S&P Dow Jones Indices announced the following changes to the Dow Jones Industrial Average (DJIA) effective prior to the opening of trading on Monday, August 31, 2020: Salesforce.com (NYSE: CRM) will replace Exxon Mobil Corp. (NYSE: XOM), Amgen Inc. (NASD: AMGN) will replace Pfizer Inc. (NYSE: PFE), and Honeywell International Inc. (NYSE: HON) will replace Raytheon Technologies Corp. (NYSE: RTX).

The index changes were prompted by DJIA constituent Apple Inc.'s (NASD: AAPL) decision to split its stock 4:1, which will reduce the index's weight in the Information Technology sector. The announced changes offset that reduction and diversify the index by removing overlap between companies of similar scope and adding businesses that better reflect the American economy.

We have the following observations about these changes to this historic index:

The Dow Jones Industrial Average is a price-weighted index. It is calculated by adding up the stock prices of its constituents and then normalizing the resultant value by dividing it by an index divisor. It does not account for a company’s number of shares outstanding. This is much different from a market capitalization weighted index, such as the S&P 500, that accounts for a company’s outstanding shares.

For price weighting, a high stock price has a major impact on the index while the number of shares outstanding has none. This critical difference is a major reason why just $31.5 billion in assets were linked to the Dow industrials at the end of 2019, versus $11.2 trillion that followed the S&P 500—in addition to the S&P 500’s greater diversity with 500 vs 30 companies.

The index divisor is key to maintaining the continuity of the index level following corporate actions (including stock splits) or index rebalancing. Apple’s stock split and the changes to the index’s constituents will all change the index divisor.

Apple was the highest priced stock in the Dow and consequently had a big influence on the index. Given Apple’s 4:1 stock split, its weight in the index was set to drop significantly and would have dropped the Technology sector from almost 28% of the index to 20%. The addition of Salesforce.com will raise the weighting of Technology back to 23%.

Energy was only 3% of the Dow and removing Exxon will reduce this weighting even further with Chevron now the only remaining energy stock.

Health Care was close to 15% of the index and switching Amgen for Pfizer will shift the emphasis to biotech from pharmaceuticals and raise the influence of Health Care on the index since Amgen trades at a much higher price than Pfizer.

Industrials was close to 13% of the index, but the emphasis will shift from Raytheon Technologies’ heavy aerospace exposure to a more diversified industrial exposure with Honeywell. Honeywell also trades at a higher price than Raytheon, which increases the influence of industrials on the index.

These changes will have a minor impact on the weightings of the other sector—Consumer Discretionary (14.5%), Financials (13%), Consumer Staples (9%), Communication Services (4.5%), and Materials (1%).

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