LOS c: Explain the advantages and risks of ETFs.

ETFs are a useful diversification tool, and investors can check their composition at any time. ETFs generally charge low fees, but some with low trading volume may be costly to trade. ETFs incur less tax liability than open-end funds.

ETF shares do trade continuously throughout the day, unlike shares of open-end funds. Investors in ETFs do have lower capital gains liabilities than investors in open-end funds because of ETF’s in-kind redemption feature. Because of the in-kind creation/redemption process of ETFs, new shares will be issued or redeemed in accordance with investor demand, thus eliminating any significant discount or premium. Because ETF shares trade on the open market, the shares are subject to a bid-ask spread, while open-end funds trade at NAV and are not subject to a bid-ask spread.

All ETFs are subject to market risk just like any other diversified portfolio. Tracking error risk is always present in an index fund. Only those ETFs that utilize a derivatives strategy will be subject to credit risk.

ETFs are typically cost-effective for the investor because they are passively managed and therefore have lower management fees than actively managed portfolios. The in-kind process has no effect on the liquidity of the ETF shares. The in-kind process does reduce asset turnover, because shares do not have to be sold in order to satisfy the redemption of shares.