The Problem With Dow ETFs

By Michael Johnston of ETF Database

NEW YORK ( TheStreet) -- The Dow Jones Industrial Average is one of the most widely followed stock indices in the world, seen as a barometer of U.S. equity market performance.

The rise of the ETF industry has given investors the option to track the performance of this benchmark, and a number of spinoffs have increased ETF options for investing in the Dow. But before buying into one of the Dow ETFs available, investors should be aware of the potential drawbacks and limitations that an ETF based on the index may have.

History of the Dow

The Dow is one of the market indices created by Wall Street Journal editor and Dow Jones founder Charles Dow, who named the benchmark jointly after statistician Edward Jones.

The benchmark is the second oldest in the U.S., behind only the Dow Jones Transportation Index. The composition of the index has changed gradually over the years, and the current version of the benchmark has little exposure to the industrial sector that once dominated its holdings and accounts for the "industrial" in its name. Exxon Mobil ( XOM) has been included in the DJIA since 1928 (originally as Standard Oil), while other components were added as recently as 2009.

Dow Drawbacks

The Dow's popularity in the investing community is perhaps more attributable to the long history and visibility of the index rather than its efficiency as an equity market benchmark. The Dow is a price-weighted benchmark, meaning that higher-priced stocks are given more weight than lower-priced counterparts.

Moreover, because the index includes only 30 component stocks, it doesn't always provide a good representation of overall market performance.

By comparison, the S&P 500 is a float-adjusted market cap-weighted benchmark with a much broader base of holdings. (See a complete guide to ETF weighting strategies here.)

Dow ETFs

Despite the potential drawbacks of investing in the Dow highlighted above, there are multiple ETFs based on the DJIA that have become popular with investors (sign up for our free ETF newsletter for ongoing ETF education):

Dow Diamonds (DIA)

This ETF seeks to provide investment results that correspond to the price and yield performance of the Dow Jones Industrial Average, and is one of the largest and most widely traded U.S. ETFs. With more than $9 billion assets at the end of 2009, DIA was the 12th largest equity ETF (see the largest ETFs by market cap here). With average daily volume of almost 12 million shares, DIA is also among the most liquid ETFs.

DIA's holdings match the underlying index almost exactly, meaning that this ETF is comprised of 30 mega-cap ETFs -- the median market cap exceeds $100 million. The difference between DIA's market value and the return on the DJIA has approximated the fund's expense ratio since its inception more than 12 years ago, indicating that DIA is generally efficient in minimizing tracking error. From a cost perspective, DIA is fairly competitive, charging an expense ratio of just 0.17%.

ELEMENTS Dogs of the Dow ETN (DOD)

This exchange-traded note is linked to the Dow Jones High Yield Select 10 Total Return Index, a benchmark that identifies the highest yielding components in the DJIA. Each December, the thirty stocks in the Dow Jones Industrial Average are ranked by indicated annual dividend yield. The 10 stocks with the highest indicated annual dividend yield are then selected as index components.

The "Dogs of the Dow" investment strategy was introduced in the early 1990s by money manager Michael B. O'Higgins in the book Beating the Dow. Current components of the index have an average dividend yield of 4.4% (as of February 2010) and include AT&T ( T), Verizon ( VZ), DuPont ( DD), Kraft ( KFT), Merck ( MRK), Pfizer ( PFE), Chevron ( CVX), McDonald's ( MCD), Home Depot ( HD) and Boeing ( BA). By comparison, DIA has a dividend yield of about 3.1% (see a guide to high dividend ETFs).

Fees are a major drawback of pursuing this investment strategy through an ETN: DOD charges an expense ratio of 0.75% for implementing a strategy that is relatively easy for most investors to execute at a much cheaper rate. It should also be noted that DOD is structured as an exchange-traded note, meaning that it exposes investors to credit risk of the issuing institution.

Inverse Dow ETF Options

For investors looking to gain inverse or leveraged exposure to the Dow Jones Industrial Average, ProShares offers a handful of ETF options:

  • ProShares Short Dow30 (DOG): This ETF seeks daily investment results that correspond to the inverse of the daily performance of the DJIA.
  • ProShares Ultra Dow30 (DDM): This ETF seeks daily investment results that correspond to 200% of the daily performance of the DJIA.
  • ProShares UltraShort Dow30 (DXD): This ETF seeks daily investment results that correspond to 200% of the inverse of the daily performance of the Dow.

At the time of publication, Johnston had no positions in equities mentioned.

Michael Johnston is the senior analyst and founder of ETF Database, a Web-based investment resource providing actionable ETF investment ideas and an ETF Screener for investors analyzing potential ETF investments. Johnston oversees ETF Database's free ETF Newsletter, one of the most popular sources for news and commentary focusing exclusively on the exchange-traded fund industry. Johnston also maintains and develops content for ETFdb Pro, a line of analyst reports and model portfolios designed to help investors utilize ETFs to meet their investment goals.

Johnston has completed the Chartered Financial Analyst (CFA) program, and obtained his bachelor's degree in finance from the University of Notre Dame. Prior to founding ETF Database, Michael worked in a private client service group performing valuations of companies operating in a wide range of industries.

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