft Foods (NYSE: KFT - News), International Business Machines (NYSE: IBM - News) and The Home Depot (NYSE: HD - News). 

ETFguide's Index Strategy Maps are a visual tool that explains to investors how stocks are being selected and weighted within an index. (See figure) Since the Dow weights companies by their stock price, it is the first fundamentally weighted measure ever invented.

The S&P 500 began publishing its results in 1957 and follows a basket of 500 stocks. The index is composed of large company stocks. According to S&P, companies with market caps larger than $4 billion can be included as index components.

The S&P weights companies by their market size, meaning stocks with the largest market caps dominate the performance of the index. S&P's index committee makes the decisions about which stocks get included inside the S&P 500's membership.

Even though the Dow and S&P both have committee members that decide which stocks enter and exit their respective barometers, both measures are using passive strategies to select companies.

Many large cap mutual fund managers will benchmark their performance to the S&P 500 rather than the Dow. The primary reason for this is because the S&P is a broader measure ofU.S. stocks.

Dow vs. S&P 500

The Dow's obvious advantages over the S&P are its longer history of 112 years versus 51 years. As the oldest barometer ofU.S. stocks, the Dow has also stood the test of time.

The disadvantages of the Dow are that it doesn't give a broad representation ofU.S. stocks, like the S&P 500. Also, the Dow's weighting methodology, according to some observers, is antiquated.

According to Rick Ferri, CFA at Portfolio Solutions the Dow has several problems. 'It's only 30 stocks selected by Editors of the Wall Street Journal and their price-weighting doesn't mean much,' says Ferri.

Ferri believes that the S&P 500 is a better measure of large capU.S. stocks.

Who follows what?

When it comes to choosing the financial products that track the Dow and S&P's performance, there are many choices. The $41 billion Vanguard 500 Index Fund (NasdaqGM: VFINX - News) is a favorite among mutual fund investors. The fund's initial launch was spearheaded in 1976 by the legendary John C. Bogle.

For others, exchange-traded funds (ETFs) like the SPDRs S&P 500 (AMEX: SPY - News) and Dow DIAMONDS (AMEX: DIA - News) are popular choices. SPY has around $78 billion in assets and the DIAMONDS have just over $9 billion. Unlike mutual funds, ETFs offer the flexibility of intraday trading, options, leveraging, and shorting.

Even Broader Measures

Despite the fact that the Dow and S&P get most of financial media's spotlight, other broader measures of domestic stocks offer more complete exposure. These benchmarks include the DJ Wilshire 5000 (AMEX: TMW - News), the MSCI US Broad Market Index (NYSEarca: VTI - News), and Russell 3000 (NYSEarca: IWV - News). Each of these indexes includes a mix of large, mid, and small company stocks.

Summary

This year the Dow's performance has been helped by its lower exposure to sinking financial stocks. The Dow has around 6.5% exposure to financial shares whereas the S&P's exposure is roughly 12.5%.

In the end, deciding whichU.S. barometer of stocks is better for you is a matter of personal taste. But before you make a final decision, know the advantages and disadvantages of each. This will help you to make informed investment decisions that help you to accomplish your financial goals.

Buzz up!