ETFs Made Easy: Understanding Spreads

April 24, 2015

If you’re coming to the ETF world from mutual funds, it can take a little time to get used to the vagaries of those first two letters—“ET,” as in “exchange-traded.”

Back in December I covered the very basics of ETF trading, but I’ll repeat the fundamentals here. Because ETFs trade on an exchange just like a stock, the price you pay to buy an ETF is generally going to be a bit less than the price you’ll fetch when you sell it. The difference between the two is called “the spread.”

Imagine you’re trading something like the PowerShares KBW Property & Casualty Insurance ETF (KBWP | C-58), a small, 24-stock ETF. As I’m writing this, it’s quoted in the market as $43.55 bid, $43.69 ask. That means you’d pay $43.69 if you wanted to buy it, but you’d only get $43.55 if you wanted to sell it. The 11-cent difference between those two prices is the spread.

In general, there are a few additional things you need to consider to know whether that spread is reasonable. First, it’s important to recognize that the spread is constantly changing. Using an intraday forensics tool like the (free!) Trillium Surveyor, we can look carefully at exactly how that spread changes and where trades actually get executed. Here’s yesterday spread action in KBWP:

Source: Trillium Surveyor

Shifting Spreads

The gray band here is the spread, and the crosses are actual trades.

You can see that the 11-cent spread being quoted right now isn’t atypical of the fund, and if you wanted to trade around lunchtime, you were actually looking at a spread of more than 20 cents. You can also see that quite a few trades happen not at the advertised bid or ask, but somewhere in the middle.

That’s not unusual, as people put in orders “inside the spread” that are immediately executed, or negotiated trades are reported to the tape.

A few patterns repeat regularly—some ETFs take a while to settle in—especially if they own a lot of stocks which themselves take time to get going in the morning. Here’s the first few minutes of bids and asks for the iShares MSCI USA Quality Factor ETF (QUAL | A-83) on April 22.

Source: Trillium Surveyor

 

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