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Three Ways to Look at ETF Liquidity and Spreads

Nasdaq

Contributor:
Nasdaq
Visit: Nasdaq

By:

Nasdaq Chief Economist

We’ve recently been looking at how spreads improve as value traded in a ticker improves.

Our latest charts show that although that trend holds for ETFs, the costs of trading ETFs are much cheaper across the spectrum.

Value traded is just one measure of liquidity. What we find when we look at turnover might surprise you. Investors and traders use ETFs very differently.

ETF spreads are much tighter than comparable spreads

When we compare spreads (Chart 1, vertical axis) against value traded (horizontal axis) we find a consistent downward diagonal shape. This shows that as liquidity improves, spreads get cheaper too.

Interestingly though, when we compare ETFs (red dots) to stocks (blue dots) although the pattern is consistent, the spread costs for ETFs are almost always significantly cheaper for the same level of liquidity.

Chart 1: ETF spreads are consistently significantly cheaper than stocks of comparable liquidity

There are a few reasons for this, mostly related to the fact that ETFs also represent a portfolio of securities.

Firstly, the ETF can typically be arbitraged versus the underlying stocks. So ETF spreads compare better to the spreads of the underlying portfolio, which is usually much more liquidity than the actual ETF ticker.

ETFs also have more beta and less stock specific risk, which makes them easier to hedge with futures or other ETFs. That in turn helps market makers keep the price of the ETF competitive.

In fact, the liquidity that you see “on the screen,” representing the value that the ETF ticker trades, is almost always a fraction of the trade size a liquidity provider could execute in the underlying portfolio. That makes it much cheaper to execute large trades in an ETF, even if the actual ETF ticker seems thinly traded.

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Originally Posted on January 30, 2020 – Three Ways to Look at ETF Liquidity and Spreads

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