The authors compare five Dow Jones Industrial Average (DJIA) substitutes with the actual DJIA to understand the impact of the company replacement policies of the Wall Street Journal. During March 1997 to September 2008, the editors of the Wall Street Journal approved 13 nonterminal event corporate changes to the DJIA. These corporate changes were largely discretionary and subjective. The authors attempt to determine whether the DJIA is higher or lower because of these nonterminal index changes and to compare the level of the DJIA with that of other market indices.

The authors find that the DJIA is biased as a result of the editors of the Wall Street Journal changing components of the DJIA by dropping and replacing nonterminal event companies. Terminal events, such as a merger, acquisition, or bankruptcy, also lead to replacement of the terminated company’s stock with another security. But the replacement decisions related to nonterminal event companies are more prone to subjectivity and human judgment, which may distort the DJIA’s role as a meaningful benchmark.

The DJIA’s bias appears to be downward from the level it could have had in the absence of nonterminal index changes. That is, the actual DJIA holding period return (HPR) would have been higher if the Wall Street Journal editors had not altered the DJIA by dropping and replacing nonterminal event companies. These changes have produced an index that is more comparable with the returns achieved in the overall market and also closer to the actual condition of the economy.

The authors also find that the DJIA is likely unbiased compared with broad market indices. The replacement of nonterminal event companies reduced the DJIA’s bias when other broad market indices were used as the comparisons.

The authors construct five DJIA indices with market data beginning in May 1991. These five indices—named Alternate Dow 1, Alternate Dow 2, and so on—differ in terms of how terminal event companies and nonterminal event companies are handled. Each of these alternate indices is compared with the actual DJIA, which reveals the impact of replacing the terminal event and nonterminal event companies.

The most important comparison is the one that evaluates the impact of nonterminal event companies being removed from the actual index and replaced with substitute companies. Alternate Dow 3 is modeled by maintaining the replacement of terminal event companies but reversing the replacement of nonterminal event companies. The changes made to nonterminal event companies are largely subjective, and the primary issue is whether these discretionary changes increase or decrease the DJIA’s value. The Wall Street Journal editors attempt to maintain an index that is representative of the entire economy and its equity market.

To facilitate a comparison of different portfolios, the authors compute a holding period return for each portfolio using return data from 1997 to 2011. These portfolio returns are used to calculate over- and underperformance.

The authors demonstrate that the alternate indices significantly outperformed the actual DJIA, which is primarily attributable to subjective changes among nonterminal event companies. During the sample period, Alternate Dow 3 generated an HPR that was 25% higher than that of the actual DJIA. The authors find that replacement of nonterminal event companies in the actual DJIA has led to a lower HPR and an index that is similar to the returns earned by the S&P 500 Index and Russell 3000 Index.

The authors’ findings are interesting. A downward bias in the DJIA seems to have produced an index that is more representative of the overall economy. It is also interesting that the authors’ findings indicate that the DJIA is less biased than other indices.