Exchange traded funds, like stocks, trade throughout the day and their prices fluctuate between trading hours. Consequently, investors will have to mind the spread.
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 exceeds the number of buyers. [What is an ETF? — Part 7: Bid/Ask Spread]
Potential buyers should be aware that thinly traded ETFs will show a noticeable difference between the bid and ask price. Consequently, investors may incur a hidden cost as trading in funds with large spreads erodes potential returns since the spread affects the price at which a purchase or sale is made.
For example, the Vanguard S&P 500 ETF (NSYEArca: VOO) provides a good instance on how spreads can affect trades. On Oct. 24, the fund went through a 1-for-2 reverse stock split. The reverse split raised the ETF’s share price while cutting the number of shares outstanding. [Vanguard Opens Up ‘New Front’ in ETF Fee War]
By increasing the per share price, investors buy fewer shares and reduce the potential costs associated with the spread, writes Matt Krantz for USA Today.
Investors would only have to buy one share at a two penny spread, instead of purchasing two shares at a two penny spread before the split to receive the same dollar investment value.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.