The hidden cost of bid-ask spreads

Trading commissions get a lot of attention from ETF investors, and rightly so. But depending which ETFs you use and the size of your trades, the impact of bid-ask spreads may be larger than you thought.

The bid price is what you expect to receive when you sell shares, while the ask price (or offer price) is what you would pay to buy them. The difference between the two is called the bid-ask spread, and it represents the profit taken by the market makers.

Unlike with individual stocks, trading volume doesn’t have a major effect on the bid-ask spread of an ETF. The liquidity of an ETF is largely determined by the liquidity of its underlying holdings: if the fund holds frequently traded large-cap stocks, its bid-ask spread should be very tight even if the ETF itself doesn’t trade very often. If the ETF holds micro-cap stocks or illiquid bonds the spread will be wider even if units trade frequently.

The underlying story

But that’s not the whole story. If the liquidity of the underlying holdings was the only factor, ETFs in the same asset class would have more or less identical bid-ask spreads, and that isn’t the case. The bid-ask spread of an ETF also includes the costs involved in creating the ETF units. Think of it this way: you could buy all the stocks in the S&P/TSX 60 directly, or a market maker could buy them for you, package them up, and sell them to you in the form of an ETF. In both cases you’ll pay the bid-ask spread on the underlying securities, but in the second scenario you also pay the costs involved in bundling the securities and selling them as ETF units. This diagram, supplied by Horizons ETFs, illustrates this idea nicely:

In the centre is the net asset value of the fund. The distance between the NAV and the fund’s bid and ask prices gets wider as one adds the spreads on the underlying stocks or bonds, plus the additional costs to assemble and trade the ETF units. The good news is, even when you total up these costs we’re still only talking about a spread of $0.01 to $0.04 cents in most cases, though there are certainly exceptions.

What’s that spread costing you?

How much does this spread cost you when you buy or sell ETFs? It’s best to think of your cost as half the spread, because both the buyer and seller give up a little in each trade. Although you can’t know an ETF’s precise net asset value during the trading day, you can expect it to be the midpoint between the bid and ask prices. If you get a quote with a bid of $19.98 and an ask of $20.02, the fund’s NAV is likely right around $20. That means your transaction cost when buying or selling is about $0.02 per unit, or half of the four-cent spread.

I decided to get some quotes for a number of Canadian ETFs to see the range of bid-ask spreads. (All of these were obtained on the morning of Nov. 20, though it should be noted that spreads are not consistent, even from hour to hour.) I’ve also included the number of shares you could buy with $10,000 and the resulting transaction cost based on half the bid-ask spread:

Bid-ask spreads are an inevitable cost of ETF investing, and if you’re buying and selling small amounts they’re not significant. But if you’re placing large orders for ETFs with wide spreads they can be a bigger factor than a $10 trading commission. Be alert when you place your trades and always use limit orders to avoid surprises.