Q1. Which statement about the advantages and disadvantages of exchange-traded funds (ETFs) is least accurate?

A)   ETFs represent an attractive diversification tool, but investors cannot check their composition daily.

B)   Most ETFs have low fees, but some may cost more to trade because of high bid/ask spreads.

C)   ETFs offer less capital-gains tax liability than open-end funds.

Q2. Which of the following is least likely an advantage of exchange traded funds (ETFs) over traditional mutual funds?

A)   The structure of ETFs prevents share prices from trading at a significant premium/discount to net asset value (NAV).

B)   ETF shares have smaller bid-ask spreads than open-end mutual funds.

C)   ETF shares trade throughout the day at continuously updated prices, while open-end funds trade only once a day at close-of-market prices.

Q3. Which of the following risks are specific to exchange traded funds (ETFs) that are allowed to purchase derivatives?

A)   Tracking error risk.

B)   Market risk.

C)   Credit risk.

Q4. A primary advantage of the in-kind redemption process of exchange traded funds (ETFs) is that it:

A)   provides greater liquidity for shares of the ETF.

B)   reduces transaction costs for the investor.

C)   reduces tax liability.

LOS c: Explain the advantages and risks of ETFs. fficeffice" />

Q1. Which statement about the advantages and disadvantages of exchange-traded funds (ETFs) is least accurate?

A)   ETFs represent an attractive diversification tool, but investors cannot check their composition daily.

B)   Most ETFs have low fees, but some may cost more to trade because of high bid/ask spreads.

C)   ETFs offer less capital-gains tax liability than open-end funds.

Correct answer is A)

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.

Q2. Which of the following is least likely an advantage of exchange traded funds (ETFs) over traditional mutual funds?

A)   The structure of ETFs prevents share prices from trading at a significant premium/discount to net asset value (NAV).

B)   ETF shares have smaller bid-ask spreads than open-end mutual funds.

C)   ETF shares trade throughout the day at continuously updated prices, while open-end funds trade only once a day at close-of-market prices.

Correct answer is B)

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.

Q3. Which of the following risks are specific to exchange traded funds (ETFs) that are allowed to purchase derivatives?

A)   Tracking error risk.

B)   Market risk.

C)   Credit risk.

Correct answer is C)

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

Q4. A primary advantage of the in-kind redemption process of exchange traded funds (ETFs) is that it:

A)   provides greater liquidity for shares of the ETF.

B)   reduces transaction costs for the investor.

C)   reduces tax liability.

Correct answer is C)

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.

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