What’s a Better Measure? The Dow or S&P 500?
April 6, 2009
By Ron DeLegge, Editor

SAN DIEGO (ETFguide.com) – Which is the better measure of U.S. stocks? Is it the Dow Jones Industrial Average or is it the Standard & Poor’s 500 ?

Each day both benchmarks are widely quoted in the financial media as key barometers for the performance of U.S. stocks. And while both the Dow Industrials and S&P may be adequate measures of U.S. stocks, investors wanting to build a portfolio that accurately represents the total U.S. stock market might want to look elsewhere. 

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

Stocks within the DJIA are selected by editors of the Wall Street Journal. There are no pre-determined criteria except that components should be established U.S. companies that are leaders in their industries. Even with this relatively simple mandate for selecting stocks, the Dow’s membership ranks have been rocked.

Over the past year, faltering stock prices have been the Dow’s Achilles’ heel.

Major Dow members like Alcoa (NYSE:AA), Bank of America (NYSE: BAC), Citigroup (NYSE: C) and General Electric (NYSE: GE) have seen their share prices crushed to under $10. American International Group (NYSE: AIG) got the boot and with bankruptcy looming, General Motors (NYSE: GM) looks to be next.

John A. Prestbo, Editor and Executive Director, Dow Jones Indexes says, “The role of the Dow Jones Industrial Average is to measure the U.S. stock market and by extension the U.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.”

Other Blue Chip components contained within the Dow are Kraft Foods (NYSE: KFT), International Business Machines (NYSE: IBM) and The Home Depot (NYSE: HD).

Because the Dow weights companies by their stock price, this makes it the very first fundamentally weighted measure ever invented. ETFguide’s Index Strategy Maps are a visual tool that explains to investors how stocks are being selected and weighted within an index. (See graphical image below.)

A Diversified Approach
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. Although the S&P 500 is supposed to represent large company stocks, many of its members have actually become mid cap stocks due to the stock market’s slide. 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 of U.S. stocks.

Dow vs. S&P 500
The Dow’s obvious advantages over the S&P are its longer history of 113 years versus 52 years. As the oldest barometer of U.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 of U.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 cap U.S. stocks.

Even Broader Measures
When it comes to choosing the financial products that track the Dow and S&P’s performance, there are many choices. The $31 billion Vanguard 500 Index Fund (NasdaqGM: VFINX) 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 or ETFs like the SPDRs S&P 500 (NYSEArca: SPY) and Dow DIAMONDS (NYSEArca: DIA) are popular choices. SPY has around $62 billion in assets and the DIAMONDS have just over $7 billion. Unlike mutual funds, ETFs offer the flexibility of intraday trading, options, leveraging, and shorting.

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

Summary
In the past, the Dow’s performance has been helped by its lower exposure to sinking financial stocks. However, with so many of the Dow’s companies engulfed in financial turmoil, the turnover of its membership ranks is higher than it’s been historically.

In the end, deciding which U.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.

--Index Strategy Map for the Dow Jones Industrial Average (NYSEArca: DIA)