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Why the Dow Clobbered the S&P in 2011

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Thursday was a cheery day for U.S. stock averages, but one performed a smidgen better than its rivals.  The Dow Jones Industrial Average gained 1.12%, versus 1.09% for the Russell 1000 index and 1.07% for the S&P 500.

That’s not nearly the first time that has happened this year, and the sum of all those tiny extra gains has turned into a matter of no small importance to investors. Through the end of the year, the Dow gained 5.5%, while the other two indexes have been about flat, not including dividends.

All three indexes are meant to track the same thing: shares of large U.S. companies. Two of them, the S&P 500 and Russell 1000, do that the conventional way: by weighting companies according to the value of their outstanding shares.  The method is designed to track the large-company market as it actually exists, rather than picking representatives.

The Dow, on the other hand, used a method that dates back to well before modern indexing. Companies are weighted according to their stock prices, with, say, a $120 share having more sway than a $30 one.

Share prices change with splits and dividends, so since 1928, the Dow has used divisors to account for these things.  Hence, it’s no longer truly an “average” of share prices. It’s also not especially “industrial”, since it includes banks, stores and other non-manufacturers.

And while we’re at it, the index is no longer controlled by Dow Jones (parent of SmartMoney.com). Its former indexing unit, Dow Jones Indexes, is now majority owned by CME Group. But don’t expect a name change to Formerly Dow Jones, Not-Entirely-Industrial Non-Average.

So why is this odd duck of an index soaring over modern rivals? In short: less banking, more of what’s working, and plenty of yield.  And above all, luck

The Dow’s stocks are selected by its caretakers, not by some strict methodology. That means it tends to overweight some sectors and underweight others relative to the actual U.S. stock market.

The Dow purged struggling financials in recent years, dropping AIG in 2008 and Citigroup (C) the following year.  This year it had just two banks, strictly speaking: JP Morgan Chase (JPM) and Bank of America (BAC).  And the banks have relatively low share prices, so they make up barely 2% of the index.

That helped, because banks got crushed in 2011.  The KBW Bank Index lost 24% through Thursday. The S&P 500 felt much of the punishment. It currently has a weighting of more than 13% in financials.  Some of that comes from insurers, real estate investment trusts and other non-banks, but much of it is from banks.

The Dow also has a heavy weighting in three of 2011’s star performers. IBM (IBM), Chevron (CHV) and McDonald’s (MCD) have gained an average of more than 24% on strong demand for cloud computing services, rising oil prices and apparently limitless world appetite for hamburgers.  Together these companies make up around one-quarter of the Dow.

Finally, Dow stocks happen to provide something investors were desperate for in 2011: yield.  All Dow stocks pay dividends.  The average yield is 2.8%. The S&P has an average yield of just 1.9%, in part because more than one in five of its members pays nothing.

Dividends helped the Dow indirectly in 2011. The average doesn’t count them, but demand for dividends among investors was such that share prices of companies that pay them rose much faster than those of companies that don’t.

Dow stocks still have relatively high yields, which is chief among reasons to believe the awkward benchmark will shine again in 2012.

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