Posted by: Aaron Pressman on June 1, 2009
Conventional wisdom says there’s money to be made buying stocks added to a major trading index. This morning comes news that Cisco Systems (CSCO) and Travelers (TRV) will be added to the Dow Jones Industrial Average replacing bankrupt General Motors (GM) and teetering Citigroup (C). So rush out and buy Travelers and Cisco? Not so fast.
The basis of the index-addition effect is the buying power of billions and billions of dollars invested in index funds. But there’s not actually that much money invested in following the Dow, despite its power over headline writers and news anchors everywhere. In fact, a study done by Messod Daniel Beneish of Indiana University’s Department of Accounting and John Gardner of King’s College London found there was no such effect on stocks which entered the Dow, just those added to the S&P 500. Why? Simple — there’s not much money following the Dow relative to the trillion plus invested in the S&P 500. Just compare the exchange-traded funds, for example. The original ETF, the SPDR Trust (SPY), which follows the S&P 500, has $61 billion of assets while the DIAMONDS Trust (DIA), which tracks the DJIA, has just $7 billion.
Also, since the Dow has only 30 component stocks and changes are made relatively infrequently (2008, 2004 and 1999 most recently), there’s a certain — how to put it — “bias” of the index makers involved. In February 2008, they decided to add Bank of America (BAC) and Chevron (CVX). Those were two stocks in two hot industries way back then. Since then? Not so hot. BAC is down about 70% since then versus a 29% drop in the S&P 500. Chevron tailed the S&P 500 for a while but has since caught oil’s upswing so it’s only off 16%.
Now we’re seeing at least one more relatively hot performer added. Cisco is up almost 19% so far this year versus the S&P 500’s 4% gain. And while Travelers is down 6% — poor relative to the index — it’s done a lot better than some of its industry competitors. So be careful out there before you go following yesterday’s conventional wisdom.