The Devil is Always in the Details

The devil is always in the details.  This is as true in index-based investing as it is in life.  Take for example the unfortunate airline crash this past Sunday of a Boeing 737 Max 8 aircraft operated by Ethiopian Airlines.  It is the second such crash in the past 5 months and has rightfully turned attention to the possibility of equipment issues or training failures.  Aside from the human tragedies in these circumstances, there are also economic issues to consider.  Is Boeing liable for any issues related to a faulty flight control system or not providing appropriate training to pilots on the new system that might have contributed to the crashes?  Will Boeing have cancellations on the thousands of planes on order that comprise a significant portion of its expected future profitability?  As might be expected, the stock price (ticker BA – $422 pre-accident March 8th) fell about 11% this week ($378 March 15th) on the uncertainty (but is still up 17% year-to-date).  For all involved, we hope that there are swift solutions on all sides to safeguard any further loss of life.

But the details we speak of are related instead to the difference between two major indices often trumpeted in the media – the Dow Jones Industrial Average (DJIA) and the S&P 500 (SPX).  

First the similarities.  Both are seen as gauges about how the general stock market is doing, as benchmarks by which investors judge stock-picker performance, and are tracked by index-based investment funds.  Both are also owned and administered by Standard & Poor’s (rebranded into S&P Global), seek a set number of stocks (30 for the Dow, 500 for the S&P 500), have eligibility requirements to qualify, and ultimately rely on a discretionary judgement by a selection committee to approve the final list.      

The biggest difference (amongst a few) is that the Dow Jones Industrial Average (DJIA) is “price-weighted” versus the S&P 500 (SPX) being “market capitalization” weighted.  What does that mean?  It means that the percentage weighting of a stock in the DJIA is determined by its stock price per share rather than the total equity value of the business.  It is one of the early lessons of investing that the price per share of a stock has no real informational value.  Management can easily choose to do a stock split or a reverse split to adjust the price per share lower or higher (respectively) without changing the fundamental value of the business one bit.  

So, by having the DJIA index being price-weighted means that the index is constructed using a metric (share price) that has no informational value.  For an unfortunate owner of a DJIA based indexed fund (like ticker DIA that has over $20bln in assets under management), Boeing stock has an 8%+ weighting in the index (#1 holding) versus the SPX where it is only 0.8% (#25 holding).  In fact, the gap in performance between the two indices this week due to Boeing explains almost the entire difference for the year-to-date.  

The point is that a fundamental part of risk management is to know what you own.  Index funds are useful tools for investors, but do not let the ease of buying basket-securities be a temptation to lose sight of the details.