With so many brokerage firms waiving commissions, many have the perception that buying and selling ETFs is free. Though most of us are aware that ETFs have bid/ask spreads, new research draws attention to how large the spreads can be and how they can be minimized.
The research titled “Examining Intraday ETF Liquidity: When Should Investors Trade?” was published earlier this year in the Journal of Index Investing. The authors, James Rowley, Charles Thomas and Ryan O’Hanlon, all from Vanguard, examined ETF trades during five-minute intervals throughout the trading day for U.S.-listed domestic equity ETFs.
Mean Bid/Ask Spread For ETFs
The research determined that the mean bid/ask spread throughout all five-minute intervals of all U.S. equity ETFs was 22.89 basis points, which equates to just under 0.23%. This translates to nearly $23 for every $10,000 bought or sold. All ETFs are weighted equally in this study.
The authors specifically looked at time of day and found that spreads were much greater in the first 40 minutes of the day. In the first five minutes of the trading day, they found spreads averaged nearly three times that amount. They did not find any truth in the common belief that spreads increase at the end of the trading day.
Other findings determined that spreads varied by:
- Fund category: Small cap stock ETFs had much greater spreads than large cap, while midcap stock ETFs were in between.
- Volume: ETFs that traded more frequently had thinner spreads.
- Issuer: Some ETF families had larger spreads than others. For some, it was common to see average spreads over 0.50% for the day.
While not part of this research, Vanguard provided me the weighted-average spreads of the 10 most actively traded ETF fund families across all ETFs. Average spreads are low (between 1 and 10 basis points), but remember, you can drown in a lake that has an average depth of 3 feet if you happen to be in the deep part of the lake.
Though iShares has an average spread of 2.2 basis points, the iShares Morningstar Small Cap Value ETF (JKL) averages a spread of 13 basis points, and you may pay more, especially if trading early in the day.
Here are my takeaways from both this study and my own experiences.
- Don’t trade in the early morning. Never put in an order after the market has closed, as it will likely execute first thing when the market opens and spreads are the largest. It also subjects you to market changes due to news released before the market opens.
- Bigger really is better. Not only do the largest ETFs tend to have the lowest expense ratios, they also trade more frequently, and thus have lower spreads. Before you trade, check out the average spreads on ETF.com. For example, the Vanguard Total Stock ETF (VTI) has an average spread of 0.01%, while the iShares Core S&P Total U.S. Stock Market ETF (ITOT) averages 0.02%. On the other hand, the Janus Henderson Small/Mid Cap Growth Alpha ETF (JSMD) averages a 0.47% spread.
- Use limit orders to buy and sell. You don’t want to be subject to either increasing spreads or market movements such as the 2010 flash crash, where a market order to sell would have produced disastrous results.
- Don’t trade often. Free commissions might make us trade more and those trades aren’t free. More trades result in more spreads being paid. There is also research that indicates greater trading leads to lower returns.
- Consider mutual funds instead. Mutual funds trade at net asset value (NAV) and don’t have spreads. For Vanguard, most ETFs are just different share classes of their mutual funds. While many of the mutual funds now have higher expense ratios than the ETF share class, many also allow you to convert the mutual funds to ETF share classes.
My advice is to be an investor rather than a speculator. Moving in and out of illiquid ETFs will cost you dearly. Buying the broad and boring low-cost ETFs with very long holding periods is the far better way to go.
Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected], or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.