One of the beneficial aspects of an ETF’s tradability is that it can tap two layers of liquidity. About 85% of all ETF volume is at the “secondary” level, after the shares have been created. The other 15% is at the “primary” level, where a market maker or authorized participant will create or redeem shares.1
The market maker taps into the liquidity of the underlying market to either buy shares of an underlying asset and deliver them to the issuer to create new shares of the ETF, or else to sell shares of the underlying asset in the case of a redemption.
The secondary market process allows the ETF spread to be narrower than its underlying “basket spread,” or the round-trip cost of the underlying securities.
There are times, though, when the underlying market conditions may change and the cost to create or redeem ETF shares may widen. In these situations, you can expect wider spreads to affect the ETF as well.
An S&P 500 ETF, in which all the underlying stocks are readily tradable, would be relatively easy to buy or sell in any market. So we would expect such an ETF to trade with a tight spread that reflects the underlying basket of securities.
But other ETFs, such as one that holds small-capitalization stocks, might operate more frequently in liquidity-constrained environments that make it harder to buy and sell the underlying securities at a fair price. This could more significantly affect the ETF’s bid-ask spread.