Understanding Risks of ETFs in Passive Equity Investing

Very Hard Passive Equity Investing Exchange-traded Funds

Sarah is a portfolio manager for a large institutional investor and is considering allocating a portion of the fund's equity investments into Exchange-Traded Funds (ETFs) that track various market indices. She is particularly interested in understanding the advantages and drawbacks of using ETFs compared to traditional mutual funds.

During her research, Sarah comes across a new ETF that claims to have lower expense ratios due to its passive management approach, and another that provides the same tax advantages typically associated with ETFs. However, she also notes potential risks related to liquidity and tracking error that could affect performance.

Which of the following statements accurately reflects a fundamental characteristic or risk associated with ETFs in the context of passive equity investing?

ETFs typically provide greater transparency regarding their underlying holdings compared to mutual funds, which is a key advantage of passive investing.

The liquidity risk of ETFs is generally lower than that of traditional open-end mutual funds due to the creation and redemption mechanism.

ETFs are often subject to tracking errors that can occur because of differences between the fund's performance and the index it is designed to replicate.

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