ETF Capital Markets Desk: Corner: Bid/Ask Spread

In my prior blogs, I covered the concepts of liquidity and assets under management when it comes to investing in exchange-traded funds (ETFs)—and we hope I’ve cleared up some misconceptions. Now, I will dive into another item on potential ETF investors’ wish-lists: a tight bid-ask spread. At the surface, it seems obvious that a tighter spread is better than a wider spread; the tightest a spread can be is $0.001. When the bid/ask spread is tight, that implies the market is highly liquid, with intense price competition and high demand for the asset in question. However, the situation is a bit more nuanced. Let’s look at two examples of bid/ask spreads in the realm of ETFs, one with somewhat obvious implications, while the second takes a little bit more digging to see.

In percentage terms, a $0.01 of bid/ask spread is higher for lower-priced stocks than higher-priced stocks, given the ratio to the share price.

Here’s an example. Let’s imagine there are two ETFs with identical underlying securities.

The market for ETF A: 21.02 Bid x 21.05 Ask
The market for ETF B: 98.73 Bid x 98.79 Ask

For ETF A, bid price is 21.02 (what the buyer is willing to pay) and the ask price is 21.05 (what the seller is offering). So, the spread of ETF A is three cents while the spread of ETF B is six cents. However, when converting to basis points (bps) , the spread on the first ETF is 14 bps wide while the second is six bps wide.

The conversion to percentage terms takes into account the price of the stock:

ETF A: 100 x (21.05 – 21.02)/21.05 = 0.14 or approximately 14 basis points
ETF B: 100 x (98.79 – 98.73)/98.79 = 0.06 or approximately six basis points

Put more simply, a three-cent spread is a larger proportion of the lower stock price than the six-cent spread is of the higher stock price.

¹ A basis point is a unit of measurement. One basis point equals one hundredth of 1% or 0.01%.

However, the bid/ask spread does not reflect what the ETF is worth.

To us, this is an important aspect that merits more discussion. The price of an ETF—especially a newly launched ETF—is driven by the costs of assembling the underlying basket of securities.

Let’s look at another example. This time we will assume two identical ETFs with identical underlying securities held at identical weights. Calculated off the price of the basket of securities, both of these ETFs are worth $27.50.

The market for ETF A: 27.39 Bid x 27.53 Ask
The market for ETF B: 27.48 Bid x 27.55 Ask

The spread of ETF A (at fourteen cents) is almost twice as wide as ETF B (at seven cents). But despite the wider spread, ETF A would be more desirable because its shares are offered closer to the price of the underlying basket. In other words, if the two ETFs are identical and have the same underlying basket of securities, the value of the securities is also the same, so it makes sense that an investor would want to buy the one offered at a lower price – i.e., to pay less for the same security.

What does all this mean to a potential investor? One of the main functions of our ETF Capital Markets team is to work with the market participants to have a discussion of the costs of assembling the basket and what that means to the price of the ETF. The goal is for the potential investor to have confidence that shares can be purchased at levels in line with the price of the underlying basket. This can be done even if the spread is not $0.01 as outlined above.

In my next blog, I will be discussing a related subject: the size, or the amount of shares on the bid or offer. Investors typically like to see a large number of shares available on the offer, ideally an amount greater than the size they are looking to purchase. I have found there are some misconceptions about what it means when this isn’t the case. Tune in next time!

David Mann’s comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.
This information is intended for US residents only.

To comment or post your question on this subject , follow us on Twitter @LibertyShares and on LinkedIn.

What Are the Risks?

All investments involve risks, including possible loss of principal. Indexes are unmanaged, and one cannot invest directly in an index. They do not reflect deduction of any fees or expenses. ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns.