ETF vs. Traditional Mutual Fund

A

When comparing an exchange-traded fund (ETF) to a traditional mutual fund, there are several key differences that can help us determine the most likely offering. Let's go through each answer choice in detail:

A. Better risk management: ETFs are known for their transparent and rules-based investment strategies, which can contribute to better risk management. Most ETFs are designed to track specific indexes or sectors, and their holdings are typically disclosed on a daily basis. This transparency allows investors to assess the risk exposures of the ETF and make informed investment decisions. Additionally, ETFs often have lower expense ratios compared to traditional mutual funds, which can enhance overall risk-adjusted returns.

B. Less portfolio transparency: This answer choice is incorrect. ETFs generally provide greater portfolio transparency compared to traditional mutual funds. ETFs are required to disclose their holdings on a daily basis, allowing investors to see the individual securities held within the ETF. In contrast, traditional mutual funds typically disclose their holdings on a quarterly basis, which can result in a lag in transparency. Therefore, an ETF is more likely to offer greater portfolio transparency.

C. Higher exposure to capital gains distribution taxes: ETFs tend to have a more tax-efficient structure compared to traditional mutual funds. This is primarily due to the creation and redemption process of ETF shares, which allows for in-kind transfers of securities. When an investor wants to redeem shares of an ETF, the ETF provider can transfer the underlying securities instead of selling them in the open market. This process helps ETFs minimize capital gains distributions, as they can avoid realizing gains by transferring the appreciated securities directly. In contrast, traditional mutual funds may need to sell securities to meet redemption requests, potentially triggering taxable capital gains for all shareholders. Therefore, it is less likely that ETFs will have higher exposure to capital gains distribution taxes.

Considering the explanations above, the most likely answer is A. Better risk management, as ETFs typically provide enhanced risk management through their transparent investment strategies and lower expense ratios.