Is the Dow Obsolete?

Is the Dow Obsolete? In 2005, American investors set a new record with net purchases of foreign stocks of more than $110 billion. American investors' home bias is waning, research shows that foreign shares represent about 16% of the average portfolio and many financial advisors are now recommending that their clients allocate 10%-30% of their portfolios to non-U.S. stocks and bonds. American companies have gone global in a big way and stellar returns from investing in global stock markets over the past few years has left U.S. only investors green with envy and red ink portfolios. But what is still the most-quoted market indicator in newspapers, on TV and on the Internet - the Dow Jones Industrial Index (DJIA). Let's look briefly at the history of this index, why it may be out of date and discuss a possible alternative to financial products that track it such as the Dow Diamonds (DIA). Charles Dow created in 1896 the first Dow Jones Index that included nine railroad stocks, a steamship line and a communications company. In 1916, the industrial average expanded to 20 stocks; the number was raised again, in 1928, to 30, where it remains. Charles Dow had the vision to create a benchmark that would project general market conditions and therefore help investors bewildered by fractional dollar changes. A revolutionary idea at the time, its implementation was simple. The averages were, well, plain old averages. To calculate the first average, Dow added up the stock prices and divided by eleven, the number of stocks included in the index. A special divisor other than the number of stocks is used to avoid distortions when constituent companies split their shares or when one stock is substituted for another. Today, the DJIA is a benchmark that tracks American stocks that are considered to be the leaders of the economy and are listed on the Nasdaq and NYSE. The DJIA covers 30 large-cap companies, which are subjectively picked by the editors of the Wall Street Journal. Over the years, companies in the index have been changed to ensure the index stays current in its measure of the U.S. economy. In fact, of the initial companies included, only General Electric remains as part of the modern-day average. The most recent deletions were when Kodak, International Paper, and AT&T were replaced by Pfizer, AIG, and Verizon. A few years ago, the Dow's overseers made history by adding the first two stocks listed not on the New York Stock Exchange, but on the Nasdaq: Microsoft and Intel. Since 1959, other companies added include Disney, Wal-Mart, McDonald's, and Home Depot. You may be thinking that the S&P 500 Index has overtaken the DJIA in popularity. But over long stretches, the Dow 30 and the S&P 500 have correlated closely. The S&P 500 Index is also market-cap weighted leading to an unhealthy concentration in the largest stocks. Furthermore, when the two have diverged, the S&P has been the more volatile, with higher highs and lower lows. Since January 2000, the steepest Dow decline was 30 percent, whereas the S&P 500's was 40 percent. Nor have S&P investors, at this point, been compensated for the additional risk associated with that volatility. As this is written both indexes still stand below their January 2000 levels, but the Dow's loss is milder. Because the DJIA is made up of exclusively U.S. companies and by definition focused on industrial companies, it does not accurately reflect the performance of large swaths of the U.S. or global marketplace. There are a lot of good companies in the DJIA but it is no longer a good barometer of the American economy or the typical American portfolio nor a useful index for investment vehicles to track. What's better out there? Using a simple value-based model and some horse sense, I put together in January 2003 an index of 30 companies drawn from the S&P Global 100 Index. Called the Chartwell Global 30, it contains 15 U.S. companies and 15 foreign companies weighted equally just like the Dow. In terms of sector weighting, the differences are surprisingly muted. The Chartwell Global 30 has more exposure to the medical and finance areas and less exposure to multi-sector conglomerates and industrial products. While many American multinationals are outsourcing to reduce short-term costs, many foreign companies in the Chartwell index make significant contributions to the U.S, economy. For example, about 60% of the vehicles Toyota sells in North America are built here and the Swiss pharmaceutical company Novartis has its global research headquarters in Boston. Making no changes and rebalancing on an annual basis, here are the results. In 2003, the Dow was up 3.15% and the Chartwell Global 30 was up 28.45%. In 2005, the Dow was down 0.61% and the Chartwell Global 30 was up 16.25%. One may ask if a two year test is inadequate but a back test of performance for the period 2000-2005 shows that the Dow is in negative territory while the Chartwell Global 30 is up 39%. An ETF tracking the Chartwell Global 30 will be available in 2006. The Dow Jones Industrial Average was revolutionary at inception and has a well deserved storied past that parallels the evolution of the American economy. For the era of the global economy and investor, it's time for a new revolution. Carl Delfeld is head of the global advisory firm Chartwell Partners and editor of the the "Chartwell Advisor" newsletter. He served on the executive board of the Asian Development Bank and is the author of "The New Global Investor." For more information go to http://www.chartwelladvisor.com or call 877-221-1496.