Since its ETF's launch in early 1999, the Nasdaq-100 actually underperformed the Dow Jones Industrial Average on a total return basis for most of 20 years, until last week.
Both the Dow and Nasdaq have outperformed the S&P 500 on a total return basis, leaving the Dow as the clear winner on a risk-adjusted basis.
Fundamentals point to the Nasdaq's recent catch-up as a repeat of the late 1990s run-up, meaning the Dow is likely to outperform again over the next 20 years.
The Dow's greatest advantage is its simplicity, and this should make it a leader in the trend towards direct indexing.
If I were to ask 80 investors under the age of 80 to describe the Dow Jones Industrial Average in one word, chances are the answers would include words like "narrow", "outdated", or even "irrelevant". I'm also sure a vast majority of that same sample of "young" investors would never have guessed that this old Dow index has actually outperformed the much more modern and sexy Nasdaq-100 Index on a total return basis over most of the past 20 years. In this article, I explain:
- the surprising past outperformance of the Dow over the Nasdaq, and
- advantages I believe will make the Dow a better starting point than Nasdaq or S&P for outperformance over the next 20 years.
Below is a chart comparing the cumulative total returns of the SPDR Dow Jones Industrial Average ETF Trust (DIA) versus the SPDR S&P 500 ETF Trust (SPY) versus the Invesco QQQ Trust (QQQ, tracking the Nasdaq-100) since the latter was launched in March 1999.
QQQ's cumulative total return since inception surpassed DIA's last week for the first time since its brief lead during the 1999-2000 dot-com bubble, and both remain significantly ahead of SPY's total return over the same period.
How Dow outperformed Nasdaq
Two factors that might explain DIA's outperformance over most of this period include:
- DIA was less exposed to dot-com stocks than QQQ, resulting in a significantly lower drawdown in 2000-2002, meaning far less in losses to make up for over the following 17 years.
- DIA's dividend yield has often been about 2-3x higher than QQQ's. In addition to indicating DIA's relative value tilt, these higher dividends mean more reinvestment into DIA than in QQQ on dips. This 1-1.5%/year extra reinvestment compounds over 20 years, providing DIA another lead QQQ needed to catch up with.
It would be a separate article to dive into how and why both DIA and QQQ outperformed SPY so significantly over the same period, though the former two ETFs' concentration on a smaller number of large-cap blue chips is probably the leading factor there.
Dow's Performance Came With Less Volatility
The first of the above two factors brings up the risk dimension investors must consider when choosing a benchmark or constructing a portfolio. The below chart shows the rolling 30-day volatility of DIA vs. SPY vs. QQQ over the past 5 years. Note that even over these most recent "best 5 years" for the QQQ, and not including the volatile 1999-2002 period, QQQ has consistently been more volatile than DIA or SPY. This means that after adjusting for "day-to-day" market risk, as measured by volatility, DIA actually performed far better than QQQ on a risk-adjusted basis, and still better than SPY.
The Dow and Nasdaq are so different
Although DIA, SPY, and QQQ represent the three main US equity benchmarks we are all used to seeing go up and down closely together on TV and newspapers from day to day, what I find so surprising is how closely these three track each other given how radically different the three are. In summary:
- DIA holds 30 stocks on a price-weighted basis (meaning it allocates 10x as much to a stock trading at $100/share as in one trading at $10/share), while the other two are market cap weighted.
- SPY is the broadest of the three, covering 500 of the largest US stocks.
- QQQ holds 100 of the largest stocks traded on the Nasdaq market, so excludes stocks listed on the New York Stock Exchange (NYSE) and also excludes the financial sector, while including a few non-US based (mostly Internet sector) companies from China, Israel and Netherlands.
Although all three benchmarks focus on owning the "biggest" and "bluest of blue chip" stocks, DIA and QQQ have an overlap of only 13.2% of their assets on just five names, as shown below.
QQQ's Nasdaq-100 index may seem somewhat unusual in filtering by exchange, but I remember that until about 1999, the Dow Jones Industrial Average contained only NYSE-listed names. It was news that year when two Nasdaq-traded names (Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC)) were added to the Dow.
Excluding the financial sector is another unusual feature of QQQ, and one I wish I would see available in other markets. For example, I would love to see ex-financial ETFs on financial-heavy markets like China, Canada, Russia or Singapore, ideally without other sector concentrations in IT or mining. Also unlike SPY, DIA has a specific exclusion of the transportation sector (for example, the Dow has never included an airline), due to the history of there being a separate Dow Jones Transportation Index. Below is the latest comparison of the relative sector weights of DIA vs. QQQ, showing as expected the former's weight on industrials and financials, but the even more extreme overweight of the latter to Information Technology and Telecommunications.
These dramatic differences make the neck-and-neck total return over the past 20.5 years, and >90% day-to-day correlation, that much more amazing in my book. But of all differences between DIA and QQQ or SPY, the one I see most criticism of is the Dow's price-weighting methodology.
Defending the Dow's Price-Weighting Methodology
The rise of index funds, especially around the S&P 500 index, has made market cap weighting the dominant way to decide how much to allocate to each stock in a fund. When Charles Dow first created the Dow Jones Industrial Average, it was meant as a simple-to-calculate average to measure the general trend of the overall stock market, rather than as a formula for portfolio construction. That said, price weighting still has the advantage of being extremely simple. An investor who prefers owning stocks directly, rather than through a fund, can simply buy an equal number of shares of each of the 30 stocks in DIA and rest assured the portfolio will track the index perfectly, at least until the next stock split. Now that major brokerages have largely eliminated most trading costs for US stock trades, this can be done in portfolios of only a few thousand dollars at comparable or even lower costs than the cheapest index funds. This investment approach is called direct indexing, and is made easier with software and commission-free trading, though remains simpler to do on the Dow than on the S&P 500 or even the Nasdaq-100. ETF.com's Dave Nadig, who seems to expect there will never be another US ETF on a price-weighted index, has also been following the direct indexing trend, and is likely to see the Dow have different relevance in direct accounts vs. in ETFs like DIA.
On my side of the Pacific, the Nikkei 225 Index remains the most followed and traded benchmark of the world's third largest economy, and is also a price-weighted index like the Dow. In this earlier article on the Dow hitting 20,000 for the first time, I compared the Dow and Nikkei and explained how the Dow was and still is the oldest and simplest benchmark for direct indexing. The advantages of direct indexing are one of the reasons I also don't buy S&P 500 index funds, apart from other fundamental reasons.
DIA vs. QQQ: Value and Fundamentals
In my investment outlook for 2020-2030, where I suggest an asset allocation targeting an 8% annual return, I make use of a simple 3-part formula for estimating the expected future return of a fund: earnings yield + earnings growth +/- change in earnings yield. Let's compare these three factors for DIA vs. QQQ:
Earnings yield: At a glance, DIA trades at about 20x trailing earnings, while QQQ trades at 27.5x trailing earnings, corresponding to earnings yields of 5% and 3.6% respectively.
Earnings growth: Looking backwards, one main driver of QQQ catching up to DIA in recent years is the former's growth in earnings per share at around 3x the rate of the latter. Looking forward, the main justification for accepting the lower earnings yield on QQQ is if you believe QQQ will continue to deliver more than enough extra earnings growth to make up the difference. Personally and professionally, I believe market expectations have gotten somewhat ahead of themselves at this point in the cycle, and like in the years following 1999-2000, QQQ is likely to disappoint relative to DIA.
Change in earnings yield: Given QQQ's exclusion of financials and tendency to include higher growth stocks than the NYSE-listed DIA components, I don't expect the spread between QQQ's and DIA's earnings yields to change that significantly relative to one another. As explained in the 8% target asset allocation article, I rather expect this factor to drive lower returns in US stocks (both DIA and QQQ) relative to emerging market stocks.
So if we assume the latter two factors will mostly wash out, and the difference between QQQ and DIA returns over the next decade will mostly come from differences in their earnings yield, we should expect DIA to outperform QQQ by an average of 1-2% per year over the next decade, as in 2000-2010.
Deviating from the Dow
Another advantage of basing a portfolio on a simple price weighted index of 30 stocks is ease of customization. The 30 names in DIA are chosen by a committee, which for example decided to replace long-time index component General Electric (NYSE:GE) from the benchmark last year. Rather than treating DIA, QQQ, or SPY as sacred recipes that cannot be deviated from, they should be seen as frameworks for constructing diversified, world-class portfolios. For investors who don't want to start from scratch, they can simply start with the 30 components in DIA, and then decide if they want to replace Coca-Cola (NYSE:KO) with PepsiCo (NASDAQ:PEP), etc. A similar framework would be to start with one share each of the first 10 stocks to buy a 10 year old, and build from there. The close tracking of DIA, QQQ, and SPY shown above should show that you don't need hundreds of names to capture most of the returns and diversification benefits of the major benchmarks.
Conclusion and Outlook
Far from being obsolete, I hope these points have shown how the Dow Jones Industrial Average remains as relevant as ever, with its key advantage being its simplicity. Given DIA's sector balance and cheaper valuation, I expect we will see DIA outperform QQQ again over the next 10-20 years, just as it has done over most of the past 20 years. By far the biggest challenge to DIA over the next decade seems to be not the index itself, but rather how easily and cheaply any investor with a few thousand dollars is able to buy the 30 stocks directly without paying the fund's fees.
Disclosure: I am/we are short SPY, QQQ. 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.
Additional disclosure: We use the SPY and QQQ ETFs largely as a trading hedge against long positions in select names that may be held in each of the ETFs mentioned.