Something New With Something Old: DIY DJIA

The growth of index funds has, in the main, helped to lower the costs and improve the performance of the average investor’s portfolio. Now, some are seeking to improve upon even the relatively low costs of conventional index funds via so-called “direct indexing”, by which investors purchase securities to match an index themselves, disintermediating the middlemen entirely. In fact, directly constructing a market-tracking portfolio might be easier than you think, and the concept is almost certainly much older than you realize.

Spoiler alert: this is really a post about replicating the 125-year old Dow Jones Industrial Average® near-perfectly, with a little more than $5,000. But, first, let’s consider replicating three possible benchmarks for U.S. equities, ordered by their increasing breadth: the S&P 500®, the S&P Composite 1500®, and the S&P U.S. Total Market Index (TMI).

In practice, an investment manager tracking any of these indices—particularly the S&P TMI—will likely only approximate the index’s holdings. Indeed, doing so while still delivering benchmark-like returns is one of the central skills of passive portfolio management. To illustrate, consider just two conditions that might be applied:

1. If a security is in the index, we must hold a non-zero position in that security.

2. Each position must consist of a whole number of shares.

Conditions 1 and 2 effectively set a minimum size on the portfolio: if we need 1% weight in a stock priced at $100, for example, we need a portfolio of a least $10,000 (equal to the price, divided by the weight). Ranging across all constituents, the largest price-to-weight ratio gives us an indication of how large a portfolio must be to replicate the index fully. Based on this simple calculation, Exhibit 1 displays the minimum portfolio size to replicate each index, assuming that the stock with the highest ratio of price-to-weight has an allocation of exactly one share, and every other constituent is allocated the whole number of shares closest to the target weight. We also report the active share of the resulting portfolio versus its benchmark.

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