Why stock trackers flock to the S&P 500

With big swings in the US stock market of late, headlines have focused on "the Dow", but there are $7.8tn worth of reasons why people should be thinking about another index.

For the general public, the Dow Jones Industrial Average, first calculated in 1896 and made up of 30 of the largest publicly traded companies such as General Electric, ExxonMobil and Apple, is synonymous with the US stock market. More than a century since its inception, though, relatively little invested money tracks it.

Instead, more mutual and exchange traded funds and institutional money tracks the Dow's broader-based counterpart, the S&P 500, an index that also reflects the market capitalisation of its members. In contrast, the Dow is calculated on the basis of each member's share price. That means a company with a high share value, like Goldman Sachs at $187, exerts a greater influence over the benchmark than lower priced constituents such as General Electric.

"Because the S&&P 500 is a broader reflection of the overall equity market place, it is a broader reflection of the opportunities for investment. And that's why you've seen the 500 become the most significant equity benchmark out there," says Jamie Farmer, managing director, index investment strategy & data services, at S&&P Dow Jones Indices.

"The Dow, while it has outstanding name recognition - more of the time than not people say what the Dow did today. What happened in the marketplace, as the basis for investment vehicles, certainly the 500 is a more appropriate benchmark."

More than $7.8tn was benchmarked to the S&P 500 in 2014 with $2.2tn of that directly indexed.

By contrast, about $37bn is indexed to the Dow, which is not typically used by managers as a benchmark.

"There's very little that's indexed directly to the Dow, although a portfolio of the Dow dividends reinvested over the years has actually outperformed the S&P 500. It's not that it's a bad investment, it just covers about 30 per cent of the market value and obviously is not inclusive," says Jeremy Siegel, professor at the Wharton School at the University of Pennsylvania.

The two indices differ in a few significant ways. The Dow is a blue-chip large-cap index with a high bar for entry. According to its methodology, "a stock typically is added to the index only if the company has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors".

The average market cap of a Dow component is $177bn versus $38bn for the average component of the S&P 500, which is less exclusive. The Dow also is price weighted while the S&P 500 has free float market weighting. The S&P 500 started in 1957 while the Dow's history is about double that.

Nostalgia plays a role in why the Dow is still the most commonly referenced US index.

"When you were growing up, when the radio announcer or television presenter would talk about the market, they were always referring to the Dow," Mr Siegel says. "It had such a hold on the market you didn't even have to say which index you were talking about."

That long history is also a reason why the Dow endures as the most recognisable US market gauge.

"It is the only continuous index that goes back before the Fed was founded, and the '29 crash,'" says Nicholas Colas, chief market strategist at Convergex. "If you wanted to look at long-term returns in the market, the Dow is the one to choose."

Is it possible to shift the cultural affinity that Americans have with the Dow?

"It is a waste of time trying to change minds," Mr Colas says. "The S&P 500 is Wall Street's indicator. Main Street's indicator is the Dow."

While the Dow may be the best way to track past performance and the S&P 500 current performance, some market participants point to the limitations of any index in being a proxy for the market or investor returns.

Membership in the Dow and the S&P 500 is not permanent. In fact, the only company that has been a Dow component from the start is GE. Apple is the most recent entrant into the index.

Mergers and acquisitions are common reasons why companies leave the S&P 500, but they can also be removed when they no longer fit the profile for entry. That includes being profitable with a market capitalisation of at least $5.3bn. Companies in the mid-cap index can also graduate to the S&P 500 if they grow beyond the constraints of other barometers.

"People say 'the Dow is doing this' or 'the S&P 500 is doing that', but that performance is being enhanced by taking out the weaker stocks and replacing them with stronger momentum stocks," says Oliver Pursche, chief executive of Bruderman Brothers. "From a broad portfolio management perspective, it is a bit more complex than just saying the index is doing this."