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Dow Jones Industrial Changes Composition (Again) at Trader’s Narrative

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citigroup replaced by travelersAccording to a June 1st press release from Dow Jones: “The Travelers Companies, Inc. (TRV) is taking the place of Citigroup, Inc. (C) and Cisco Systems, Inc. (CSCO) is going in for General Motors Corp. (GM).”

The changes will go into effect on the opening of trading next Monday - June 8, 2009. The last time the Dow Industrial Average was changed was about a year ago when Bank of America and Chevron (CVX) replaced Altria (MO) and Honeywell (HON) (Dow Jones Technical & Fundamental Analysis)

GM replaced by ciscoThere is an ongoing debate between ‘passive’ vs. ‘active’ portfolio management. Very few money managers are able to beat wide indexes over time. But when you think about it, we don’t really have passive portfolios. If the Dow was truly passive it would still be comprised of companies like Standard Rope & Twine (a component from 1898). But obviously, such an index would have long ago ceased to exist; just like its component companies. To continue to exist and be relevant, an index must evolve along with the stock market. And that makes it an actively managed portfolio.

The only real difference is that a ‘passive’ investment portfolio like the Dow Jones has a much lower turnover rate than more actively traded portfolios managed by you or a hedge fund trader or a mutual fund portfolio manager. So the debate is really about turnover. When you start to buy/sell at a furious pace, not only do you have to deal with transaction costs but shrinkage due to spreads, errors and taxes. Unless you have an edge that can beat those costs, you’re trying to get out of a hole by digging faster.

The funny thing is that although these index changes are necessary, most of them result in lower performance. There have been a lot of studies done on indexes like the Dow and the S&P 500 which show that in the short term, companies that are removed provide higher returns than those which they were replaced by. Which means that GM (GMGMQ) and Citigroup (C) are probably going to outperform Cisco (CSCO) and Travelers (TRV) going forward. So the price that you pay for having an index like the Dow or the S&P 500 continue indefinitely is that their performance is actually lower than it would be, had there been less interference with their composition.

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