Understanding And Playing The Dow Jones Industrial Average

By Troy Adkins AAA

The Dow Jones Industrial Average (Dow or DJIA) is one of the most closely followed stock market indexes in the world. Although the Dow is watched by millions of people on a daily basis, many of its viewers neither understand what the Dow really measures or represents, nor do they understand how to capitalize on the information provided to them. Let's look at the structure of the Dow, an important type of investment vehicle that replicates the performance of the Dow, and three investment strategies you can use to bolster your investment knowledge, experience and net worth.

Structure of the Dow Jones Industrial Average
The DJIA was created in 1896, and it is the second-oldest stock market index in the U.S. Only the Dow Jones Transportation Average has a longer history. The DJIA consists of 30 large-cap blue chip companies that are, for the most part, household names. Ironically, the DJIA is no longer a true proxy for the industrials sector, because only a fraction of the companies that make up the Dow are classified as industrials. The remaining companies are assigned to one of the remaining sectors found in the Global Industry Classification System. The only sector that is not represented by a company in the DJIA is the utilities sector.

As of April 30, 2013 – The DJIA sector allocation looks like this:

  • Industrials:                          20.41%
  • Consumer Services:           16.36%
  • Technology:                        15.58%
  • Health Care:                       11.45%
  • Financials:                          11.13%
  • Oil & Gas:                           10.92%
  • Consumer Goods:               6.16%
  • Telecommunications:           4.73%
  • Basic Materials:                   3.26%

In addition to the sector diversity of the Dow, further diversification is provided by the multinational operations of its constituents. This means that investors can gain indirect exposure to the international markets, and use the global diversification of the companies in the index to hedge against the negative impact of a weak U.S. economy. Moreover, the companies that make up the Dow generate a significant amount of revenue each year. This helps to reduce the business risk of the companies that make up the index.

Criticism of the Dow Jones Industrial Average
While the DJIA has many excellent attributes, one of its biggest criticisms stems from the fact that it is a price-weighted index. This means that each company is assigned a weighting based on its stock price. In comparison, most companies that make up an index are weighted according to their market capitalization. The S&P 500, an index that is different from the DJIA in many ways, is a good example of this. As you can assume, there would be a significant difference in the weighting of the companies in the Dow if the index committee used market capitalization instead of stock price to structure the index proxy. That said, there is really nothing that makes a price-weighted index inferior to a market cap-weighted index, or even an equally-weighted index or a revenue-weighted index. This is because the idiosyncratic nature of each index construction methodology has many strengths and weaknesses that make it difficult to reach consensus on the best methodology to use.

An Important Distinction Between Risk and Volatility
When analyzing the performance of the Dow, it is important to keep in mind that it is considered by some to be a volatile index. Therefore, many investment professionals will not typically recommend investing in products that track the DJIA. That said, there is a significant difference between the business risk of the companies that make up the Dow and the volatility of the index. This is because the companies that make up the DJIA represent 30 of the most well-established companies in the world. Therefore, their business risk is relatively low because it is very unlikely that they will go bankrupt. Nevertheless, the stock price of these companies can fluctuate greatly over short periods. As a result, investment products that replicate the performance of the Dow can experience significant short-term gains and losses.

A Better Investment Vehicle for Today's Market Environment 
Given the highly unpredictable and volatile markets that investors have experienced over recent years, exchange-traded funds (ETFs) should be considered the new investment vehicle of choice. ETFs are ideal products because they trade on a real-time basis, they have a low tracking error in relation to the index, their exposure to the market can be hedged through the use of put and call options, they can be margined in order to leverage performance, they can be sold short, they are tax efficient, they require a minimal amount of cash to employ and they are inexpensive. Given these features, ETFs have a significant structural advantage over mutual funds because they are more flexible and empower investors with more options for dealing with market uncertainty.
Old Investment Strategies for New Investors
Investors must understand that there is the potential for extreme losses if they invest in products tied to the Dow. Therefore, the following strategies are not for inexperienced investors who want to use an "invest and forget it" approach to investing. That said, if you have an interest in investing, and are willing to take the time and effort to learn more about it, there are a host of strategies that you can use that are superior to the strategies touted by most financial advisors. However, these strategies also require a change in philosophy - from the simple buy-and-hold mentality, to strategies that have a much shorter time horizon. The following is an example of three such strategies:

Protective Put
A protective put strategy consists of a long position in a Dow ETF and the purchase of put options on the same underlying ETF. This strategy will pay off if the DJIA goes up, and will protect your investment if the DJIA goes down.

Short Selling
In contrast, investors can implement a protective short selling strategy by selling short the Dow ETF and buying call options on the same underlying ETF. This strategy will pay off if the DJIA goes down and will protect your investment if the DJIA goes up.

Covered Call
Finally, investors can generate a modest premium on top of a long Dow ETF position by implementing a covered call strategy. This strategy entails buying the DJIA ETF and selling call options on the same underlying ETF. This strategy will profit if the Dow remains relatively flat, and does not exceed the strike price of the call options sold. That said, there is no downside protection provided by a covered call strategy, so investors must be confident that the Dow is going to remain flat before implementing this strategy.
The benefit of these strategies is that investors can select the amount of risk that they want to take, or the extra premium that they want to receive, by establishing the strike price on the put or call options that they use. As you can see from these examples, derivatives can be used to mitigate or eliminate the risk of loss on an investment, and they can be used to generate a modest risk-free rate of return. Based on these strategies alone, it should be clear that derivative instruments are not "weapons of financial mass destruction" - at least not if they are used appropriately by competent investors.

Now that your focus is on the Dow, and you know the type of investment vehicle that you should use and the appropriate investment strategy to use in each type of market environment, the next two questions that you should ask are: "How can I determine if the current level of the DJIA is undervalued, fairly valued or overvalued, and how can I determine which direction the DJIA is likely to move?"

Unfortunately, there is no sure way to forecast the future direction of the markets. However, investors can assess the premiums associated with the options tied to the Dow ETF to gauge the current view of the anticipated volatility in the market. This determination should be based on the cost of the options, where higher option premiums are indicative of higher implied volatility in the market. In addition, investors can use the cost of the options tied to the Dow to determine the breakeven amount on the DJIA ETF. By using these approaches, investors can determine if the current risk in the Dow merits market participation. Moreover, if you are willing to take the time to analyze the historical range of the stock prices associated with the components that make up the Dow, and then review the market multiples of the companies that make up the Dow, you should be able to accurately gauge the valuation level of the index, and therefore, its potential volatility. Finally, by using this approach, you should also be able to gauge the direction the Dow is trending, the appropriate strategy to employ and the risk and potential profit that you stand to make over your investment time horizon.

The Bottom Line
Individual investors who want to increase their investment knowledge, gain more hands-on investment experience and take control of their personal investment responsibilities should consider investing in an ETF that is tied to the Dow Jones Industrial Average. By following these strategies, not only will you increase your investment knowledge well above most investors, you will also likely develop a constructive hobby that will pay off with many direct and indirect future benefits.

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