What Is Your Benchmark?
Every weekday evening you are likely to hear on the radio or TV about how the Dow Jones Industrial Average (The Dow), and the S&P 500 did that day in the markets. The S&P 500 and the Dow Jones Industrial Average are two widely recognized benchmarks used to gauge the performance of the stock market in the United States. While both indexes provide insights into the overall health of the market, there are some key differences between them.
History:
The Dow was created in 1885 to track 12 of the nation’s biggest companies. The index today consists of 30 blue chip stocks. It was initially designed to track the performance of large industrial companies but has evolved to include names from various sectors (excluding transports and utilities). The criteria for a company to get on the Dow are somewhat vague. The companies are leaders in their industries and all are very large. The components in the DJIA do not change often as a committee does not take changes lightly. If the index comes up for review, the members of the committee may replace more than one company at a time. When the Dow was created in 1885, well before computers, the only way to calculate a market indicator was to add up its components’ share prices and divide by the number of components. So that’s what Charles Dow did.
However, by 1956, when the S&P 500 was launched, technology had advanced to the point that S&P could base stock weightings in the index on total stock market values rather than on share prices. The stocks in this index are from all sectors of the economy and are also selected by a committee. To be selected, stocks must have a market cap of
$14.6 billion or more, have a public float of at least 10%, have positive earnings for the most recent four quarters, and have adequate liquidity as measured by price and volume.
Composition:
One of the largest differences between the two indexes is the difference in composition and number of securities. The S&P 500 consists of 500 of the largest U.S. companies, representing a significant portion of the total market capitalization in the country. It covers a broader range of industries and sectors, providing a more comprehensive view of the over- all stock market. On the other hand, the DJIA comprises 30 large, well-established, blue-chip companies selected from various sectors.
The S&P 500 is often considered a broader and more representative benchmark of the U.S. stock market due to its larger number of constituent companies across various sectors. The DJIA, with only 30 companies, is seen as a measure of household names of the largest blue-chip companies.
Weighting Methodology:
Perhaps the biggest difference between the two indexes lies in how they weight companies to calculate the total index price. In the S&P 500, companies with higher market values have a greater impact on the index’s performance. In other words, the largest companies have the greatest weight in the index thereby having the greatest influence on the overall level of the S&P 500.
In stark contrast to the S&P 500, the Dow still maintains its general methodology from the 1880s, where the stock prices of its constituent companies determine their influence on the index. This means that the higher-priced stocks can have a more significant impact, regardless of the company’s size. However, we know that prices do not have any significance as to the size of the company, as companies can issue more shares, or split their stocks, etc. (Google and Amazon both split their stocks 20 for 1 last year which has no impact on the valuation of the company – you just end up with 20 times your previous shares at 1/20th the previous price).
For example, United Health Care has a stock price of around $460, the highest priced stock of the 30 stocks in the Dow. This results in a weight in the index of 9.3%. Apple on the other hand, has a price of around $178, the 12th highest stock price in the Dow, which results in a weight of 3.7%. Apple, our country’s most valuable stock, has a market value more than five times United Health, which means that it has the highest weight in S&P 500 with 7.4% due to the market cap weighting methodology in the S&P 500.
Due to this differentiation in methodology, there can be divergent movements in the two indexes, just as there are this year. Year to date the S&P 500 is up 16.9% while the Dow is up only 4.9%. This year’s divergence is largely due to the large tech names in the S&P 500 which have soared this year. The seven largest constituents of the S&P 500, Apple, Microsoft, Alphabet, Amazon, NVIDIA, Tesla and Meta are all up significantly so far this year (with year-to-date returns ranging from 42% to 190%). Without those seven names, which comprise 27.6% of the S&P 500, the index would be up only 5.8%; much closer to the Dows return of 4.9%.
The S&P 500 is generally favored over the Dow by the in- vestment world for the reasons mentioned above, method- ology, composition, and a much larger number of securities. It’s worth noting that both indexes are useful tools for investors and provide insights into the overall market performance. However, due to their differences in composition and weighting methodology, they may occasionally exhibit divergent movements. As such, investors often consider multiple benchmarks (beyond just the Dow and S&P 500) to gain a more comprehensive understanding of market trends and dynamics.
One such benchmark is the Morningstar US Large-Mid Cap Total Return Index which illustrates the performance and fundamental characteristics of the large-mid cap segment of the U.S. equity market. This Morningstar Index is comprised of 672 holdings and similar to the S&P 500, the top ten holdings represent 29% of the index. Morningstar conducted a study on the net contribution of the top constituents in their US Large-Mid Cap™ Index:
If you ever have any questions about the benchmark your portfolio is measured against, please give us a call!
