Arbitrary Price Weighting
Wim Grommen has been claiming for years that the Dow Jones Industrial Average is a sham, because it is manipulated to push up the market.
Investment manager and writer Barry Ritholtz notes today:
The venerable Dow … remains deeply flawed in its methodology, driven rather arbitrarily by the price weightings of its constituents rather than their market values.
You can see how this affects the weighting of each component in the index. Companies with higher stock prices such as Visa and Goldman Sachs have a 9.7 percent and 6.7 percent weight, respectively, while lower-priced stocks such as Cisco Systems and General Electric are merely 1.05 percent 0.91 percent, respectively. Why Goldman Sachs, with an $84 billion capitalization, matters more to the Dow than General Electric, with a $257 billion capitalization, is rather mystifying. A high-priced, smaller company carrying more weight than a lower-priced, bigger company makes no sense.
Not only that, but it is an actively selected — though not actively traded — portfolio, managed by a group of editors. Originally these editors were employees of Dow Jones, the company, but since 2012 the index has been 73 percent owned by McGraw Hill Financial. The CME group, which had purchased the index from Dow Jones in 2010, owns 24.4 percent; Dow Jones retains the remaining 2.6 percent stake.
What qualifies a company to be included in the Dow? According to the DJ Index fact sheet, a “stock typically is added only if the company has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors.” (The full history of additions and deletions can be seen here). But that description is so broad as to be almost useless. There are hundreds of companies with those qualifications.
Based on their track record, the editors in charge of selecting Dow components don’t really seem to have a firm grasp on what stocks are worth watching or are reflective of the state of U.S. financial markets and the economy. That’s why investors pay less and less attention to the Dow index.