Mind the Gap: Understanding the ETF Bid-Ask Spread
February 10th 2011 at 1:00pm by Tom Lydon
Often overlooked, one of the most crucial things you can keep an eye on when trading exchange traded funds (ETFs) is the bid-ask spread.
the bid-offer or bid-ask spread is one overlooked cost that will gradually eat away at your returns. The spread is determined by the difference in the buy and sell price for a security before any other trading fees. [The Pros and Cons of ETFs.]
Generally, the tighter the bid-ask spread, the better. But the spread all comes down to the fund’s underlying securities. Heavily traded and highly liquid securities tend to have lower bid-ask spreads since it is easier to find a buyer for all the sellers due to the fund’s popularity. [ETF Correlation Among Asset Classes Is Dropping.]
The Accumulator for Monevator posits five ways to fight wide spreads:
- Invest in broad market-indexes that hold very liquid securities.
- Take note of the underlying index. If the ETF reflects a niche segment of the market, underlying securities may trade at less liquid levels, which could result in higher bid-ask spreads.
- Observe the bid-ask spread of a potential ETF investment to get a feel for how the spread will average out.
- In comparing similar funds, investors may want to take a look at assets under management, daily trading volume and number of market makers for a better idea of how liquid the fund is.
- Long-term investors will benefit more since bid-ask spreads eat away at returns per trade.
When investing in ETFs, it is generally a good idea to be in the habit of using limit orders because this option puts you in control of how high you want to buy and how low you are willing to sell. If the price exceeds the limits placed, the trade won’t go through.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.