Large, Liquid ETFs With High Spreads

The harsh truth of trading is this: Not every ETF can or will have a pennywide spread. But for large, well-traded ETFs, most investors expect trading costs to be relatively constrained—an expectation that is usually met.

Usually.

For there are a few exceptions to this rule. A handful of large, well-traded ETFs—as in, more than $100 million in assets under management, trading more than $10 million in daily average volume—carry surprisingly high spreads. Understanding why is an exercise in due diligence, and a reminder that if a metric sounds too good to be true, it just might be.

Understanding ETF Spreads

An ETF's trading spread represents the difference between the price at which someone is willing to buy shares of the fund (the "bid") and that at which someone is willing to sell them (the "ask") (read: "Understanding Spreads & Volume").

For large, liquid ETFs, the difference between bid and ask is usually fairly small, because competition for trades on exchanges is so high. Everybody wants to trade these ETFs, so it's easy for authorized participants (APs) and individual investors to secure a favorable price.

For example, the SPDR S&P 500 ETF Trust (SPY) has a bid/ask spread of just 0.01%—effectively, a penny.

Generally speaking, spreads for more thinly traded ETFs tend to be higher. That's because the fewer trades that happen in a day, the less price competition occurs and the less pressure there is to keep bids close to asks. (That's not to say it's impossible to secure a good price on a thinly traded fund—just that it takes more work.)

Wide Spreads Widen

Spreads can widen, even in well-traded funds, for various reasons. If the underlying securities aren't trading well—or at all—then it can be harder for ETF traders to source competitive prices for their shares. Small-caps trade less frequently than large-caps, and international stocks trade over fewer market hours than domestic equities, and so on. 

However, spreads can also widen if something fundamentally breaks down within an ETF's creation/redemption process. If an ETF has difficulty attracting enough APs to keep creation/redemption humming along smoothly, or if the ETF stops issuing new shares entirely, then spreads often widen on the secondary market—even if the ETF trades with brisk daily volume.

ETFs With Highest Spreads

Using our ETF Screener, we ranked all equity ETFs with at least $100 million in assets under management and at least $10 million in average daily trading volume in order of highest to lowest spread.

The vast majority of these ETFs had spreads in the single percentage points. However, 10 ETFs had spreads higher than 0.10%:

Sources: FactSet, ETF.com; data as of Oct. 25, 2018

The three large, liquid ETFs with the highest spreads were the Invesco S&P Emerging Markets Low Volatility ETF (EELV), the ETFMG Alternative Harvest ETF (MJ) and the Invesco FTSE RAFI Developed Markets ex-U.S. ETF (PXF).

Two of these three funds have high spreads for similar reasons, while MJ has a different cause.

Real-World Consequence Of Custodial Risk

Let's start with the most unusual of the three: MJ, the marijuana ETF. As we've covered extensively, MJ has dealt with uncertainty around its custodian bank almost since its inception last December, with its former custodian bank, U.S. Bank, threatening for months to terminate the relationship (read: "Promise & Peril Of Marijuana ETFs").

Last month, MJ's issuer, ETF Managers Group, suddenly switched to a new custodian bank and transfer agency (read: "Marijuana ETF Shifts Custody"). This led to the ETF trading at temporarily high premiums to net asset value, premiums that have since come down considerably.

Shortly after the switch, ETMFG's Jason Wilson told Bloomberg News that the premiums were the result of high investor demand in the U.S.' only marijuana ETF, and that the fund now had four APs on hand to handle creations and redemptions. That, he says, was more than MJ had before the transition to the new custodian bank and transfer agency.

AP Arbitrage

However, four APs is not a particularly high number for such a large, highly traded fund; and if MJ had had fewer APs on hand previously, that may have helped widen the fund's spread.

That's because APs create and redeem ETF shares purely to make a profit from the transaction arbitrage; only price competition between APs keeps spreads small. The more APs an ETF has, the more price competition there will be among them in creating/redeeming new shares. And spreads tend to be lower.

Exacerbating the issue is the fact that MJ tracks an index largely comprising small-caps/micro-caps and international stocks. Both categories have lower liquidity than, say, U.S. large-caps, even though investor interest in marijuana is at an all-time high.

Lower liquidity results in higher trading costs for the underlying stocks, which means it's more expensive for APs to create and redeem ETF shares—and those costs get passed along throughout the creation/redemption process.

Deceptively High Volume In EELV

Turning back to EELV and PXF, it is unclear whether these two ETFs have few or many APs; most ETF issuers and exchanges don't disclose that information publicly. For what it's worth, however, these two ETFs likely appear on our list not because of creation/redemption snafus, but because their reported volume is somewhat misleading.

Let’s start with the Invesco S&P Emerging Markets Low Volatility ETF (EELV), which reports an average daily volume of $11 million, but that figure is just that: an average. The actual day-to-day volume numbers tell a different story:
 

Sources: ETF.com, FactSet; data as of Oct. 25, 2018

For most days in 2018, EELV has traded either not at all or in minimal amounts (less than $10 million). There were, however, two-consecutive days in April of massive inflows that brought in roughly $420 million in new investment assets. Then, in September, there were several days of massive outflows, totaling almost the same amount, $408 million.

Looks Can Be Deceiving

Those September trades skewed EELV's average daily volume, which is calculated on a rolling 45-day basis, thus making it seem like EELV is traded more often than it really is. Note that EELV's median volume (also calculated on a 45-day basis) is just $1 million.

A low-volume ETF with a sizable spread is not unusual—it's actually par for the course. EELV only looks like a high-volume spread, unless you dig into the daily flows.

On top of that, EELV is an emerging markets fund. Though it holds large-cap companies, many of those stocks are traded in overseas markets that aren't open during the usual U.S. market day. As we mentioned earlier, that timing mismatch can lead to pricing disconnects, which in turn can widen spreads.

Spreads For A Buy-And-Hold Fund

A similar story is true for the Invesco FTSE RAFI Developed Markets ex-U.S. ETF (PXF), which trades about as infrequently as EELV, but with trades of larger magnitude.

On most days in 2018, PXF didn't trade at all; money only exchanged hands on 14 trading days up until Oct. 25. But when investors did trade PXF, they did so in larger chunks: The average inflow for those 14 days in which PXF traded was $16 million:

Sources: ETF.com, FactSet; data as of Oct. 25, 2018

Large trades that happen infrequently can produce an illusion of high trading volume, when in fact, the actual activity that happens day to day in the fund is fairly modest. And as we stated earlier, a low-volume fund with high spreads really isn't anything special.

That's not to say investors will have a hard time getting in and out of PXF; the ETF's underlying stocks are actually very liquid and well-traded, including names like BP, Total and HSBC. But the fund itself isn't trading very often, which is why its spreads are fairly high. PXF's $224 million in net inflows year-to-date implies that investors are buying and holding.

Trade High-Spread ETFs With Care

So what's the moral of the story here? For starters, if a high-volume fund looks like it should have a tight spread but doesn’t, then that usually indicates more to the volume data than a first glance might suggest. Sometimes a high-volume ETF actually … isn't. It’s sporadic.

Sometimes, however, high spreads indicate hiccups in the creation/redemption process that can potentially bite investors.

It's not always easy to tell which scenario is at play. When in doubt, work with a capital markets desk to source a trade you need in the size you need it. And remember to trade funds with high spreads—be they large or small, high-volume or not—with care.

Contact Lara Crigger at [email protected]