by ETFZone staff

We thought it was time to put a common misconception on exchange-traded fund liquidity to rest.

Some investors appear to believe that the liquidity of an ETF is dependent on the fund's average trading volume, or the number of shares traded per day. However, this is not the case. Rather, a better measure of ETF liquidity is the liquidity of the underlying stocks in the index. Understanding this fact requires a brief look into how ETFs function on a basic level.

Since ETFs trade like stocks, market makers (also called authorized participants or APs) are the folks that order the creation and redemption of ETF shares. Market makers build an ETF share from the shares of the companies in the underlying index. They create or redeem shares depending on the market demand for the ETF shares.

It should also be noted that market makers and specialists can create and redeem shares to arbitrage premiums or discounts to the underlying net asset value (NAV). This activity is beneficial to ETF investors because it keeps the price of the fund in line with the NAV and prevents specialists from making unfair markets. Think of it as a mechanism that ensures retail investors like us will get a fair price as the APs step all over each other trying to make a buck. Pretty neat, huh?

Large brokerage houses such as Morgan Stanley and Salomon Smith Barney also occasionally act as authorized participants when a client makes a large order. Based on their ability to purchase the underlying stocks in the ETF, they can create a huge number of ETF shares instantly with little difficulty in a liquid index like the S&P 500. In essence, there is enormous liquidity in ETFs based on popular indexes - the AP just has to turn on the hose.

Not surprisingly, ETFs based on indexes that also have derivatives tied to them have even slimmer bid-ask spreads. The reason is that there is heightened interaction between the specialists, market makers, and arbitrageurs. In other words, ETF shareholders benefit from this increased competition because it narrows spreads. For example, State Street Global Advisors recently reported that the average bid-ask spread calculated over 160 days on SPDR 500 (AMEX:SPY - News) was 0.09%. More firms are researching ETF bid-ask spreads, and the results confirm that ETFs tied to liquid indexes have very small spreads.

Investors with a healthy apocalypse complex might notice here that an ETF's liquidity could dry up in severe market conditions. This did in fact happen with a Malaysian basket of stocks after that country instituted currency controls. We don't mean to harp on this fact, but investors should at least be aware of this bit of ETF history.

However, if you have confidence in U.S. market liquidity then you should feel safe using existing broad-based domestic ETFs, and their history thus far bears that out. We would add that a wait-and-see attitude could be beneficial for potential ETFs tied to illiquid indexes - private securities or municipal bonds, for example.

To quantify ETF liquidity, Salomon Smith Barney has conducted several "snapshot studies" that take random pictures of the ETF market to look at bid-ask spreads of domestic and international ETFs. Below are the results of the latest snapshot study conducted in January 2002, when Salomon Smith Barney gathered data from 40 random snapshots taken throughout the month.

Source: Salomon Smith Barney, Bloomberg, the AMEX

Source: Salomon Smith Barney, Bloomberg, the AMEX

Salomon also looked at premiums and discounts for the domestic and international ETFs. The tables below show that that the premiums and discounts for ETFs are very small. Not surprisingly, the international ETFs have larger premiums and discounts because the stocks are not as accessible.

Source: Salomon Smith Barney, Bloomberg

Source: Salomon Smith Barney, Bloomberg

The analysts who wrote the report noted that the results improve dramatically each time they conduct the snapshot study. They also said the growth in popularity of ETFs has helped shrink spreads, although the growth in the number of smaller funds has probably had an adverse affect on the overall results.

Additionally, a very competitive market was established in the Vanguard Total Stock Market Vipers (AMEX:VTI - News). The managers of other broad-based competitor ETFs have countered by shrinking spreads in their own funds, according to Salomon Smith Barney.

Finally, the New York Stock Exchange is trading several AMEX-listed ETFs, and the addition of more specialists has created increased competition and helped reduce spreads even further.