When High Spreads Mean ETFs Work

There's something comforting about the list of the ETFs with the highest trading spreads.

With so much uncertainty in the world these days, it's comforting to know that some things still work the way they should.

Take ETF trading spreads. Most ETFs have very tight trading spreads: Of 2,071 ETFs on the market (excluding leveraged/inverse products and ETNs), only 37 carried a spread higher than 1.00%. Only 195 funds had spreads higher than 0.50%.

Objectively, that's pretty darn good for investors: Lower trading costs mean a lower total cost of ownership, no matter how big or small your pile of invested assets might be.

A few ETFs do still have wide spreads, of course. But there are good reasons these edge cases exist, and ultimately, the rules of ETF physics still apply.

What Are Spreads?

A security's bid/ask spread is defined as the dollar difference between that security's bid and ask prices, divided by the midpoint price between them, or:

Spread = |Ask Price – Bid Price|/Midpoint Price

Note: A trading spread isn't a guarantee that you definitely will pay some set-in-stone markup whenever you buy a fund (or eat the same cost when selling). But for smaller investors who can't tap into block liquidity, an ETF's spread can be a fairly good estimate of the cost to enter and exit a fund, barring commissions.

Spreads are strongly correlated to volume: When a high-demand ETF has robust volume, its spread tends to be small. But when an ETF (or its underlying securities) are thinly traded, its spread often widens. That’s because when there's no market for an ETF—that is, when few shares are changing hands—bid and ask prices become stale, and begin to move away from one another.

We see exactly that reflected in the list of the ETFs with the highest trading spreads:

Source: ETF.com. Data as of Oct. 26, 2020.

All of these are small, low volume funds, with less than $100 million in AUM and, save one exception, less than $100,000 in daily traded volume. The ETF with the largest spread—the Teucrium Agricultural Fund (TAGS)—is also the smallest fund of the bunch; indeed, at $1.2 million, it's one of the smallest and lowest volume ETFs still trading on the market today.

Without sufficient volume, the bids and asks for these funds have drifted away from each other, with very little impetus to bring them back in line.

International Factor

You probably noticed something else about these ETFs, too: Overwhelmingly, they are all international funds—in fact, eight of the 10 hold securities that trade in markets with little to no overlap in open hours with the U.S. Of the remaining two, one is an emerging market bond fund that technically holds U.S. dollar-denominated bonds, but whose returns still depend on overseas markets in differing time zones.

Market-hour disconnects matter because they make stale prices even staler. For example, if an authorized participant (AP) wants to make a creation unit's worth of new ETF shares, then first they'll need to purchase that ETF's underlying securities—a tough task, if the exchange on which those securities are listed isn't open. If the market is closed, then the AP must wait until the next morning to buy them, thus increasing their risk and trading costs, which they pass on to investors.

On top of that, APs dealing in international markets often must exchange currency from U.S. dollars to local currency and back again, which adds the cost and headache of forex trading into the overall creation process. That too can increase the ask price and widen spreads.

Comforting Spreads

So while it may sound odd, seeing spreads like these make me feel downright cozy, as if I'm curling up with a warm blanket and some hot chocolate. Because this is how ETFs are supposed to work: Low volume ETFs with illiquid underlying securities are the ones you'd most expect to develop high spreads. Clearly, that's what's happening.

That's not to say that these ETFs are bad or uninvestable funds, or that investors shouldn't trade them. That's your choice. However, if you do want to trade a fund with a high spread, use some common sense—and maybe also a limit order, to ensure that you're only paying to trade within a range that's acceptable to you.

Contact Lara Crigger at [email protected]