A Fund That Won by Tracking the Dow

NEW YORK ( TheStreet ) -- During the past ten years, S&P 500 index funds suffered through rough markets and then rebounded to deliver solid results. Over the decade, SDPR S&P 500 ETF ( SPY) returned 8.0% annually, outdoing two-thirds of large blend mutual funds tracked by Morningstar. The strong record has not gone unnoticed. During the past year, shareholders poured $18.6 billion into the SPDR ETF, according to IndexUniverse.com.

But investors could have done even better with SPDR Dow Jones Industrial Average ( DIA), which returned 8.3% annually over the past ten years. The Dow Jones ETF seems particularly notable because it was less volatile than the S&P 500. During recent downturns, the Dow has outdone the S&P 500 by comfortable margins.

Should you dump your S&P 500 funds and shift to the Dow Jones choice? Not necessarily. The Dow average is a peculiar contraption that may not excel in every market. But there is a strong case for shock-proofing a portfolio by putting a limited amount of assets into the Dow.

Charles Dow created his index in 1896 by adding up the prices of 12 stocks. Since then, the benchmark has been expanded to include 30 leading companies that are broadly representative of the U.S. economy. A Dow Jones committee picks the names, seeking to find dominant businesses that should maintain their strong positions because of their competitive advantages.

The committee's judgments are subjective, and there are no mechanical rules dictating when new names must be included. Still, the committee has proven adept over the years, selecting rock-solid blue chips. The ETF now holds such reliable performers as Exxon Mobil ( XOM), Caterpillar ( CAT), and Coca-Cola ( KO).

Though it includes a limited number of names, the portfolio does provide some diversification because holdings are massive multinationals that operate in many businesses and derive much their sales overseas. "The Dow Jones ETF offers a way to own very high quality companies that can do relatively well in downturns," says Alex Bryan, a Morningstar ETF analyst.

The giants in the portfolio may not grow as fast as the latest technology stars, but many of the Dow stocks pay reliable dividends. The ETF yields 2.4%, a nice payout at a time when the S&P 500 yields 2.1%. Because the Dow stocks are not necessarily glamorous, they sell at modest multiples. The ETF has a price-earnings ratio of 12.9, compared to 14.0 for the S&P 500.

Though it is representative of many industries, the portfolio is skewed toward a few holdings because of the benchmark's peculiar weighting system. Under the Dow Jones rules, stocks are weighted according to their share prices. So the biggest holding is IBM ( IBM), which has a share price of $199 and accounts for 11% of assets. Microsoft ( MSFT) only accounts for 1.5% of assets because its share price is around $27.

This approach is very different from the S&P 500 which weights every stock according to the market value of the shares. In the S&P, IBM and Microsoft both account for about 1.5% of assets. Academic researchers have long argued that the market-cap weighting of the S&P 500 is a better system that accurately reflects the realities of the economy.

The Dow has other peculiarities. It excludes Apple ( AAPL) as well as transportation and utilities stocks. The Dow underweights financials compared to the S&P 500. The underweighting helped the benchmark outperform when bank shares collapsed in 2008. For the year, the Dow ETF lost 32%, compared to a decline of 36.8% for SPDR 500.

For investors who want a dose of giant stocks in a more modern package, Morningstar's Alex Bryan suggests Vanguard Dividend Appreciation ( VIG). The ETF owns companies that have increased their dividends in each of the past ten years. Holdings are weighted according to their market caps. Stocks in the portfolio include many Dow names, such Wal-Mart ( WMT) and Procter & Gamble ( PG). Holding 133 stocks, the Vanguard ETF is more broadly diversified than the Dow.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.