Do you really know what exchange traded fund (ETF) liquidity is?

A true measure of ETF liquidity is based on the liquidity of the underlying stocks in the index, reports ETFZone staff. To understand this, you must realize how an ETF functions on a basic level. Because ETFs trade like stocks, market makers are the ones who order the creation and redemption of ETF shares. They build the share from the companies within the underlying index. They create or redeem shares based on the market demand for the share.

ETFs based on indexes with derivatives attached to them have slimmer bid-ask spreads because of the concentrated interaction of specialists, market makers, arbitrageurs. One example is the SPDRs (SPY), which has a calculated bid-ask spread of 0.09% over 160 days. As more research is done on bid-ask spreads, results confirm that ETFs tied to liquid indexes have smaller spreads. If you have faith in U.S. market liquidity, then you should feel safe using a broad-based U.S. market ETF.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.