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Factoring Down the Dow

The Dow Jones Industrial Average occupies a funny place in finance. First calculated in 1896, it is one of the oldest and most prestigious indices. People have watched its movements throughout their career. However, it is handcuffed by an archaic methodology that makes it inferior to most other indices.

First, it's comprised of only thirty stocks. This is far fewer than most modern indices and means that it might only have two stocks representing whole sectors. Much more importantly, the Dow isn't a market capitalization weighted index, nor did they pick anything rational in place of a market cap weighted index. To wit, it isn't revenue weighted, book value weighted, or even equal weighted. Instead, the stocks are price weighted. So Goldman Sachs has a 50% higher weighting than Apple, despite Apple having a market cap roughly 8 times higher that of GS.

This creates an index with curious properties, and while the financial press will cite the performance of the Dow along with the S&P 500 and Nasdaq 100, most investors learn not to take it very seriously.

But what if you wanted to take the Dow seriously? What drives its performance?

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Note: The Long side in the image above represents the DIA, and the Short side represents the top 2000 companies by market cap.

The first thing that stands out is that it is a large capitalization index, as befitting its purpose. Looking at the price to book ratio, it's interesting to see that the Dow Industrial Stocks are actually a little bit more expensive than the average US market. But contrary to this, they have a higher dividend yield. This makes sense as they are among the older and more established companies, which established a tradition of dividend payments before buybacks became a popular way to return capital to shareholders in a tax efficient manner.

Another thing to note is that Dow stocks generally have low short interest and low volatility.  Low short interest goes together naturally with large stocks and low volatility.


When we analyze the individual stocks, of which there are only 30, we can seek exceptions to the pairing of low volatility and low short interest. We see that Caterpillar (CAT) is one of these few exceptions. Its higher volatility, cyclical nature and declining sales and revenue seemingly encourages the short sellers to pile on.

The Dow’s factor exposures have generally been pretty stable.

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So while it’s kind of silly that we are still tracking a price weighted index in 2016, the creators of the index have done a good job at ensuring that it has been tracking essentially the same factors over at least the past few years.


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