Create or Buy: A Comparative Analysis of Liquidity and Transaction Costs for Selected U.S. ETFs

Abstract

Examining 12 popular exchange-traded funds (ETFs), the authors find that ETFs and common stocks exhibit qualitatively different liquidity and cost characteristics. The limit order book for ETFs is deeper than that of common stocks, with similar daily share volume, price, spread, and volatility characteristics, especially at price levels immediately surrounding the prevailing mid-quote. The differences in trading mechanisms and liquidity provision between ETFs and common stocks affect transaction costs. In order to reflect these differences, an appropriate transaction cost model should be properly calibrated and parameterized. It should also consolidate the entire ETF liquidity accessible on the secondary market and through the creation/redemption procedure. The authors demonstrate that considering cost estimates for trading ETFs’ underlying constituents provides additional clarity about an ETF’s true cost. Their comparison of ETF and basket costs, in conjunction with a look at creation/redemption fees, indicates the need for monitoring relative ETF liquidity, as the optimal switching points between trading an ETF and creating/redeeming vary widely across ETFs and trading styles.

TOPICS: Exchange-traded funds and applications, portfolio construction, in markets