It isn’t enough to just look up an exchange traded fund’s expense ratio to grasp your total costs of holding an ETF. Since the funds trade like stocks on an exchange, investors have to consider implicit costs in executing trades, such as the bid-ask spread.
“The expense ratio tends to be the largest, most explicit, and most stable component of the total cost of holding an ETP,” according to Morningstar analyst Michael Rawson. “In contrast, trading costs can be more difficult to measure.”
Specifically, investors should monitor the costs of doing trades, including commissions per trade, the bid-ask spread when executing a trade and potential market impact to limit the effects of large orders.
The bid-ask spread is one of the largest components in trading costs. The spread is the difference between the highest price someone is willing to buy a share, or the bid, and the lowest price at which someone is willing to sell a share, or the ask.
Since the bid-ask spread is affected by a market’s liquidity, investors should consider the liquidity of the ETF itself, along with the true liquidity, or the liquidity in an ETF’s underlying assets.
According to Morningstar data, the average bid-ask spread among 41 ETFs with over $10 billion in assets over a 30-trading-day period was 0.02%. However, the spread drops off in smaller funds, with an average spread of 1.72% for the 680 ETFs with less than $50 million in assets.
Looking at the underlying assets, ETFs that track very liquid markets, like U.S. stocks, show tighter spreads than those of less-liquid securities, like the bond market, and international exchanges that have little overlap with normal U.S. hours. For instance, 339 international equity ETFs showed a median bid-asks spread of 0.39%, compared to 256 U.S. equity ETFs with a median 0.19% spread. [The Underlying Value of an ETF’s Portfolio]
“A fair comparison of the costs of ETP ownership should include an analysis of trading costs such as the bid-ask spread,” Rawson added. “Both the liquidity of the ETP and that of its underlying holdings influence trading costs.”
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.