ETFs 101: Understanding ETF Bid and Offer Spreads

BY David Bassanese | 14 July 2015
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Among the issues investors need to consider when buying and selling exchange traded funds (ETFs) are buy and sell spreads. Spreads are often seen as an unavoidable cost of trading and investing, and are not unique to ETFs per se.  What’s more, the competitive nature of open exchange markets – as well as the impact of dedicated market makers – help to ensure ETF bid-offer spreads are as tight as possible.

What are buy-sell spread, and why should I pay them?

An ETF’s buy-sell spread is the difference between the price at which investors can buy the ETF on the exchange and the (lower) price at which it could be sold back to the market. This ‘spread’ can be seen when looking at the websites of online brokers and is also displayed by the ASX on the market data pages of its website.

Clearly, the narrower the spread the better, as this reduces the trading costs associated with buying and selling ETFs.  That said, the fact that ETF trading is subject to buy and sell spreads should not be considered a major negative for investors. After all, the issue of buy and sell spreads is not unique to ETFs.

Indeed, it should be remembered that all securities traded on the ASX are subject to buy and sell spreads, as this is the way the professional trading houses that invest their time and financial risk by standing ready to buy and sell these securities at an investor’s behest – effectively making markets and enhancing liquidity – are compensated. What’s more, even unlisted investment funds are subject to buy and sell spreads, which can be a combination of entry/exit fees levied by the fund manager and/or an allowance for estimated transaction costs incurred in buying and selling underlying investments.

How are spreads calculated?

It should be noted that, unlike the situation with unlisted funds, the buy and sell spreads for exchange traded securities like ETFs are not set by the product providers (such as BetaShares) or even effectively by the market makers that quote them.

Instead, exchange based spreads as on the ASX  are set by the competitive tensions between market markers. If a market maker’s spreads are too wide, it will lose business to other markers makers that are able to maintain tighter spreads.

As in the case of company shares more broadly, the size of the spreads that ETF markets makers are able to competitively maintain naturally depends on liquidity factors, such as the frequency and average size of trades involved. For that reason, spreads on larger companies – which are subject to more extensive trading activity – are typically tighter than for smaller companies.

The same considerations apply for ETFs. ETFs that invest in liquid underlyings (which applies to most of the ETFs available on the ASX), have a large number of investors and a large total value of units outstanding may have more liquidity than an ETF that does not have some or any of these features, which should result in somewhat tighter spreads. Similarly, ETFs which invest in relatively illiquid underlying assets such as small companies, will have a higher spread than an ETF which invests in larger, more liquid, “blue chip” stocks.

The table below provides indicative bid-offer spreads for selected BetaShares funds.

bid-offer

As an example, at around 0.17% in recent months, the average bid-offer spread for the BetaShares FTSE RAFI Australian 200 ETF (ASX Code: QOZ) is comparable to that of most other large cap Australian equity ETFs offered by other major Australian ETF providers. For an investor that bought and sold $20,000 worth of QOZ, the bid-offer trading costs would be a moderate $33.80. Clearly, as with most investments, trading costs rise in line with the level of trading activity. The bid-offer cost of buying then selling become a much smaller drag on overall returns when investments are held for the longer-term.

It’s worth noting that the bid-offer spreads on BetaShares’ cash and currency products have historically been even smaller. Indeed, there has historically been  virtually no bid-offer spread applicable when trading the BetaShares Australian High Interest Cash ETF (ASX Code: AAA). And at 0.12%, the recent average bid-offer spread on the BetaShares US Dollar ETF is very competitive with commission rates charged by many financial institutions for foreign currency deposits and money exchange services. At an AUD/USD exchange rate of US 75c, for example, a bid-offer spread of 0.12% amounts to an effective buy/sell spread of US75c/US75.09c or 0.09 of 1 US cent.

When to buy?

To further reduce the impact of bid-offer spreads, investors should also consider the time of the day in which they trade. As regards ETFs, it is advisable to avoid trading near market opens or closes, as this is when professional market makers face more risk in pricing ETFs correctly (as they are less sure of the market prices of the underlying securities) and in being able to hedge their risks.  For this reason, bid-offer spreads may tend to be widest at these times of the day.

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