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The Importance of ETF Liquidity: State Street

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Expense ratios are a key consideration when deciding to choose one ETF over another, but so is liquidity, according to State Street Global Advisors.

The firm — which introduced the first ETF on the market, the S&P SPDR (SPY) in early 1993 but has a current market share of only 17% — has launched a new initiative to educate investors about liquidity and its impact on the total cost of ETF ownership.

“Depending on your rebalancing frequency, trading costs can significantly accumulate and have a larger impact on the total cost of ownership than any expense ratio difference between two ETFs,” said Matthew Bartolini, head of SPDR Americas Research for State Street Global Advisors, in a statement.

Take an a ETF with an average gross expense ratio of 13 basis points and an average bid/ask spread of 2 basis points that trades twice a month. Its annual trading costs average a total 59 basis points, according to a State Street example. In contrast, an ETF with a 10 basis-point gross expense ratio and an average bid/ask spread of 4 basis points that also trades twice a month has average total trading costs of 102 basis points. The less liquid fund, which costs the investor 43 basis points more, is 73% more expensive.

In its example, State Street is equating liquidity with trading volume, which, in turn, impacts bid/ask spreads. The more volume, the narrower the spread, which can be important for investors who trade frequently or at least twice a month. It’s not as important for investors who trade less frequently.

More specifically, without naming names, State Street is comparing its sector ETFs to Vanguard’s. Its technology Select Sector ETF, XLK, for example, has an expense ratio of 13 basis points and an average daily volume of 10.89 million shares over the past 20 trading sessions, according to Nasdaq. Vanguard’s Information Tech ETF, VGT, has a lower expense ratio of 10 basis points but an average trading volume of 630,790 over the same period, according to Nasdaq.

If an investor buys the Vanguard ETF and saves 3 cents, then trades the ETF later on to buying another ETF as a substitute, that investor could lose those savings, breaking even or even paying more, says Todd Rosenbluth, senior director of ETF and Mutual Fund Research at CFRA.

Another example is the State Street’s SPDR S&P 500 ETF Trust, SPY, which has a 9 basis-point expense ratio but higher volume than Vanguard’s S&P 500 ETF, VOO, which charges 3 basis points. During last December’s market slump, the State Street ETF had a much narrower spread than the Vanguard ETF.

VOO – Vanguard S&P 500 ETF

“Trading volume and bid/ask spreads should be part of the due diligence process” when choosing ETFs, according to Bartolini. Asked whether State Street’s initiative is somewhat self-servicing since the firm has been losing market share to other ETF providers, Bartolini noted that State Street is “an ETF authority,” the first firm to launch an ETF and the firm with seven out of the 10 most liquid ETFs, which is why it needs “to educate investors” about liquidity.