GE kicked out of Dow- and a question on Index Funds

[Johnez]

http://money.cnn.com/2018/06/19/investing/ge-dow-jones-walgreens/index.html

S&P Dow Jones Indices announced on Tuesday that the iconic maker of light bulbs and jet engines will be replaced in the 30-stock index by Walgreens Boots Alliance.

GE (GE) was an original member of the Dow in 1896 and has been in it continuously since November 7, 1907.

Now I've read that these indeces have done this in the past with other loser companies, usually when they fold or whatever. 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?

[maizefolk]

Well so the thing to remember is that the change in the index isn't retroactive, so it doesn't create an upward bias in historical indices.

What it does mean is that most indexes are not representative of the returns from completely pure buy-and-hold investing, but instead are representative of returns with uncommon trades from companies on downward trajectories to those on upward trajectories.

[matchewed]

https://en.wikipedia.org/wiki/Historical_components_of_the_Dow_Jones_Industrial_Average

There is rather frequent turnover when you only consist of 30 stocks...

In short your choice of fund to analyze whether the US market can or can not return 7% is a poor choice.

[Johnez]

Well so the thing to remember is that the change in the index isn't retroactive, so it doesn't create an upward bias in historical indices.

What it does mean is that most indexes are not representative of the returns from completely pure buy-and-hold investing, but instead are representative of returns with uncommon trades from companies on downward trajectories to those on upward trajectories.

Ok makes sense, so far I get that GE's gains and losses during the time they were listed aren't gone.

I'm a simpleton however, and apologize for belaboring the point, but does the bolded part mean that the "7% returns average" does not hold up? I don't understand after the bolded statement.

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?

[Johnez]

https://en.wikipedia.org/wiki/Historical_components_of_the_Dow_Jones_Industrial_Average

There is rather frequent turnover when you only consist of 30 stocks...

In short your choice of fund to analyze whether the US market can or can not return 7% is a poor choice.

Well I'm invested in the S&P 500, but figured the question universal across the index funds.

[maizefolk]

I'm a simpleton however, and apologize for belaboring the point, but does the bolded part mean that the "7% returns average" does not hold up? I don't understand after the bolded statement.

7% average return holds up. If you buy an S&P 500 index fund for example, they'll automatically trade out of companies that leave the index and into new ones that replace them.

[Systems101]

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.pdf

Over 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-357912

To 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.

[Johnez]

Wow, thanks for the extremely detailed response Systems101. Feel pretty good about the index funds again heheh.

[Davids]

Is the Dow really a good index to follow? I feel it is an index for the "novice" investor meaning that when a question is asked how did the market do a "novice" investor could say it was up 150 points today but do they even know what that really means? The Dow is just a nice large number but not a real true index to follow since it is just 30 large cap stocks.

On another note wow has GE fallen to now be kicked off the Dow.

[Chris22]

Well so the thing to remember is that the change in the index isn't retroactive, so it doesn't create an upward bias in historical indices.

What it does mean is that most indexes are not representative of the returns from completely pure buy-and-hold investing, but instead are representative of returns with uncommon trades from companies on downward trajectories to those on upward trajectories.

Ok makes sense, so far I get that GE's gains and losses during the time they were listed aren't gone.

I'm a simpleton however, and apologize for belaboring the point, but does the bolded part mean that the "7% returns average" does not hold up? I don't understand after the bolded statement.

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?

I think it's looking at it backwards, no?  They're not trying to pick stocks to support a return, they're picking stocks that are market representative.  So if the market is returning a certain percentage, the stocks picked should approximate that return because they are a representation of the market. 

[Arbitrage]

For an index such as the S&P 500, there is a non-zero effect to companies leaving and joining the index.  Certain investors will arbitrage the index funds when these inclusions/exclusions are announced - buying companies before the index funds have to, selling before the index funds have to, to take advantage of the additional demand/price pressures. 

That's one reason to go for a total market fund over the S&P 500.  However, these effects are pretty darn small in the grand scheme of things.  Plot the historical returns of S&P vs total market to convince yourself, remembering that the S&P omits small caps and smaller mid caps.

[FIRE@50]

Well so the thing to remember is that the change in the index isn't retroactive, so it doesn't create an upward bias in historical indices.

What it does mean is that most indexes are not representative of the returns from completely pure buy-and-hold investing, but instead are representative of returns with uncommon trades from companies on downward trajectories to those on upward trajectories.

Ok makes sense, so far I get that GE's gains and losses during the time they were listed aren't gone.

I'm a simpleton however, and apologize for belaboring the point, but does the bolded part mean that the "7% returns average" does not hold up? I don't understand after the bolded statement.

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?

I think it's looking at it backwards, no?  They're not trying to pick stocks to support a return, they're picking stocks that are market representative.  So if the market is returning a certain percentage, the stocks picked should approximate that return because they are a representation of the market.

I think the Dow Jones Industrial Average was created to track a small(well less than 30) basket of industrial companies. The intention was to track the economy more so than the overall market. Remember, index investing is a relatively new phenomenon. The DJIA has grown a lot over the years and now is almost exclusively non-industrial companies. The economy has evolved and the index has evolved with it.