Question #21
Reading: Reading 35 Exchange-Traded Funds - Mechanics and Applications
PDF File: Reading 35 Exchange-Traded Funds - Mechanics and Applications.pdf
Page: 7
Status: Correct
Correct Answer: A
Question
All else constant, significant tracking error in an ETF is most likely to cause the ETF to:
Answer Choices:
A. be a poor instrument for hedging an exposure to the underlying index
B. trade at a discount
C. outperform the underlying benchmark
Explanation
Tracking error results in divergence (positive or negative) between the ETF's performance
and the performance of the underlying tracked index. This difference might make the ETF
a poor hedging instrument to hedge an exposure to the underlying index. ETFs may trade
at a premium or discount based on the size of the arbitrage gap and whether the sponsor
has stopped creating new units. However, tracking error does not affect the arbitrage gap
on an ETF.