For example, the purpose of the Dow Jones U.S. Select Dividend Index is not to measure the broad market but rather to track a selection of 100 high-yielding stocks with sustainable dividends. The sizes of the companies involved are beside the point. This index is weighted by dividend payouts. (It was launched in late 2003, making it the first of the current generation of "fundamentally weighted" indexes.)

A number of the new indexes make no pretense of measuring markets; rather, they mirror investment strategies that are intended to beat the market. Take the FTSE RAFI US 1000 Index, for instance. It comprises the 1,000 U.S. stocks with "the largest RAFI fundamental values," which are derived from average sales, cash flow and dividends over the prior five years, plus current book value. Then the components are weighted relatively by a combination of those same values. Market capitalization is nowhere in sight—except in the indexes to which FTSE RAFI compares itself.

Rob Arnott, the developer and champion of this methodology, aspires to have his creation supplant market-cap weighting as the indexing standard. His argument is that market capitalization sends investment dollars chasing after "overpriced" stocks at the expense of "underpriced" ones. That is the opposite of what investors should do in a market where stocks tend to revert to average performance after periods of leading or lagging.

Whether his fundamental-weighting cocktail is the answer remains to be seen. But he is absolutely right that market-cap weighting exaggerates the influence of hot stocks with fast-rising prices. In short, market-cap indexes can inflate bubbles.

Consider the dot-com effervescence of the late 1990s. From Dec. 31, 1995, the S&P 500 rose 148 percent to its high point before the bear market began, while the DJ industrial average gained 129 percent. (The two indexes reached their highs on different dates in 2000.) Unsurprisingly, the S&P 500 dropped 49 percent in the bear market versus the Dow's 38 percent fall.

[The more recent credit bubble is not a good example, however. From Dec. 31, 2005, to Oct. 9, 2007 (the day the bull died at the close), the S&P 500 gained 25.38 percent to the Dow's 32.16 percent; it was held back by lagging performance in the bottom half of its components. From that high point, through Oct. 31, 2008, the S&P 500 lost 38.10 percent to the Dow's 34.17 percent, primarily because the S&P 500 had more basket cases—Bear Stearns, Countrywide, Fannie Mae, Lehman—than the Dow (only AIG).]

What caused the skewing a decade ago? In bull markets—particularly runaways—companies tend to issue more stock, not to mention "go public" for the first time. Therefore, market-cap indexes are being boosted both by rising prices and increasing outstanding shares. Stock selection also plays a role. In the late 1990s, the S&P stock-picking committee added several technology stocks to the 500, which intensified its rise and subsequent fall.

Dow Performance Depends On Stock Selection

While price-weighted indexes sidestep the influence of share numbers, they of course cannot escape the movement of stock prices. To the extent they succeed in reflecting the broad market—as the Dow does—it is because of stock selection. The Dow's components are very large, very durable companies that lead their respective industries. They tend to issue additional shares mainly to make acquisitions, which also affects the price.

If the editors of The Wall Street Journal suddenly added a smaller, newer, fast-growing company to the Dow, the components' shared stability characteristic would be thrown out of whack. Similarly, if a Dow component's price skyrocketed without a stock split, its weight would dominate the index. Allowing either situation to persist would undercut the Dow's ability to reflect the market accurately.

Thus does the long answer wend its way circuitously to "yes." Price-weighted indexes can and do measure markets as well as market-cap indexes, but their component selections must be managed carefully to achieve that end. Price-weighting, like the other "alternative" weighting schemes, does not reflect the market's capitalization structure. So, a price-weighted index cannot be a benchmark in that sense.

But price-weighted indexes can be benchmarks of a different sort—representing the opportunity cost of capital. The very-liquid futures, options and the Diamonds ETF are testimony to the myriad ways investors use the Dow in their strategies. This liquidity legitimizes the Dow's performance as a benchmark of equity-market exposure, against which an investor can measure the results of his or her choices in any given period.

The way an index weights its components is indeed an important element of its methodology, but does not in itself either establish or invalidate the index's usefulness. Making that judgment requires, in addition, a careful review of an index's purpose and its component-selection and reconstitution procedures. This is not an easy task, but there is no alternative.

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