Next Monday (31 August), Apple will split its shares four to one, meaning holders of Apple stock will have four shares trading at a price of $125 instead of one share at the current price of $500. This is Apple’s fifth stock split, aimed at making the stock more accessible to new investors (it is possible to buy less than one share of some companies, but not easy).
A ‘book-entry’ change should not affect investor views of the total valuation of a company. After all, the holding of existing investors is not diluted – at the moment the split happens the company’s market capitalisation is unchanged. But history shows that it can, at least temporarily. This seems to have been so for Apple this week.
Apple’s fairly normal corporate event has also had a major structural impact on America’s oldest stock index: the Dow Jones Industrial Average (Dow). The Dow measures the performance of America’s 30 largest companies, but because it does so on a price-weighted basis (explained below), Apple’s split means that the company will receive a smaller representation
The Dow has a mechanism to deal with stock splits. However, Apple, and the booming US technology sector it leads, had become so dominant that the mechanism was inadequate, and a substantial index shake-up became necessary.
To offset the change, three stocks are being kicked out of the index, with another three set to take their place. The committee overseeing the Dow is giving the boot to pharmaceutical firm Pfizer and industrial company Raytheon, bringing in Amgen and Honeywell, respectively. But the big news is that ExxonMobil – a Dow participant for nearly 100 years – will be replaced by tech firm Salesforce.com. Exxon’s exit is another signpost of its fall from grace: once the world’s most valuable company at $575 billion back in 2007, the energy giant is now worth $180 billion.
The domino effect of Apple’s change will trigger all the investments that track the Dow to automatically trade the affected stocks. Changing the constituents of a concentrated index like the Dow – based not on a company’s performance, but on its decision to deliberately lower its share price – brings into question the value of the index as an indicator of economic health. What it also highlights is that the stocks in leading indices are not selected by algorithm, as one might expect, but by committee.
The Dow’s committee made its changes to reflect the stock market dominance of mega-techs. It highlights how different a stock index’s performance can be from its underlying parts. Despite being one of the most famous and recognisable indices in the world, as an investable asset the Dow has fallen some way behind its peers. Overall, the Dow is down 4.2% from its record highs in February, while the Nasdaq 100 – a much more tech focused index – is 20% higher than its pre-pandemic levels. Over a 20-year period, the performance has been in a similar range – Apple’s share price drop will only re-enforce the Dow’s ‘underperformance’.
The difference in the performance of the Dow and the Nasdaq 100 is down to how they are calculated. The Dow is weighted by the price of individual stocks, rather than by the market cap of the underlying companies. It was originally calculated by totalling the per-share price of the stocks of each company in the index, then dividing this sum by the number of companies, but it is no longer this simple to calculate.
Although price weighted indices may have been useful at one point, many investment professionals now see such indices as unrealistic – and outdated – ways of measuring the market. An accusation that is perhaps not surprising, given the original methodology began in 1896. The 30 companies in the Dow are decided by committee and their selection does not seem to follow any consistent process, making it difficult to forecast what they will include.
Nonetheless, both the Dow and the Nikkei get a great deal of media coverage in their respective countries and internationally. From our perspective though, this seems to be more down to their history and longevity rather than their worth as investment tools.
By contrast, the S&P 500 is weighted primarily by market capitalisation (share price times number of shares), with a committee also deciding constituent stocks with other factors like liquidity, public float, sector classification, financial viability, and trading history. The Nasdaq Composite Index is also weighted by market cap, including all the stocks traded on the Nasdaq exchange and excluding financial institutions. Germany’s DAX index is similar, but also incorporates order book volume as well as market cap.
The different ways of calculating indices have their uses in terms of measuring market performance, but crucially, indices are not just about measuring market performance; they are about investing in the underlying stocks. In years gone by, investing in these assets would be achieved by a fund manager trying to replicate the performance of the index. Now, thanks to changes in technology, efficiency and the rise of exchange-traded funds (ETFs), investors can replicate an index’s performance much more easily.
Indeed, there is a lot to be said for investment of this sort. Studies show that the average active fund manager – who picks their own stocks rather than investing in the broader market – underperforms the market once their fees are taken into account (which is unsurprising, given that the sum of investors are the market). This, coupled with easier access to a broader basket of stocks at a cheap price, has led to the rapid rise of passive investment funds.
Of course, not all benefit from this. Remember the Wirecard fraud scandal earlier this year? The assumption is that a bust company would automatically leave an index, but that’s not necessarily the case. Deutsche Boerse, the stock exchange that listed Wirecard, had to change its own rules last week so that insolvent companies can be removed from the DAX with two trading days’ notice. Wirecard was only removed on Monday, as Deutsche Boerse had to wait for its quarterly review The new rule, could also make it difficult for fund managers to sell a certain stock in time.
The well-known downside to passive funds is that, while active managers fail to beat the market on average, passive funds can never beat the market, owing to their lack of flexibility or ability to react. It is also possible that the rise in passive funds has contributed to the outperformance of large stocks, which have larger weights in portfolios than active managers. As flows continue towards passive funds, the big stocks are supported, keeping their performance strong, creating more flows and so on. This is likely one of the reasons that America’s tech superstars – Apple, Facebook, Amazon, Netflix, Microsoft and Alphabet (Google) – now account for more than a quarter of the entire S&P 500. That is an astounding level of stock market concentration. To return to the Dow, this is exactly the sort of performance it struggles to account for, given its priceweighting.
The Dow, as a way of investing, is probably a thing of the past. Its value lies almost entirely in that past, measuring the glory days of American investments since 1896.