My question, just how much does this affect the "returns" every year from the fund? I'm not even sure where to start, but my main concern is-does the "average of 7% return" every year that the S&P 500 is said to bring really hold up when accounting for the shuffling of the index?
Short version: Yes
Longer answer: Yes, but there are some secondary effects that might add up to some fraction of a percent. That's because there are a few different effects of a stock swap in either index:
(1) Because index swaps are announced ahead of time and when the swap date occurs, there is a "known" buying and selling pressure from the swap of stocks, there is a counter-trade (arbitrage) that occurs, which effectively bids up a stock like Walgreens that is entering an index and bids down GE. This transfers some value from the index funds to those that do the arbitrage trade, see:
https://pdfs.semanticscholar.org/1957/2e5fdbd901c06ac6c21fd5db5f60ca532def.pdfOver time, this has an effect, but it's dwarfed by the overall return.
(2) What maizeman said, in terms of there is some selection bias that makes it more than a total market fund, but this is also dwarfed by the overall return.
(3) The ratio of movement for the DJIA will change. That is necessary due to an issue you point out:
This might also sound like a dumb question (apologies), but let's say GE's stock is priced at $10, does swapping them out for Walgreens at $100 show some sort of gain that isn't really a gain?
This is not a dumb question - actually a good question that provides some insight for folks not familiar with how the DJIA works.
It's also related to this:
Well I'm invested in the S&P 500, but figured the question universal across the index funds.
...because the S&P 500 and the DJIA are different. The S&P 500 is market-cap weighted (so the holdings are roughly equivalent to the market capitalization (price times stock quantity) for each of the stocks in the S&P 500) and the DJIA is price weighted (so weighting is based on the dollar value of a share, market cap is not considered), so they will behave somewhat (or sometimes very) differently.
The net change here for the DJIA is that it will change the divisor so that the index value doesn't change and a $1 change in any DJIA stock will now be different than it was before the replacement.
From:
https://www.thebalance.com/understanding-the-dow-jones-industrial-average-djia-357912To compensate, the divisor of the DJIA is frequently modified for corporate events and transactions. Long story short, in the event of a stock split, the value of the Dow Jones Industrial Average is calculated both before and after the split. The post-split divisor is modified so that a change in the stock price of the company results in the same percentage change in the overall index as if the split had never happened.