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What Do Changes to the Dow Mean for Investors?

US News & World Report -  Money logo US News & World Report - Money 9/18/2020 Paulina Likos

A shakeup occurred in August to one of the most popular U.S. stock market indices: the Dow Jones Industrial Average. Oil giant Exxon Mobil Corp. (ticker: XOM), aerospace and defense manufacturer Raytheon Technologies Corp. (RTX) and pharmaceutical company Pfizer (PFE) were kicked out of the blue-chip index last month – the first restructuring to the index since Walgreens Boots Alliance (WBA) replaced General Electric Co. (GE) more than two years ago.

Changes to the DJIA are significant when trying to understand how it impacts future Dow performance as well as what it means for stocks in the index and the ripple effect on investment portfolio returns. Here are a few things to know:

  • Dow's composition.
  • Performance of companies in and out of the index.
  • What do changes mean for investors?

Dow's Composition

Changes to the Dow needed to be made because of Apple's (AAPL) 4-for-1 stock split, which means for every existing share, an investor now has three additional AAPL shares. This split resulted in each share going from roughly $400 to $120 but did not impact the value of the stock. In its announcement, Apple said it implemented the split to make the stock "more accessible to a broader base of investors."

AAPL carried a big portion of the weight in the Dow, and its high price influenced the appreciation of the index. The split has recalibrated the index and reduced AAPL's impact on the index's direction. The stock represented around 12% of the index; it's now less than 3% and only the 18th-largest component of the index.

Apple is the only one of the FAANG stocks in the Dow, which is underweight in technology compared with the S&P 500, which holds many of the Big Tech stocks in its index.

Salesforce (CRM), a cloud-computing company covering the information technology sector, replaced Exxon. Amgen (AMGN), a biotechnology company covering the health care sector, took Pfizer's place. Honeywell International (HON), a company that delivers aerospace products, control technologies and performance materials to specific industries covering the industrials sector, replaced Raytheon Technologies.

The motive behind the Dow changes was to have a more representative mix of U.S. companies. These changes will help "diversify the index by removing overlap companies of similar scope," according to the S&P Dow Jones news release, along with balancing out the disruption caused by Apple's price appreciation.

"After the Dow's changes, there will also be some significant shifts in sector weightings for the DJIA," says Chuck Etzweiler, chief research officer and senior vice president at Nepsis in Del Mar, California.

"Technology will still have the largest weighting at 23.1% but will still see its share of the index declined by the largest amount (4.6 percentage points)," he says.

Performance of Companies In and Out of the Index

The exchange of the companies listed in the Dow may lead to changes in the index's performance and will likely serve the companies that were added to the index well, but the same cannot be said for the companies removed from the index.

The companies that were replaced were dampening the DJIA's overall performance. Exxon's performance has been dwindling. After peaking at more than $100 per share in July 2014, the stock started its steady descent to its current price of around $37. XOM is down about 47% for the year, and with the energy sector facing uncertainty as a result of the health crisis, there are major challenges the energy sector must grapple with that may continue to impact Exxon's performance.

Raytheon Technologies is no doubt a big player in the industrials sector, but it supports the aerospace industry, and with air travel drastically hit from the pandemic, the company has taken a few blows. Most recently, Raytheon announced 15,000 job cuts at its subsidiaries, Collins Aerospace and Pratt & Whitney, due to the steep decline in air travel.

Pfizer and Merck & Co. (MRK) were competing in the pharmaceutical space in the Dow. Comparing both pharma companies' historical performance, MRK's steady price growth over the years leading to its current stock price of about $85 beats PFE's at around $36. Since price is most important for the DJIA, Pfizer's booting from the index makes sense. Amgen, on the other hand, has been growing for years and compared with PFE stock, AMGN's share price of about $248 is a much better competitor and better suited per Dow standards.

"The DJIA Committee seeks to best represent the U.S. economy by placing the 30 most relevant companies in the index," Etzweiler says.

However, he continues, with that effort comes the underlying and little-known secret of not placing highly priced stocks in the index to sway the index in one direction or the other – such as Apple did.

"This is why, unless a stock split occurs, Berkshire Hathaway (BRK.A), Amazon.com (AMZN), Chipotle (CMG), and Alphabet (GOOG, GOOGL) will likely never be added to the Dow," Etzweiler says.

What Do Changes Mean for Investors?

Changes to the Dow don't have a critical impact on investors. If you're an exchange-traded fund investor that tracks the Dow, your portfolio may experience some swings, but this comes naturally as the economy evolves.

"The fortunes of the investor in a Dow Jones Industrial Average ETF will rise and fall with the new economy stocks Salesforce, Amgen and Honeywell and will not depend upon old economy stocks like Exxon, Pfizer and Raytheon," says Robert Johnson, professor of finance at Creighton University.

At the time of this writing, the SPDR Dow Jones Industrial Average ETF Trust (DIA) was priced around $277 per share, which is close to its trading price ($288 per share) at the start of the year. It reflects that, overall, there hasn't been too much price movement for the fund, despite the composition change.

But there may be some impact on the investors who owned the companies that were booted from the Dow. Within the last month, PFE is down 5%, XOM is down 9% and RTX is slightly up at 2.5%. But for most investors, the Dow's changes likely don't impact much in their portfolios, says Jason Blackwell, chief investment strategist at The Colony Group in Atlanta.

"While the DJIA is a frequent topic of conversation, few funds try to track it. About $28 billion of assets are in indexed products which track the Dow, while $4.6 trillion track the S&P 500," Blackwell says.

Copyright 2020 U.S. News & World Report

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