Dow Changes Will Trigger Big DIA Trades

September 18, 2013

Pulling off the latest changes to the Dow will be trickier than it may seem.

Price weighting is so 19th century. Nevertheless, the price-weighted Dow Jones industrial average remains a frequently cited barometer for the state of equity markets.

While the issues with price weighting are many, once the security selection is set, the direction and magnitude of change for the DJIA has tended to mimic the performance of large-cap U.S. stocks.

When changes do occur, the nature of the 30-security index can change dramatically, as a new entrant with a high stock price will immediately make up a significant portion of the index.

As such, I’m shocked by the limited coverage the recent rebalance announcement from the Dow Jones committee has received.

The changes are quite significant: On Sept. 23, Bank of America (BAC), Hewlett-Packard (HP) and Alcoa (AA) will be replaced by Goldman Sachs (GS), Visa (V) and Nike (NKE). More importantly, the three new holdings will make up almost 18 percent of the index, while the exiting stocks made up just over 2 percent.

The shake-up leaves the sole ETF tracking the index, the SPDR Dow Jones Industrial Average ETF (DIA | A-75), with some tough decisions. While the index just rebases the denominator and continues on its merry way, the fund’s trustee, State Street Global Advisors, has a much taller task ahead.

As a unit investment trust, DIA must fully replicate its index. According to the fund’s prospectus, the trustee has three business days before or after an index change to align the fund’s holdings with the underlying index.

Assuming nothing changes, the fund currently has assets of approximately $12 billion. This means that the fund will need to sell all of its holdings of Bank of America, HP and Alcoa—as well as enough of the remaining 27 holdings—to make room for Goldman, Visa and Nike.

At their current prices, Visa will become the index’s second-largest holding, at 7.9 percent. Goldman will be third largest, with a 6.9 position. Nike, meanwhile, will make up just 2.9 percent of the index.

Doing the math shows that the manager will be making some large trades over a fairly short time window.

In the case of Goldman, DIA would have to purchase about $830 million in shares. If that’s done over one trading day, it would constitute more than twice Goldman’s average daily volume over the past month. Such a large trade would likely move Goldman’s stock price by at least 2 percent.


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