Considerations for Pension Funds Transitioning to an ETF Strategy

As passive investing has gained increasing popularity over the past two decades, Exchange-Traded Funds (ETFs) have become a cornerstone of this strategy, providing investors with diversified exposure to various asset classes. In light of this evolution, consider the following scenario:

A large pension fund is evaluating its equity investment strategy and is considering transitioning a significant portion of its actively managed equity portfolio to a passive strategy utilizing ETFs. Some portfolio managers within the pension fund express concerns about potential drawbacks, including tracking error, liquidity issues during market downturns, and the possible impact of management fees on long-term performance.

Discuss the key considerations that the pension fund must evaluate when assessing the shift to a passive ETF-based strategy. Additionally, analyze how tracking error can uniquely affect different types of ETFs, such as sector-specific versus broad-market ETFs, and how this may influence the pension fund’s decision-making process. Finally, consider the implications of liquidity in various market conditions, particularly how it may influence the fund's overall risk profile in turbulent markets.