ETF shelf space and the 1/n heuristic

09Jan08

One of the big selling points of the exchange traded fund or ETF was the notion that this would simplify investor’s lives. Broad-based, low cost indexed funds would allow investors to cheaply and simply construct well-diversified investment portfolios.

While the roster of ETFs has now nearly spanned all available asset classes, it has also generated dozens (even hundreds) of ‘quasi-active’ equity ETFs which purport to have a superior approach to security selection. How do investors in the real world approach the portfolio allocation process?

Felix Salmon at Market Movers takes a look at how the folks at WisdomTree Investments are stepping on their own message. While there may very well be a sound historical case to tilt toward value (and small) stocks the level of complexity inherent in their lineup makes fund selection a challenge.

As an investor in index ETFs myself, I value simplicity greatly: it helps bring down the all-important expense ratio, and it means that I don’t need to worry about which fund to pick – I just pick the broadest, simplest fund I can find. Walking through Wisdom Tree’s virtual front door, I feel a bit like someone faced with 60 different types of toothbrush at the supermarket. And so I retreat to something cheaper and simpler elsewhere.

We wonder how many other investors have Felix’s reaction and act accordingly? Our guess is very few. Simple portfolios composed of broad-based, low cost indexed funds are in all likelihood the exception, rather than the rule.

There is a heuristic seen in the behavioral finance literature called the “1/N solution.” Where investors faced with constructing a portfolio often simply allocate their assets equally across whatever options there are available. Barry Barnitz at Asset Allocation has an entire post devoted to the topic which is well worth checking out.  An ‘1/n solution’ is clearly impractical in a world of hundreds of ETFs.  However the temptation for investors to seek out new and novel ETFs is always present.

On the other hand, there is some guidance out there for individual investors. The burgeoning ‘portfolio simplicity’ or ‘lazy portfolio’ approach seems to be gaining some momentum. Since we have previously touched on this topic we will point readers to a previous post. In the meantime let’s note a caveat in all of this. Portfolio simplicity is not always altogether simple. It requires a level of discipline and self-restraint many investors find difficult.

It is hard to blame the ETF sponsors in all this. They are simply trying to make a buck. Indeed many fund executives state that their funds are designed specifically for active investors and institutional traders. This rush to fill up virtual shelf space will in all likelihood create some ‘orphan ETFs‘. It is incumbent on investors to realize that just because an ETF was created does not mean it necessarily belongs in your portfolio.

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