Amazon stock split exposes absurdity of the Dow Jones index

Source: Reuters

Shares of Amazon.com Inc. surged briefly last week after the company announced a stock split, a jump that defied logic to many outside observers. For practical purposes, stock splits are cosmetic and mostly immaterial: In a 20-to-1 split such as Amazon’s, each original share receives 20 new shares worth 1/20th as much. So why did the stock pop, and what does it say about this market?

My colleagues Tae Kim and Jeran Wittenstein explored several possibilities last week. But one widely floated explanation is that the split — like another one announced recently from Alphabet Inc. — will help the company get into the vaunted Dow Jones Industrial Average, the 125-year-old index of 30 blue-chip companies that is constructed using an antiquated and overly simplistic price-weighted system. Companies generally want to be in as many indexes as possible because index-tracking funds are required to buy their stocks.

However, the price-weighted Dow is an unusual departure from the popular practice of weighting by float market capitalisation, which is used by indexes such as the S&P 500. In essence, the Dow is built so that a $100 stock has twice the weighting of a $50 stock, regardless of how much fractional ownership it confers in the company.

According to the Dow’s public methodology, the “Index Committee monitors whether the highest-priced stock in the index has a price more than 10 times that of the lowest,” which is currently Intel Corp., which closed at $44.40 on March 14. Amazon ($2,837.06) has far too high a price tag and would drastically throw off the index. The same is true of Alphabet ($2,519.02).

There is, of course, a better solution: The Dow could forget tradition and turn into a float capitalisation-weighted index like the S&P 500.

In the early days of the stock market, there was value in the Dow’s simplicity. Charles Dow, its creator at the Wall Street Journal, knew that stocks were relatively new to investors. The tool he created was so straightforward that anyone could replicate it simply by purchasing a single share of each company. This had its advantages in an era before index-tracking exchange-traded funds, which offer broad market exposure to investors. But today, price weighting is just a recipe for suboptimal portfolio construction, and the Amazon episode is the latest example of how ridiculous it all is.

The Dow may be a rough proxy for the broad market, but it isn’t truly representative of it. Over time, the index was found to perform similarly to others that use better accepted weighting methods, according to a recent paper by Stanford University graduate student Jacky Lin, with Cornerstone Research’s Genevieve Selden, Stanford economics professor John Shoven and University of Texas at Austin McCombs School of Business professor Clemens Sialm. The paper found the bigger driver of divergence in performance was not price weighting but the choice to exclude dividends (another matter entirely).

Past performance doesn’t guarantee future results, of course. As Lin told me in an email, “I’m hard-pressed to find a justification for why anyone may want a price-weighted index.”

Ray McConville, a spokesman for S&P Dow Jones Indices — which is responsible for both the S&P 500 and Dow — told me by email that the company doesn’t comment on methodology changes before public consultation, but referred me to a paper and a pair of blog posts from the company’s experts on the occasion of the Dow’s 125th anniversary. Like Lin’s paper, one such blog post found that the S&P 500 and the Dow had a “similar long-term risk/return profile and high correlation.”

I’m generally for anything that simplifies the market to make it more accessible to everyday investors who don’t have the time to learn, for instance, the intricacies of index construction. But the Dow is actually convolution masquerading as simplicity. Yes, the index construction is ostensibly straightforward, but it creates an environment in which retail investors often don’t know what they’re getting. As John Paglia, a Pepperdine Graziadio Business School finance professor, told me by phone on March 14, “In today’s day and age, I’m not sure that simplicity is really a net advantage if individuals think they’re investing in the broad market”, but actually aren’t.

Moreover, from the standpoint of Amazon investors, nothing about this episode is easy to understand:

• A company just carried out a cosmetic share split that shouldn’t have any impact on the underlying business;
• And it maybe caused the stock to surge;
• Because the move might help it to win access to a widely followed market gauge that uses a methodology from 1896.

There’s nothing simple about that logical sequence. Clearly, I’m not the first person to point out the Dow’s inadequacies, and I won’t be the last. When there’s a broad consensus about an index’s shortcomings, it’s hard to understand why it continues to exist in its current form: I can’t imagine many other industries — certainly not, say, science or medicine — hanging on to an old and obviously suboptimal practice solely out of a sense of tradition and because, well, it’s not clearly harming anyone too much.

That’s why it’s time to retire the Dow’s price weighting once and for all.