ETF Analysis and the Paradox of Choice

One of the driving forces behind exchange-traded funds (ETFs) is the idea of low-cost diversification. To say the least, it’s been successful – perhaps too much so. There are now thousands of ETFs out there, and that means proper ETF analysis is a real challenge, particularly because many of them are so similar.

But by leveraging advanced analytical tools, investors can navigate the vast ETF landscape more efficiently, and reduce the cognitive burden of choice while still benefiting from the diverse options available.  

The Paradox of Choice

The paradox of choice is the concept that, the more options someone has, the less happy they are with their eventual decision. You would think that a world where you can pick from a huge variety of products is better than one offering a minimal selection. But studies have revealed that too many options result in mental overload as a person struggles to decide what’s important to them, and then apply this “choice architecture” to a wide selection of products. In the end, many of us rely on “second-order” decisions that might not result in the best outcome, but which are easier to make.    

Does this Paradox Affect Investors?

In the financial industry, the paradox of choice is hard at work, and nowhere is this truer than in the ETF sphere. There are approximately 10,000 ETFs at present, and some funds cover thousands of companies and other entities. There are even a number of ETFs that are based on the same index, with the S&P 500 being a popular choice to replicate, while other funds are based on more novel strategies. 

Making this situation even more complex is the number of fund types. Originally, the potential of ETF investment upsides came from the low management fees that were charged. ETF fund supervisors often choose an index to follow and that is about it (AKA a “passive” fund). In comparison, mutual funds are actively managed, so that holdings are changed constantly to provide more value – but come with higher fees as well. Yet there has also been diversification here, with some ETFs being actively managed, and some mutual funds being passive.   

Beating the Paradox 

Unlike many of the choices that we make, investments can be changed. They can also be evaluated objectively by calculating ROI. On a constant basis, investors and analysts are able to view the performance of an ETF and compare results between funds. Particularly in the long run, spotting a winner is easy. 

A greater challenge is to choose the best funds upfront. There are a number of investor resources that can help advisors and their clients to understand what sort of ETF investments match somebody’s financial goals. Is the client a growth investor, or more focused on income or stability? From that point, the advisor’s job gets much harder. 

Ratios Aren’t Everything

Many analysts who deal with ETFs start with a certain set of ratios to compare funds. The most common one is the expense ratio, which looks at how much it costs to invest in a fund. 

Now let’s say that you are comparing funds of similar composition, or based on the same industry, and have accounted for fees. You find a difference in performance. Now what? You can’t just go for the one that is performing better today. Historical returns count, but it’s more important to look into the future. Otherwise, who needs analysts?

For stocks, the obvious approach at this stage is to take a deep look at financial statements, news reports, industry forecasts, and other indicators. But it’s not so easy with ETFs. As mentioned, some of them are made up of thousands of holdings. For example, the Vanguard Total Bond ETF covers almost 18,000 assets. In a way, the very thing that makes ETF a great investment also makes them more of a gamble: the complex nature of their underlying assets.

The Best Investor Tools for ETFs

Even with an analysis method that helps you to cut through the clutter, ETFs remain a challenge. Most investors want to increase diversification by holding a number of ETFs (the general recommendation is between five and ten). More experienced and/or advanced clients might want a larger number than this. For advisors who have numerous clients and varying goals, that’s a lot of analysis.

In this environment, financial AI can provide a solution. The leading financial AI platforms sift through a full range of datasets for thousands of companies across the globe and boil down the information to a clear set of metrics, comparisons, and recommendations. Perhaps most importantly, AI will examine every holding in an ETF’s index and deliver data that is essential for understanding the fundamental components of an investment. 

By embracing advanced AI solutions, prioritizing financial education, and focusing on personalized solutions, the investment community can transform the ETF choice paradox from a stumbling block into a stepping stone towards more effective, tailored investing.

Make the choice of investment faster, easier, and more accurate with the Bridgewise platform for fund analysis. Bridgewise’s AI technology provides investor tools that are critical for financial institutions wishing to remain competitive, and help clients to choose funds with confidence. Start transforming your analysis today with a Bridgewise demo.