There are a couple of big takeaways for investors. Generally the more trading volume a security has, the tighter its bid-ask spread tends to be, which lowers the trading cost for investors. In some cases, the ETF’s spread is actually tighter than the spread of its underlying securities – this is typically the case with some of the more liquid ETFs out there (see below). For example, EEM’s spread of 2.3 basis points compares favorably to the average weighted bid-ask spread for its underlying basket of stocks at 45 basis points. That cost savings, for the same economic exposure, can be attractive to investors transacting in the secondary market and is a compelling feature that many ETFs offer.
In addition to the benefits of secondary market liquidity, ETFs also benefit from the primary market function. When there’s significant supply or demand pressure on an ETF, shares can simply be redeemed or created in order to meet investor needs. This means that an ETF’s on-screen liquidity (i.e. shares available to trade) only tells part of the story, because authorized participants (APs) can always make more.
When we say that ETFs have “two layers of liquidity” or “hidden liquidity”, this is what we’re referring to: the secondary market, which can provide easier access and tighter spreads, and the primary market, which can meet the supply and demand needs of investors.
Dodd Kittsley, CFA, is the Head of Global ETP Market Trends Research for BlackRock.