Concerns over secondary market liquidity for European ETFs seem to have been around since the market's inception. The EDHEC 2006 European ETF survey showed that half the (institutional) respondents who expressed dissatisfaction with ETFs did so because of poor liquidity. Along these very lines, a recent comment on one of my articles at IndexUniverse.com mentioned large bid/offer spreads in secondary market trading—one of the hottest topics and most frequently raised questions at last week's Terrapinn ETF conference in London. The concern seems particularly acute amongst retail investors.

At the same time, ETF providers continue to voice reassurances that ETFs are as liquid as their underlying securities, and that investors suffer no real disadvantage by buying them.

So what is going on and who is right?

In the most recent edition of the Journal of Indexes, my colleague Matt Hougan conducted a revealing exercise, examining secondary market spreads in U.S. ETFs. He found that, according to NYSE data, over half of all U.S. ETFs had secondary market bid/offer spreads of less than 0.2%, while over 90% had spreads of less than 0.5%. Only 18 of 666 ETFs surveyed had spreads of over 1%.

In order to conduct a similar exercise for European ETFs, I've made use of data provided by two of the exchanges—Deutsche Boerse/XTF and Borsa Italiana, the first and third-largest of the European exchanges (Note: The Borsa Italiana data appear to relate only to Italian-listed ETFs and do not incorporate data from the London Stock Exchange, with which the Borsa Italiana recently merged). The XTF survey alone includes 363 European ETFs, which represents over half of the market by number of funds, and so is a large sample.

One further note on methodology: The Borsa Italiana survey is conducted monthly and calculates dealing spreads across categories of ETFs (e.g., developed market equity, emerging market equity, corporate and government bond, style ETFs and others) for notional dealing sizes of 1(!), 5,000, 15,000 and 25,000 euros. The XTF spread data are based on a quarter's trading history and are expressed by the "Xetra Liquidity Measure" or "XLM", which measures the bid/offer spread in percentage terms for a notional dealing size of 25,000 euros. Stockbroker fees are not included in either case, so, for a true calculation of retail trading costs, fees would need to be included.

What do the data show? The Borsa Italiana figures for May 2008 show an average bid/offer spread of 0.24% across all listed ETFs in a dealing size of 25,000 euros. By category, spreads range from a relatively cheap 9 basis points for bond funds to 50 basis points for emerging market equity funds. Going a level deeper into subcategories of funds, the cheapest European ETFs for secondary market trading are seen to be liquidity funds, with an average spread of just 2 basis points. The most expensive are protective put funds, with an average spread of 181 basis points. Further details are available on the exchange's Website.

How do the Deutsche Boerse/XTF's figures compare? They offer the investor the advantage of researching funds at a more granular level, with the XLM liquidity measure available for all ETFs listed on the exchange.

At an aggregate level, the simple average XLM for XTF-listed ETFs is 0.45%. At first sight, this seems quite out of line with the Borsa Italiana data, but is almost certainly explained by the fact that the latter are asset-weighted and the XTF data have been calculated on a nonasset-weighted basis. As one would expect, dealing spreads in the largest funds are considerably lower than in others, both because the biggest ETFs are more regularly traded and because they typically invest in very liquid benchmarks such as government bonds or country or pan-European equity indices. Therefore, asset-weighting the spread figures will tend to depress them.

How do the dealing spreads compare across the ETFs listed on the Deutsche Boerse/XTF?

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