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The Dow Jones Industrial Average was prominently in the news Monday not only because it eked out a small gain of 58 points, thereby overcoming weakness earlier in the session.
A lot of attention was also paid to the announcement that two stocks would be deleted from the 30 that make up the Dow Jones Industrial Average
Since then, the four deleted stocks have gained an average of 27%, while the four stocks that were added have produced an average loss of 40%. The Dow itself over this period has gained 14%. (These calculations do not take dividends into account; the difference between the average addition and deletion would be even greater if dividends were included.)
In other words, the Dow would be higher today if the list of companies making up the Dow had not been changed in 1999.
That's because companies that are added often are coming off a period of dynamic growth. A company that is substantially out of favor typically does not get added. This skews the Dow towards the large-cap growth sector of the market, which historically has underperformed smaller stocks and issues that are closer to the value end of the value-growth spectrum.
There are exceptions, of course. Bank of America, which is one of the stocks that will be added to the Dow later this month, is down significantly from the high it set a year ago. But, notwithstanding the recent turmoil in the sector, the financial industry has dominated the bull market over the last five years. Though there are some who would disagree, I would be hard pressed to classify it as a value stock.
In any case, if it were indeed the case that the Dow's deletions have, on average, been better performers post-deletion than the stocks that replaced them, it would be in good company. The same is most definitely true for the S&P 500 index (SPX:
Believe it or not, according to Siegel, by last year this pure buy-and-hold portfolio would have, on an annualized basis, been 88 basis points ahead of the actual S&P 500 index. What this means is that the net effect of all changes to the S&P 500 index over the last 50 years has been to markedly reduce the index's returns.
In other words, the Dow would be higher today if the list of companies making up the Dow had not been changed in 1999.
According to Norman Fosback, editor of Fosback's Fund Forecaster, the Dow would today be more than twice its quoted level had IBM not been removed in 1939.
Are these examples typical of all changes made over the past 110 years? I don't know, since I have not gone back and calculated the returns of all stocks that were added or deleted to the Dow subsequent to its creation in 1896. But I wouldn't be surprised if the average deleted stock has outperformed the average addition.
That's because companies that are added often are coming off a period of dynamic growth. A company that is substantially out of favor typically does not get added. This skews the Dow towards the large-cap growth sector of the market, which historically has underperformed smaller stocks and issues that are closer to the value end of the value-growth spectrum.
There are exceptions, of course. Bank of America, which is one of the stocks that will be added to the Dow later this month, is down significantly from the high it set a year ago. But, notwithstanding the recent turmoil in the sector, the financial industry has dominated the bull market over the last five years. Though there are some who would disagree, I would be hard pressed to classify it as a value stock.
In any case, if it were indeed the case that the Dow's deletions have, on average, been better performers post-deletion than the stocks that replaced them, it would be in good company. The same is most definitely true for the S&P 500 index (SPX:
S&P 500 Index
I can say this confidently, because that is what Wharton University finance professor Jeremy Siegel found upon carefully studying additions and deletions to this index since its creation in March 1957. He calculated the return of a portfolio that bought the original 500 companies in the index and made no other changes over the next 51 years. This portfolio therefore continued to hold each of those stocks, even if Standard & Poor's took it out of the index. In the event any of those original 500 stocks was taken over by another company, the portfolio would have continued to hold whatever compensation received from the acquiring company. And, finally, this portfolio would not have bought any of the additional companies that Standard and Poor's added along the way.
Believe it or not, according to Siegel, by last year this pure buy-and-hold portfolio would have, on an annualized basis, been 88 basis points ahead of the actual S&P 500 index. What this means is that the net effect of all changes to the S&P 500 index over the last 50 years has been to markedly reduce the index's returns.
In an interview Monday afternoon, Siegel cautioned that this pattern that he documented for the S&P 500 could very well be weaker for the Dow, since a company will more automatically get added to the former than the latter by virtue of its market capitalization growing big enough. So the S&P 500 will be even more skewed to the large-cap growth sector than the Dow.
Still, at a minimum, Siegel's findings, coupled with the performance of the stocks added and deleted to the Dow over the last decade, make it clear that you should neither automatically buy the stocks that are being added to this index, nor automatically sell those that are being deleted.
Indeed, given the data presented in this column, a contrarian might consider selling the additions and buying the deletions. 
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