Don't Let Spreads Eat Into Your Returns

[This article comes from the Learn section of our website, a comprehensive database of educational articles and resources]

ETFs trade like stocks. ETFs trade nothing at all like stocks.

Both of these statements are true, and understanding how that can be the case is critical to becoming a good ETF trader.

The Bid/Ask Spread

The place to start with understanding how ETFs trade is to understand how individual stocks trade.

At any given time, there are two prices for any common stock: the price at which someone is willing to buy that stock (the “bid”) and the price at which someone is willing to sell (the “ask.”). The difference between these two prices is called the “spread”.

The reason spreads exist is because, in any open market, folks try their best to negotiate the best prices they can get. If you’re looking to buy, you’ll naturally want to see if someone is willing to sell for less than the last traded price.

Conversely, if you’re selling, you’ll naturally hope that someone will bend and be willing to buy it for more than the last quoted price. Spreads are simply the result of buyers and sellers negotiating on prices.

For example, let’s imagine British Telecom’s stock is trading with the bid at £49.90 and the offer at £50.10. The spread is therefore £0.20. If someone asked you what a share of BT was “worth”, you’d probably choose the midpoint: £50.00, or maybe the last price at which you can see a trade actually happened.

But if you wanted to buy BT right now, you would probably have to pay £50.10. If you wanted to sell right now, all you’d get is £49.90. Those are the prices you’d get if you enter a market order into your brokerage window.

The wider the spread, the more it will cost you to trade BT.

Bid/ask spreads are so important to ETP trading because, unlike a mutual fund, that you buy and sell at net asset value, all ETPs trade like single stocks, so ETPs trade with bid/ask spreads. That’s the price of the “exchange-traded” in the name.

Spreads widen and narrow for various reasons. If the ETF is popular and trades with robust volume, then bid/ask spreads tend to be narrower. But if the ETF is thinly traded, or if the underlying securities of the fund are highly illiquid, that can also lead to wider spreads.

Overall, the narrower the bid/ask spread, the lower the cost to trade.

Volume And Market Impact

Bid/ask spreads aren’t the only factor to consider when trading, whether you’re trading stocks or ETFs. You also have to look at volume and so-called market impact.

Volume is the number of shares that trade on any given day. The higher the volume, the better. For example, if BT trades, on average, 10 million shares per day, it will be easier to trade than something that trades 100 shares per day. Note, however, that spreads could be tight on both, which could mislead unwitting investors to conclude that both securities are equally liquid.

Typically, the number of shares offered on the “bid” or the “ask” will be small—sometimes 100 shares, sometime more, but rarely a huge amount. If you try to buy 10,000 shares of something that only trades 100 shares per day, you could have trouble.

To go back to our BT example, someone might be willing to sell you 100 shares of BT at £50.10, but if you want to buy 10,000 shares, you might have to pay £50.25 or more. The amount that you drive up the price of something you are trying to buy is called the “market impact.”

How Does That Impact ETF Trading, And How Are ETFs Different?

Because ETFs trade on exchanges like stocks, they have bid/ask spreads, volumes and potential market impact, too. All else equal, you will do better trading something that has high volume and a tight bid/ask spread. In this way, trading ETFs is just like trading a stock.

But ETFs have a critical difference that dramatically alters the playing field for investors.

With single stocks, there is no way to create new shares. If someone wants to buy 10,000 shares of BT, he or she must find another investor who wants to sell. If no one wants to sell, he or she may have to pay a lot of money to get that trade done.

But ETFs are different: As covered earlier, a group of institutional investors called authorised participants (APs) are allowed to create new shares of an ETF to meet demand. So if you want to buy a lot of an ETF … say, 50,000 shares … an AP might create those shares to fill your order (see Creations And Redemptions).