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By Alex Bryan

Since its inception in 1896, the Dow Jones Industrial Average has served as a barometer of the U.S. stock market by tracking a select group of the country's industrial leaders. Earlier this week, S&P Dow Jones Indices announced that Visa (V), Nike (NKE), and Goldman Sachs (GS) will replace Hewlett-Packard (HPQ), Alcoa (AA), and Bank of America (BAC) in this iconic index, effective Monday, Sept. 23. Because the index weights its constituents by their share price, rather than by market capitalization, these changes will have a significant impact. Both Visa and Goldman Sachs currently trade above $150, which will make them two of the index's top three holdings. They will also help take some of the weight out of IBM, which currently represents more than 9% of the index. In contrast, the three departing stocks account for less than 2.5% of the index combined.

Price weighting is a relic from the 19th century that was adopted primarily because limited computing power made alternatives impractical. This simple price averaging approach that gives higher-priced stocks larger portfolio weights does not have a sound economic basis. Price weighting also limits the index committee's selection options. Although Apple (AAPL) and Google (GOOG) are leaders in their fields, if either company were included in the index it would account for more than 15% of the portfolio, which would distort the Dow's representation of the U.S. market. The index construction methodology does not follow mechanical rules, so there are no firm guidelines dictating how or when the committee overseeing the index will pick new constituents. Despite these idiosyncrasies, the Dow was 0.97 correlated with the market-cap-weighted S&P 500 Index over the past 10 years.

Although price weighting leaves something to be desired, the Dow tracks a fairly diverse set of top-quality companies that approximates the industry composition of the U.S. stock market. SPDR Dow Jones Industrial Average (DIA) offers investors a convenient way to replicate its performance and may be a suitable core holding. The fund only invests in mega-cap stocks and, therefore, does not represent a large segment of the U.S. market. However, most of these companies have sustainable competitive advantages that may help protect their profitability in bad times. In fact, more than two thirds of DIA's assets are invested in companies with wide moats, Morningstar's assessment of a firm's competitive advantage. The corresponding figure for the S&P 500 is around 43%. As a result, DIA exhibited less volatility than the S&P 500 over the past 10 years, despite its more concentrated portfolio.

Fundamental View
In light of the Dow Jones Industrial Average's mandate to track U.S. industrial leaders that are representative of the broad U.S. stock market, the decision to replace Alcoa and Hewlett-Packard with Nike and Visa was prudent. Hewlett-Packard is clearly no longer a leader in the computing industry. While Alcoa is still the largest aluminum producer, the metals and mining sector is a very small part of the U.S. stock market. In contrast, Nike and Visa both carry wide moats and are leaders in their respective industries, which represent a meaningful part of the U.S. stock market.

Bank of America was a less obvious candidate for replacement. It is still one of the largest and most competitive banks around. If anything, it is getting stronger, not weaker. But the decision to replace it with Goldman Sachs may have less to do with the fundamentals of either company than their share prices. Goldman will receive nearly 10 times the weight of Bank of America. The index has been light on the financial-services industry over the past few years. It may seem like overkill to add both Goldman and Visa to address this issue, but not everyone classifies Visa as a financial-services company. S&P groups it with the information-technology sector because it makes its money from payment processing rather than from lending. In contrast, Morningstar classifies it as a financial-services company. Based on S&P's GICS classification system, the new constituents will bring the Dow's financial-services stake closer to the sector's weight in the S&P 500 Index. If Visa is grouped in with the financials, the index's exposure to the financial-services sector will more than double from its current weight.

The index's quality tilt gives it a defensive posture that can help it outperform the broader market in bad times. Over the trailing 20 years through August 2013, the Dow Jones Industrial Average outpaced the S&P 500 Index by nearly 1.2% annualized, with slightly less volatility. It also generally held up a little better during market downturns. There is some evidence that the market does not fully appreciate the long-term sustainability and predictability of high-quality firms' earnings more than a few years into the future. This inefficiency may arise because many investors have relatively short investment horizons. There may be an opportunity for long-term investors to profit from the market's myopic focus by buying the type of quality stocks this fund holds at reasonable prices.

Although the Dow Jones Industrial Average has had a good run over the past few years, valuations are still reasonable. At the end of August, the index's constituents were trading at a slightly lower average price/forward earnings multiple (14.2) than the S&P 500 Index (15.4). Morningstar equity analysts cover all 30 stocks in the Dow Jones Industrial Average. Based on their fair value estimates of the fund's underlying holdings, DIA is fairly valued. Only five holdings in the new portfolio, including new additions Visa and Nike, currently carry a Morningstar Rating of less than 3 stars. Adding to its appeal, DIA currently offers a slightly higher dividend yield than the S&P 500.

Rising interest rates could create a headwind for the fund's holdings as the Fed unwinds its bond-buying program. However, they should continue to benefit from the strengthening U.S. economy. According to Morningstar director of economic analysis Robert Johnson, consumer debt as a percentage of income has declined from 140% to 112% between 2008 and 2013. Bank balance sheets have also significantly improved over the past few years. Manufacturing productivity and oil production have picked up, inflation remains low, and the unemployment rate has continued its gradual decline.

Portfolio Construction
DIA tracks the Dow Jones Industrial Average by owning all 30 stocks in the index. This index reflects the performance of U.S. industrial leaders, excluding stocks in the utilities and transportation industries. A committee, which includes the managing editor of The Wall Street Journal, selects stocks for the index on the basis of subjective factors, including the strength of each firm's reputation, industry leadership, investor interest, and a history of successful growth. In constructing the index, the committee also takes steps to ensure that the index is representative of the U.S. economy. While the committee seldom changes the index's composition, it reviews the entire index when it replaces any component. Therefore, multiple changes often occur at once.

The index dates back to 1896, when Charles Dow would simply average the stock prices of the index's constituents to calculate the index value. Unlike most indexes, each component in the Dow is weighted by its share price. For example, with a stock price near $200, IBM receives a greater weight in the portfolio than Wal-Mart (WMT), which trades around $75. Stock splits reduce the weight of a constituent in the index, even though they have no effect on a company's relative value. This odd weighting scheme and low number of holdings result in a highly concentrated portfolio. DIA's top 10 holdings soak up nearly 55% of its assets. The fund is structured as a unit investment trust.

Fees
The fund charges a 0.17% expense ratio, which is comparable to its peers. However, there are cheaper and better diversified alternatives. The fund offers good liquidity, which keeps the cost of trading it low. State Street engages in share lending, the practice of lending out the fund's underlying holdings in exchange for a fee. It passes through 85% of the proceeds to investors, which partially offsets the fund's expenses.

Alternatives
Vanguard Dividend Appreciation ETF (VIG) offers a similar quality-oriented portfolio with greater diversification and a lower expense ratio (0.10%). VIG screens for companies that have increased their dividends in each of the past 10 years and have the capacity to sustain that growth. Despite that high hurdle, VIG offers broader market representation than DIA and extends its reach further down the market-cap ladder. In fact, VIG's average market capitalization is less than half of DIA's. VIG applies market-cap weighting, which more accurately reflects each constituent's market footprint. Over the past five years, these two funds were 0.98 correlated.

Investors can also get direct exposure to quality stocks through iShares MSCI USA Quality Factor (QUAL) (0.15% expense ratio). It targets stocks with high return on equity, low debt, and stable earnings. Because it was just launched a couple of months ago, QUAL still only offers limited liquidity, which can make it more expensive to trade.

Investors looking for similar market-cap exposure as DIA might consider iShares S&P 100 Index (OEF) (0.20% expense ratio), which invests in a subset of the largest stocks from the S&P 500. iShares Core S&P 500 ETF (IVV) (0.07% expense ratio) is a good option for broad large-cap exposure, while Vanguard Total Stock Market ETF (VTI) is a suitable alternative for investors who also want exposure to mid- and small-cap stocks. VTI represents close to 99% of the total U.S. stock market for a rock-bottom 0.05% expense ratio.

Disclosure: Morningstar, Inc.’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

Source: The New Dow Jones Industrial Average