In July, I wrote about European ETF secondary-market liquidity, concluding that, in general, investors' concerns about wide bid-offer spreads were not backed up by the data, but that there was a wide variation between fund types (see article here).

How has the continuing deterioration in equity markets changed this picture, if at all?

XETRA, the Deutsche Boerse section that has the largest number of ETF listings in Europe, has recently published its quarterly "ETF Facts and Figures", which includes a calculation of the "XETRA liquidity measure" (or "XLM") for all 356 ETFs listed on the XETRA market. To recap, the XLM measures the cost to an investor of a "round-trip" trade; in other words, a simultaneous purchase and sale of an ETF, based on a notional trading size of €25,000. It thus measures the bid-offer spread (although it does not factor in brokerage commissions).

Although the report does not include the month of October, which saw the most dramatic market moves and the appearance of some short-lived, but significant discounts to index values in certain ETFs, it's still an interesting exercise to trace the evolution of ETF liquidity over the year-to-date.

First, here's a look at the ten cheapest and ten most expensive European ETFs that were bought and sold in the secondary market at XETRA during Q3.

Ten Cheapest European ETFs To Trade

Cheapest of all to trade are the two largest money market ETFs in Europe, offered by Lyxor and DB x-trackers. The tightness of the bid-offer spreads goes a long way to explaining the popularity of these cash management vehicles, which have raised several billion euros in assets since their introduction.

The other funds in the top ten are short-maturity government bond funds and two DAX trackers. With a few Euro STOXX 50 equity ETFs just outside the ten-cheapest list, but also with single-figure dealing spreads in basis points, this reinforces the image of the DAX and Euro STOXX 50 as the most liquid European equity ETFs—let's say the European equivalent of the S&P 500 SPDR (NYSEArca: SPY) and the NASDAQ-100 QQQs (NasdaqGM: QQQQ).

What about the other end of the scale?

Ten Most Expensive European ETFs To Trade

The contrast is dramatic, with dealing spreads running above 3% for the least-liquid fund. The appearance of five Market Access funds in the ten least-liquid ETFs suggests some structural problems in its dealing relationships, where there appears to be insufficient market maker support. It's not otherwise clear why bid-offer spreads should be so wide for some of the markets covered. The same appears even more true for the two UBS funds, which are tracking what are normally highly liquid areas of the market (the FTSE 100 and the MSCI USA indices). Could the root of this be counterparty credit concerns, which might be affecting the normally smooth arbitrage mechanism between market makers and ETF issuers?

The other funds in the list hint at liquidity problems in the underlying markets. The iShares corporate bond ETF is one that stands out, as this fund subsequently exhibited substantial discounts to NAV during the worst of the October panic (as IndexUniverse .com covered at the time), reflecting the almost total disappearance of secondary market liquidity in corporate bonds.

Changing Over The Year

The change in the XLM from Q1 and Q2 to Q3 should give us an interesting picture of the evolution of ETF liquidity during the course of the year.

At the headline level, the simple average XLM across all XETRA's ETFs increased from 44 basis points in Q1 to 45 b.p. in Q2 and 49 b.p. in Q3. This seems consistent with reports of worsening underlying liquidity in a number of asset markets, especially in Q3.

But this is not true for all funds, some of which showed an improvement in secondary market pricing.

Here are the ten ETFs with the greatest decline in XLM between Q1 and Q3 (i.e., those with the greatest improvement in bid-offer spreads).

ETFs With The Greatest Improvement In Liquidity

Here, by contrast, are the ten funds showing the greatest increase in XLM (the greatest deterioration in liquidity) over the same period.

ETFs With The Greatest Deterioration In Liquidity

The appearance of EasyETF commodity-related ETFs at the top of both lists suggests that there may be some rogue data at play in this particular case. But there are nonetheless some interesting observations to make, particularly on the second table.

Three db x-trackers ETFs covering European sovereign debt issues made it into the list of the ETFs with the greatest deterioration in liquidity. While the absolute level of bid-offer spreads is small, and below average, for all three ETFs here—the db x-trackers II iBoxx € Sovereigns Eurozone 1-3 TR Index ETF showed an XLM increase from 3 to 15 b.p., the 3-5 year ETF from 5 to 15 b.p., and the Total Return Index ETF from 7 to 20 b.p.—the change in the spreads may reflect investor concerns over the relative creditworthiness of some European sovereigns. We've seen the credit spreads on some Southern European government debt issuers balloon this year, and this would undoubtedly affect the willingness of investors to hold and trade ETFs that amalgamate euro-denominated debt issues from across the region.

The change in the Lyxor Russia ETF XLM is also noticeable—from 53 basis points in Q1 to 146 b.p. in Q3. Emerging market equity ETFs have had a terrible year, and the price declines have been accompanied by deteriorating liquidity. Russia in particular has been troubled, with the market closing outright at times throughout the year, which has also contributed to wider spreads.

There are many other ETFs from the emerging market sector whose bid-offer spreads have more than doubled over the period.

Interestingly, the db x-trackers DJ STOXX 600 Banks Short ETF makes the top ten of funds with deteriorating liquidity, even though it has been one of the best performers this year, and through no fault of its own. Here we can blame the securities regulators and their short-selling bans for affecting the ETF's bid-offer spread.

Where Do We Go From Here?

All in all, the XETRA report makes interesting reading. With bid-offer spreads for some ETFs running to the hundreds of basis points, they are in many cases a multiple of the total expense ratio, making them highly relevant for investors considering investing in particular sectors.

At the other end of the scale, the most liquid ETFs are very competitive in terms of trading costs, and continue to compare favourably with alternative investment options.

We will review the Q4 figures when they are compiled early in 2009, and it will be interesting to see whether recent attempts to prop up the financial sector have had the desired effect. Certainly, one can expect a further widening of bid-offer spreads in the data for October. Will the more recent improvement in credit market sentiment, and the last weeks' cuts in official interest rates, manage to reverse the overall trend of worsening liquidity?