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?

As shown in the table below, 22% of all funds have spreads of below 0.2%; nearly 70% have spreads below 0.5%; and 93% have spreads below 1%. We can make an immediate comparison with Hougan's figures for the U.S. market, which showed that half of U.S. ETFs had spreads below 0.2%, and over 90% had spreads below 0.5%.

Clearly, on this basis, trading European ETFs is a more costly exercise than trading U.S. funds.

The discrepancy could be explained to some extent by the relative immaturity of the European market, the prevalence of off-exchange trading (and at tighter spreads?) for institutions and maybe by a greater proportion of nonequity and less plain-vanilla funds in Europe that carry higher fees and trading costs.

But even if European dealing spreads are not that high in absolute terms, there is some room for improvement here if retail investors are to get as good a deal as they have in the U.S. market.

To give a bit more flavour to this analysis, let's look at 10 European ETFs with the lowest secondary market spreads and the 10 with the highest spreads, again, using the figures provided by the XTF exchange for Q1 2008.

The top 10 most-expensive-to-trade funds include three emerging market equity ETFs and six ETF securities exchange-traded commodities. Given the relative illiquidity of some of the frontier equity markets and certain commodities, this is unsurprising, but the size of these spreads would make frequent trading punitive.

What about of the most popular ETFs by trading volume? Using the XTF data for Q1 2008, the 10 most actively traded ETFs (average spreads given in parentheses) were: four funds tracking the EURO STOXX 50 index (8, 8, 9 and 11 basis points, respectively); three tracking the German DAX (6, 8 and 10 basis points); one inverse DAX fund (12 basis points); an MDAX ETF (23 basis points); and one ETF tracking the EONIA cash deposit index (2 basis points). So we see, for the most popular funds, bid/offer spreads are minimal indeed.

When it comes to less-traded, and more niche areas of the financial markets, spreads can vary substantially, so it pays to check before choosing an ETF. To take Russian equities as an example, the three different Russian country ETFs listed on the XTF had spreads varying from 46 to 263 basis points, a significant difference indeed.

What About Commodities?

So far we have focused on ETFs only, but the Deutsche Boerse/XTF also calculates the XLM liquidity measure for ETCs. For the 47 ETCs they tracked (46 of which are the offerings of ETF securities) during the first quarter of 2008, the simple average bid/offer spread was 93 basis points, more than double the simple average spread of 45 basis points for the ETFs. Looking down the ETF Securities' fund list, only four funds had an average spread of less than 30 basis points: The ETFS Brent Oil, Crude Oil, WTI Oil and Physical Gold ETCs. Perhaps the underlying cost of buying and selling commodities is higher than buying and selling the more liquid equity or bond markets, but this makes frequent trading into and out of these funds a more expensive proposition.

Secondary Listings

Does ETF liquidity vary between primary and secondary listings of the same fund? I raised this question with Paolo Giulianini of UniCredit, the Europe-wide ETF market-makers. According to Giulianini, there may be slight differences in secondary dealing spreads between the different exchange listings of the same ETF, but this is outweighed in importance by the ease of access provided to investors by the practice of cross-listing in different European countries. Nevertheless, to give a full picture of European secondary market ETF liquidity, it would be useful to compare funds across all their relevant listings.

Conclusion

How then would we summarise our findings? On average—and particularly when asset flows and fund sizes are taken into account—secondary market dealing spreads are not a significant problem for investors. European spreads are higher in general than for U.S. funds, but not dramatically so. However, there is a fairly long "tail" of ETFs and ETCs for which spreads are significantly wider. There can also be a surprising difference in secondary market liquidity between different ETFs from different providers covering the same asset class. And lastly, it pays to check the liquidity data provided by the exchanges when choosing an ETF, especially as the data is freely available and covers a substantial part of the market.