Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF?–Part 6: Premiums & Discounts] [What is an ETF?–Part 8: Trading Costs]
ETFs prices change throughout the trading day. Before diving in on an investment, potential investors should monitor a prospective fund’s bid/ask spread to optimally enter or exit a position.
The bid/ask spread, or simply the spread, is the difference between the bidding price and asking price of a security, which is determined by basic market supply and demand. More buyers translates to more bids and more sellers translates to more asks. Typically, the asking price will be higher than the bidding prices, or the number of sellers usually exceed the number of buyers.
In any highly liquid market, there will be a lot of sellers and buyers. For ETFs, this means that prices have been efficiently priced, with bid/ask spreads just pennies apart.
In contrast, thinly traded ETFs will show a noticeable disparity between the bid and ask price. Consequently, investors may incur a hidden cost as trading in funds with large spreads will eat away at potential returns since they affect the price at which an ETF purchase or sale is made.
For past stories in this series, visit our “What is an ETF?” category.
Max Chen contributed to this article.