Latest Dow Jones Index is Flawed

I took time off from the supposedly off-the-record gloom at the Merrill Lynch Banking & Financial Services Investor Conference, at which John Thain called the present crisis a repeat of 1929, to hop west to Dow Jones’ offices to learn about their new international index: the Global Dow. It is nearly as quirky as the Dow Jones Industrial Average.

As the DJ newswire has blared out to the world, the index is not capitalization weighted. So Chinese solar power producer Suntech (STP) is carried at the same weight in the index as Exxon (XOM). STP is one of a trio of Chinese stocks in the new index, along with two banks.

Equal weighting and a relatively small number of stocks (150 in the new index) makes it easy to produce minute-by-minute numbers. But there are risks. Despite equal weighting, country selection was based on market cap. This creates a few anomalies like the exclusion of Israel, most of whose shares trade in the U.S.

One the countries were picked, the selection process depended on the reporters of the Dow Jones network. Their interest is in companies making news, not companies whose investments make sense. The index was created to correlate now with larger indexes including some from Dow Jones like its Dow Wilshire Global TMI.

But it doesn’t make sense to use these stocks as a proxy for the whole. They will not continue to correlate as well because the selection process was flawed.

There are too many countries with a “singlet”, one stock acting as a proxy for the whole country. ING Groep N.V. (ING), for example, is the sole Dutch share, in part because Dow Jones rules treated Schlumberger Ltd (SLB), which is incorporated in the Dutch Antilles, as a U.S. stock because it trades a lot here. But Telefonica S.A. (TEF), which also trades mostly in the U.S., was treated as one of the four Spanish stocks, along with two banks and Gamesa.

Given the panoply of Dutch multinational corporations including dual-national ones like Shell (RDS.A) or Unilever (UN), this seems to be singularly mindless.

Singles also represented Portugal (ute EDP (EDPFY.PK)); Finland (Nokia (NOK)); Denmark (Vestas Wind System (VWDRY.PK)); Sweden (Ericsson (ERIC)); Norway (Renewable Energy Corp.  (RNWEF.PK), which has a new ADR); Italy (Unicredito (UNCFF.PK)); Greece (National Bank of Greece (NBG)); Australia (NAB (NABZY.PK)).

This is a crap shoot. Already the new index had to be rejigged after the collapse of AIG which had been in the U.S. part. The U.S. accounts for 42% of Global DJ. It is relatively easy to replace one of 63 stocks in the U.S. cohort. But what if ING, sole representative of the Netherlands, continues in difficulty? How will it be replaced? And GM is probably on the skids too.

The Global Dow prospectus says:

The index composition will be altered as seldom as possible—typically only when a major event such as a merger or acquisition affects one or more of the index components. When this happens’ all of the other components will be reviewed as well.

Leaving out bankruptcy is fine, but even as stated the index can change lickety-split.

I cannot imagine anyone will create an exchange-traded fund based on this pool of companies because you might have to change your portfolio at the worst possible moment. And do it fast. This is a product for reporters, not for investors.

The idea was to pick world-scale companies which led to a down-rating of purely domestic earners: the Global DJ underweights telecoms, utes, consumer services. But if you invest internationally you might well want to hold companies immune from global turmoil. DJ opted to leave out the too domestic stocks, except when it didn’t, for example by including AT&T (T).

The index also includes a single share from Russia (OAO Gazprom (OGZPY.PK)); two from India; two from Mexico; two from Brazil (one of the Companhia Vale do Rio Doce (CVRD) (RIO)). DJ is to be applauded for including these supposed emerging markets which have world-scale companies, along with countries treated as emerging markets which in fact are developed countries, like South Korea, Taiwan, and Hong Kong.

Another problem is the degree to which selected index company stock can be bought. I talked to DJ index maven John Prestbo about the issue but got brushed off. Among the French companies in the index is Saint Gobain, controlled by the holding co. Wendel & Cie (WNDLF.PK); Total (TOT), controlled by a “noyau dur” including Power Corp of Canada; and GDF Suez (GDFZY.PK), controlled by the French government. They are not investable to the same degree as XOM. That means no institution or fund will run the risk of tracking the Global Dow.

It is good that Dow Jones is supporting the trend toward Global Investing to create a worldwide index, and that several of our companies received the Dow-Jones imprimatur, but the new index is unlikely to survive the way the DJIA has done.

Comments

[Shiv Kapoor:]

I thought it was a pretty good index. By thr way, there are 4 from India Reliance Industries Limited, Bharti Airtel, Infosys & Tata Steel.

2008 Nov 14 11:50 AM