ETF Bid-Ask Spread: The Hidden Transaction Cost
Measure the gap between best bid and ask in dollars and percentage before trading an ETF.
In this article
Two ETFs on the same index, with the same management fees, can cost very different amounts to buy. The difference appears in no prospectus. The bid-ask spread, the gap between the best buying price and the best selling price, is paid on every transaction. In dollars, on a real amount, it can be negligible (one cent) or substantial (ten or twelve cents, which equals years of management fees). The liquidity behind that number has two levels: that of the fund and that of its underlying assets. A fund of thinly traded securities takes on their spreads. Execution has its rules: place the order mid-session rather than at the open or close, aim for the hours when a foreign fund's underlying market is open, and use a limit order whenever the spread is visible. This article shows the dollar-cost calculation, the comparison between twin funds and the execution habits that remove a cost that is invisible but avoidable.
Read both prices before placing the order
The gap between an exchange-traded fund's best bid and best ask is a transaction cost. You pay it on purchase as on sale, and it shows on no statement. Read it before you place the order, directly in the order book: two displayed prices, and their difference in cents. That figure varies through the day and from one security to another, so no general rule is enough. Checking takes five seconds and tells you whether to place the order now, later or with a limit.
Express the spread as a percentage of price
A spread of five cents says nothing until you compare it to the price. Five cents on a $50 security is a tenth of a percent. Five cents on a $5 security is a full one percent. On a round trip, that second case costs two percent, more than the annual management fees of many index funds. Converting to a percentage lets you compare two similar funds. At equal management fees, the one with the thinner spread costs less to hold.
Distinguish the fund's liquidity from its assets'
A lightly traded exchange-traded fund is not necessarily illiquid. Its real liquidity comes from that of the securities it holds, since market makers can create units on demand. A fund of large Canadian companies therefore keeps a narrow spread, even if it trades little. Conversely, a fund of illiquid bonds or emerging-market equities shows a wide spread despite respectable volume. The right indicator is the nature of the underlying assets, not the fund's own daily volume, contrary to what many people assume.
Trade while the underlying market is open
Spreads widen when market makers cannot price the held assets precisely: at the open and close of the session, and above all when the underlying market is closed. A European equity fund traded in Toronto in the afternoon, once European exchanges have closed, shows a much wider spread than in the morning. The practice is simple. Trade these funds mid-session, when the underlying markets are open, and use a limit order rather than a market order. Avoid the open and the close.
Quebec scenario
Two ETFs track the same Canadian index with identical management fees. An accountant in Sherbrooke is about to pick one at random, then notices a column on the exchange's website: the bid-ask spread. The first fund shows $24.50 bid and $24.51 ask. The second, less traded, shows $24.42 and $24.54. In dollars, it is clearer than in percentages. On his $15,000, crossing the spread costs about $3 in the first case and $37 in the second, at purchase and again at sale. It is a real transaction cost that no expense ratio mentions. At the brokerage desk, he is told that liquidity has two levels: that of the ETF itself, maintained by market makers, and that of its underlying assets. A fund of rarely traded stocks takes on the spreads of its holdings. The time of day matters too. Spreads widen at the open, at the close and during announcements. For a fund of foreign assets, the spread tightens when the underlying market is open. He writes three rules in his notebook: pick the thin-spread fund when the index is the same, place orders mid-session, and use a limit order rather than a market order whenever the spread is visible. The lesson costs him nothing, since he avoided the guesswork in time.
Checklist
- Record the compared funds' bid-ask spreads
- Convert the spread into dollars on your amount
- Count the round trip, purchase and sale
- Choose the thin-spread fund at equal index
- Check the underlying assets' liquidity
- Place orders mid-session
- Wait for foreign funds' underlying market to open
- Use limits on any visible spread
- Add spread and fees together in comparisons
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