Assessing ETF cost: Understanding the bid/ask spread

When analyzing the total cost of purchasing exchange-traded funds (ETFs), an investor must not only consider the annual expense ratio but also be mindful of other variables – including the secondary market bid/ask spread, premiums/discounts, and brokerage commissions. Investors should analyze bid/ask spreads when buying or selling shares of an ETF in the secondary market, with the goal of executing trades at prices in line with the underlying security basket.
 

Defining the spread

The bid/ask spread represents the difference between where an investor can enter and exit an ETF position on the secondary market. The spread is normally set by market makers around the intrinsic value¹ of the portfolio and includes the transaction costs associated with creating or redeeming shares on the primary market. For ETFs, the transaction costs to trade the underlying security basket are passed on to investors via the spread. This is quite different from the traditional mutual fund structure, where transaction costs are absorbed within the fund by all shareholders and come directly out of fund performance. Let’s take a closer look at the breakdown of what is typically built into the spread of an ETF.
 

Prices here and there

The spread can be broken down into the various trading costs which include the creation/redemption fees, bid/ask spreads of all securities in the creation basket, risk of hedging² or carrying costs, taxes, and lastly, desired profit for the market maker.

For example, here’s a hypothetical bid/ask spread for an ETF:

• The intrinsic value of the underlying creation basket is being calculated at $40. The market maker will set the secondary market spread around the intrinsic value.
• Let’s now assume the bid/ask is $39.95/$40.05. In this case, $39.95 is the bid side of the market and is the highest quoted price an investor would receive in a sale. On the other hand, $40.05 represents the ask (or “offer”) price and is the lowest quoted price an investor would pay in a purchase.
• The bid/ask spread is now calculated as the difference between the ask and the bid, which is 10 cents.
• The investor would pay half the spread when buying and the other half when selling shares of an ETF.
• Remember, this spread includes all the cost components mentioned above that are incurred by the market maker when effecting a creation or redemption of shares.
• Lastly, it’s important to understand that spreads should be viewed as a percentage of the total ETF share price. A spread of 10 cents would represent a greater cost for an ETF with a share price of $40 (0.10/40=0.25% or 25 basis points) than an ETF with a share price of $100 (0.10/100=0.1% or 10 basis points).

The sum of its parts

The more expensive the underlying portfolio is to trade, the wider the spread will be set, due to the fixed security transaction costs. Generally speaking, one should expect a US equity ETF to have a tighter spread than an international equity ETF. This is because foreign markets are inherently more expensive to trade due to local market bid/ask spreads, local taxes and different local market hours. This can also be true for certain fixed income ETFs that hold generally less liquid underlying securities, as these can be more costly to buy or sell when immediate execution is required.

Additionally, as an ETF grows in size and popularity, an actively traded secondary market can actually reduce the spread inside the total transaction costs. As natural two-way flows of buyers and sellers in the secondary market are matched off with existing shares of an ETF, market participants do not need to completely rely on trading the underlying basket. Therefore, those creation and redemption costs do not fully come into play. This phenomenon is one of the benefits of the ETF structure but is only achieved with more mature products that have size and scope and cannot be expected for all ETF products, especially those new to market.

Know what you’re buying

As previously mentioned, in the traditional mutual fund structure, trading costs exist but are not directly visible to the end investor. When dealing with daily cash flows, mutual fund managers buy and sell fund securities with the trading cost aggregated and absorbed across all shareholders, which will adversely affect performance. When comparing costs of mutual fund vs. ETF shares, investors should remember they are paying an explicit transaction cost for an ETF share, which must be added to the expense ratio for a realistic comparison.

Investors should also understand that such trading costs occur outside the ETF fund structure, with the end investor paying those costs via the bid/ask spread when entering and leaving the ETF.