Index of the Future? Nasdaq and Dow Watchers Stake Their Claims

Personal Finance takes center stage as mutual-fund reporter Ilana Polyak chats live with Faraz Naqvi, co-manager of the Dresdner RCM Biotech Fund and the Dresdner RCM Global Health Care fund. Have your questions ready for this exclusive free chat on TheStreet.com Tuesday August 8 at 5 p.m. EDT.

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Over the years, index investing has gained steam for good reason: Until recently, relatively few active managers have come close to besting their benchmark indices. But which index should you use?

We put this question to the portfolio managers of funds that track two well-known but very different indices, the venerable Dow Jones Industrial Average and the upstart Nasdaq 100.

Charles (Chuck) Carlson's (SDOWX Quote)Strong Dow 30 Value fund invests half its assets in the 30 companies of the Dow and then underweights or overweights those positions with the rest of the fund's assets. William Seale's (UOPIX Quote)ProFunds UltraOTC uses leverage to try to produce twice the return of the Nasdaq 100 (though it is not measuring up to that goal this year, according to Jim Cramer's latest Smarter Money column).

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TSC: Looking at the indices, I wonder if the Dow is still a good proxy for this economy? Are 30 stocks enough to really capture what's going on in the economy?

Chuck Carlson: Well, the Dow's always been kind of a whipping boy for investors, particularly those looking at the New Economy. This average has been around since the 1890s, it's only 30 stocks, heck it's got Eastman Kodak (EK Quote). What good is that?

"I think it's interesting that in 1999, arguably the best year ever for technology stocks, the Dow beat the S&P by 6 percentage points, while the S&P usually gets the nod in terms of being the hipper index." -- Chuck Carlson (SDOWX Quote)Strong Dow 30 Value fund

The origin of the Dow Jones Industrial Average is that Charles Dow in 1896 said, "Listen, I'd like to have some index to provide a barometer on the economy -- not the stock market." Quite frankly, if you want indices that are representative of the stock market, per se, there might be some other indices that are better. But if you are somebody who wants to try to get a window into the economy, I think the Dow with 30 stocks is fine.

The notion of 30 stocks being too few is really incorrect. There's been enough academic work to show that you can have 30 stocks in a portfolio and have very, very meaningful diversification. The technology sector now represents 25% to 27% of the Dow. That's still a little bit less than the S&P 500, certainly a lot less than the Nasdaq.

Because the Dow's a price-weighted index, that has always been a bone of contention with analysts. Whether you think it's a good thing or a bad thing, the big question is, can you make money in the Dow? And I think the answer is yes. Stocks like the Alcoas (AA Quote) of the world, the Eastman Kodaks of the world and the Caterpillars (CAT Quote) of the world -- the industrial cyclical stocks, which don't mean anything in market-capitalization-weighted indices like the S&P 500 -- matter a great deal in the Dow.

Bill Seale: I think Chuck's right in the fact that the Dow has a very rich history and there's been an awful lot of academic work done to indicate what it does reflect.

	" In the Nasdaq 100 you have an awful lot of the darling stocks . . . and as a consequence, the Nasdaq 100 as an index simply just outperformed." -- William Seale (UOPIX Quote)ProFunds UltraOTC fund

The difference in what we're doing with the Nasdaq 100 as the New Economy index, or whatever one might call it, rather than being an arithmetic index, it is a modified cap-weighted index based on a proprietary algorithm the Nasdaq folks have.

It used to be simply cap-weighted back until December 1998, but it does include these tech stocks. While Chuck points out that the Dow is 25% technology, the Nasdaq 100 is 85% technology, and it does represent the Information Age.

The other thing that's kind of interesting is that the Dow is dynamic, as I think all these indices are. They're living things, and the Dow now does have two of the major components, Intel (INTC Quote) and Microsoft (MSFT Quote) that the Nasdaq 100 has relied on.

30 Stocks vs. 100

TSC: Even though the Nasdaq 100 has 100 stocks as opposed to 30, is that just too narrow of a slice of the economy for an investor to be in?

Bill Seale: I spent a significant portion of my life in and out of academia, and one of the things I always used to be quite fascinated by is how big should an index be, and should it be cap-weighted or should it be arithmetic or should it be something else? And I came away from those experiences concluding, gee I don't know.

Certainly an index like the Nasdaq 100 adequately reflects the things it reflects, and that is the 100 largest, most liquid stocks traded on the Nasdaq. Whether or not it reflects what's going on in the underlying economy, I don't know. It would be hard to make that argument because this index has progressed so dramatically in the past couple of years, and so I think it's certainly looking at a segment. I would be hesitant to say that the index reflects what's happening in the U.S. economy generally.

Chuck Carlson: The Dow, I think, is in a bit more of a defensive position right now. The price-to-earnings ratio is down now to 20, vs. 27 a year ago; the P/E is considerably lower than that of the S&P 500. You get a higher yield and you get representation in some industry sectors that really haven't participated in this market. Whether that's good or bad, time's going to tell, but at least there are certain value areas.

I mean last year, for example, the Dow was up about 26% for the year, beating the S&P 500 by about 6 percentage points. That's a pretty palatable way to play a value approach in a portfolio without going off the deep end into a deep value area.

The one final point about the Dow is that, given the fact that most of the Dow stocks have at a minimum of 30% of their business from overseas, I think the Dow index provides an interesting kind of international flavor that you're not going to get in some of the other indices.

Head to Head The Nasdaq 100 vs. the Dow in the past year.

TSC: Should the Dow, with these very industrial sectors, be reconstituted more often to reflect more of what's going on in the economy?

Chuck Carlson: I think it should, and it has, and it will continue to be. I think the Dow people have done a pretty good job. I think there have been eight changes to the index, and that's pretty significant in a 30-stock index within the last, I believe, three years or so. And the changes that have been made, obviously, have been a shift towards this New Economy.

I've had this question asked of me several times: What's your favorite New Economy stock in the Dow? And I've replied General Motors(GM Quote). Obviously, General Motors is about as Old Economy as it gets until you start digging, seeing what General Motors is doing on the Internet, seeing the type of business-to-business commerce Internet sites it's constructing, and the type of rolling Internet portals that automobiles may be in the future. And you look at a company like Boeing (BA Quote) and what it's doing on the Internet, General Electric(GE Quote), and where Wal-Mart (WMT Quote) is headed. The distinction between Old Economy and New Economy is going to be very muddy.

Bill Seale: It's kind of interesting. If you look back at the original 12 in the Dow, are any of 'em still in it?

Chuck Carlson: The only one left is General Electric.

Bill Seale: It's so hard sometimes for folks to understand, and from our businesses as indexers, that indices are actually living, breathing things. And while the Dow has a constitutional authority that makes a decision about what's going to constitute the index, the market constitutes what's going to be part of the Nasdaq 100. But both of them are dynamic things. They change to reflect what's going on in the economy, what's going on in the Nasdaq market, and they simply aren't static.

Indices Evolve

TSC: So, does the Nasdaq 100 change too often?

Bill Seale: Oh, no, no. I think what happens is, the Nasdaq reconstitutes once a year, basically. It's 85% tech-weighted, and it's still the Ciscos (CSCO Quote), the Oracles(ORCL Quote), the Microsofts(MSFT Quote), the computers, which constitute a very large portion of the index.

Chuck Carlson: I think over time there's going to be a closer convergence between the performance of the Dow and the New Economy indices, because that is where the economy is heading. The people at Dow Jones will respond to that.

Getting back to the Dow and this notion of price-weighted index, you could have the exact same stocks in the Dow as you have in the Nasdaq 100, but because the two indices are computed dramatically differently, their performance is going to be, in some cases, [significantly different].

We saw a perfect example of it at the end of [July]. Intel, was the highest-priced stock in the Dow at about 140 per share, thus it also had the biggest impact on the Dow, representing about 7.5% of the Dow.

That all changed on July 31 when Intel split two-for-one. In effect, its weighting in the Dow was cut in half along with its stock price. In the Dow, rightly or wrongly -- in the case of Intel, unfortunately, I think it was wrongly -- there's a kind of self-adjusting mechanism. As stocks split, their weighting in the Dow becomes muted. So, it's very, very difficult for any single stock to become so dominant in that index over time.

TSC: Doesn't that punish successful companies?

Chuck Carlson: Well, to some extent it does. It certainly punishes their weighting in the index. It's kind of like some of the Russell indices where a company gets punished for being successful and becoming so big it gets thrown out of the index.

What About the S&P 500?

TSC: How did these indices compare with the S&P 500? Obviously the S&P has elements of both, sort of right in the middle.

Chuck Carlson: Last year, the Dow beat the S&P by about 6 percentage points; the prior year to that, it was about a mirror image in reverse. So this year the Dow is losing to the S&P by about 6 percentage points, last time I checked. I think it's interesting that in 1999, arguably the best year ever for technology stocks, the Dow did win by 6 percentage points, while the S&P usually gets the nod in terms of being the hipper index.

You come in with a stock like an Alcoa, up 126%, which has a much greater impact on the Dow than it does on the S&P 500, consequently that helps the Dow vs. the S&P.

Probably over the next five to 10 years, I don't expect there's going to be dramatic divergence in the performance. There may be on a six-month or 12-month basis, but I think over that time frame, you're probably going to have a similar performance.

TSC: What accounts for the huge disparity in performance between the S&P and the Nasdaq 100?

Bill Seale: Well, in the Nasdaq 100 you have an awful lot of the darling stocks, the stocks that everybody likes to look at and track along with. I mean, you have the Ciscos, the Microsofts, the Oracles, and these stocks just simply went up an awful lot over the past couple of years as the Information Age has expanded or grown. And as a consequence, the Nasdaq 100 as an index simply just outperformed.

TSC: Any closing thoughts?

Chuck Carlson: Well, the concept of index investing sometimes is thrown out there as a real generic concept: Index investing is good, therefore, go out and get an index. It's not necessarily as simple as that. There are many different types of indices out there, attracting many different things, with many different purposes, and one index simply does not fit all.

Bill Seale: I think that's a very good point, and I think that indexing will continue to be more and more popular. I think it will be a more popular investment for individuals, and that certainly there's room in portfolios, as Chuck says, for lots of different kinds of index investments.

And we here at ProFunds believe we have the next evolution in indexing by the fact that we have these levered index funds, and we are, without question, worshippers at the shrine of efficient markets, because we simply don't try to pick stocks. We simply say we're going to follow the index and wherever the index goes, that's where your investment's going to go.