Holders of the SPDR Dow Jones Industrial Average ETF (DIA) woke up Monday morning to a negative divergence in their security’s performance at the open of trading versus other market indices. That is because of two things: Boeing (BA) shares' double-digit percentage decline into the open and the relative sensitivity of the Dow Jones Industrial Average and the DIA-tracking security to Boeing's performance. DIA holders have two very different takeaways and lessons learned as a result. First, a focused portfolio carries more risk than a more broadly diversified one, even when the portfolio is a passive tracker of a market index. Second, diversification still served as a risk reducer, even in this case.
The charts here of the SPDR Dow Jones Industrial Average ETF, the SPDR S&P 500 (SPY), Invesco QQQ Trust (QQQ) and Boeing illustrate our points. The DIA security opened down on Monday, while the S&P 500 tracking ETF and the Nasdaq tracking ETF were both higher. There was one reason for that, and it goes by the name of Boeing.
At the Open 03-11-19
SPDR S&P 500 (SPY)
Invesco QQQ (QQQ)
SPDR Dow Jones (DIA)
As I authored this piece in the pre-market Monday, the shares of Boeing were collapsing and dragging down DIA. The dramatic drop in the shares of Boeing came in the aftermath of a Boeing made airliner crash in Ethiopia. Because it was the second crash of a Boeing 737 Max 8 aircraft in less than six months, several sovereign regulators grounded the fleets of all such aircraft operating within their nation’s airspace. Most important among those grounding aircraft was China, which has the most 737 Max 8s in operation (97).
The Drag on the SPDR Dow Jones ETF
Boeing shares were off by a very significant 12%, as the combination of accidents raises a specter about product safety. This could impact future ordering of Boeing aircraft, especially if it affects the decisions of travelers. However, this article is not about Boeing.
The S&P 500 Index and the Nasdaq-100 Index were both higher in the pre-market, while the Dow Jones Industrial Average was lower. The reason for this was because Boeing is one of 30 stocks making up the price-weighted Dow Jones Average, while it is one of 500 stocks within the S&P 500 and not included in the Nasdaq 100. Furthermore, Boeing is the top holding in the SPDR Dow Jones ETF because of its price importance, comprising some 11.5% of assets, while it carries much less significance for the market capitalization-weighted S&P 500 Index.
The Dow Jones Average is a Focused Portfolio
The Dow Jones Industrial Average is comprised of just 30 stocks, and so is a “focused” portfolio. Many active managers run focused portfolios, which seek to maximize stock-picking skill but at the same time raise risk. Here, we have a passive portfolio that is operating a focused strategy. In any event, when one company within a focused portfolio has a significant change, either up or down, it will obviously have a more important impact on the portfolio than it would on a portfolio operating a more diversified strategy. And in this case, where the Dow Jones Average is a price-weighted index, there is outsized risk sensitivity to the shares of Boeing in particular.
Perhaps investors in the DIA security do not expect their index-tracking investment to have such a divergent day, or such significant downside when the whole market is not also declining. And, perhaps some conservative investors appreciate the brand value of the Dow Jones Average as representative of blue chip quality and large-cap companies and did not realize there was also special alpha risk to holding them as a group. That is not the case, however, because of the DIA’s concentration of assets and its sensitivity today to Boeing. Let this be a lesson learned.
Diversification Still Protected People
Even so, because the ETF represents a diversified portfolio, investors in it diluted the 12% apparent loss on the event and the stock specific risk exploited in Boeing shares. So, diversification still protected investors here, despite the divergence between the indexes.
The Dow is a Bet on Cyclicals
That said, the DIA security is also a focused bet on cyclical stocks. Thus, it should see exaggerated downside on signs of economic trouble. Likewise, it should benefit from optimism about a potential trade deal between the U.S. and China. It should also benefit from the dovish shift apparently underway in Federal Reserve monetary policy, at least for as long as the economy does not tank.
Let Monday’s action in the SPDR Dow Jones security serve as a lesson to passive investors that even when holding some passive securities, they can still carry special risk. Whether that comes in the form of specific holding sensitivity, as in the case with Boeing and its company specific problem, or if it comes due to concentration in economically sensitive cyclical shares, this can be the case. The prospective news for DIA holders is that if Boeing can shake off the day's concerns, the divergence in the DIA will turn positive.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.