How the bid-offer spread inflates your ETF costs

Investing involves so many costs, fees and charges that sometimes I think my assets stand about as much chance as a stick of pepperami in a piranha tank.

The bid-offer spread is yet another oft-overlooked cost that will nibble away at your returns unless you take evasive action. And, as a passive investor, one thing that I’m active about is costs.

The bid-offer spread (or bid-ask spread in the US) afflicts passive investors who use Exchange Traded Funds (ETFs) and to a lesser extent Unit Trusts. The spread is the difference in the buy and sell price offered for a security at any given time.

Just like when you convert foreign currency at a Bureau de Change, it always costs a little more to buy than you can get when you sell.

An example will help explain:

Consider the FSTE Magic Upside Generator ETF (Ticker: MUG).

The bid price (i.e. the highest price I can sell for) = 99p

The offer price (i.e. the lowest price at which I can buy) = 101p

The bid-offer spread = 2p per share (or 1.98%)

The bid-offer spread therefore costs me 1.98% from the moment I buy into the MUG ETF, on top of any other trading fees like broker’s commissions.

Once I’ve bought, I need the bid price to rise to 101p before I break even on the deal (ignoring all other costs).

Tighter is better

Clearly, the tighter the bid-offer spread, the better off you are. But unfortunately, there’s no such thing as a ‘normal’ or ‘acceptable’ bid-offer spread.

The spread reflects the nature of the fund’s underlying securities like a bulge beneath your t-shirt reflects an underlying fondness for pies.

Heavily traded, liquid securities have lower bid-offer spreads because it’s easier to match up the buyers and sellers of such popular fare, which lowers the middleman’s transaction costs1. If your desired ETF tracks the FTSE 100, the spread can be as little as a few hundredths of a percent.

In contrast emerging market funds generally have wider spreads, reflecting the higher cost of trading in more illiquid shares.

Some ETFs carry huge bid-offer spreads of over 3% – a massive cost clobbering to take.

Where to find the bid-offer spread

Bid-offer prices can be found on the website of the ETF provider, via your online broker, or through the stock exchange itself.

To give you a taste of what to expect, here’s a quick sample of bid-offer spreads, using January 28 closing prices for some UK-listed ETFs:

ETF	Bid (pence)	Offer (pence)	Spread (%)
iShares FTSE 100	587.2	587.6	0.07
dbx Emerging Markets	2,605.54	2,613.3	0.3
CS MSCI UK Small Cap	9,549	9,860	3.15

As you’d expect, the highly liquid, large cap equities of the FTSE 100 show a miniscule spread. But the gap widens to a not insubstantial 0.3% once we’re into emerging markets territory.

Then there’s our controversial old friend CS MSCI UK Small Cap, which is about as liquid as the surface of Mars. Its spread of 3% brings to mind the hideous initial charges of expensive mutual funds!

Five ways to fight the spread

1. Be broadminded

The best way to avoid gaping bid-offer spreads is to invest in broad market indexes that track highly liquid securities.

2. Consider the index

Always check what index your potential ETF purchase tracks.

If it’s mimicking a liquid index like the S&P 500 or the DJ Euro STOXX 50 then you’ll have very little spread to worry about.  But if your index is slicing and dicing a tiny portion of the market – solar energy, or ethical tobacconists, perhaps – then trade in the underlying securities is likely to be less brisk, and bid-offer spreads will widen.

And don’t be lulled into a false sense of security if you’re looking at a niche sector that’s flavour of the month. It could be liquid now as everyone piles in but freeze up later when everyone’s bolting for the exit.

3. Watch and wait

It’s a good idea to watch the bid-offer spread of your target ETF for a few days before you buy, so you can get a feel for how wide it should be. (This is even more true if you turn to the darkside buy individual company shares).

4. Numbers speak volumes

If you’re comparing similar funds, then use the following indicators as a tie-breaker:

• Assets under management
• Daily trading volume
• Number of market makers

You’re looking for higher numbers in all these categories when comparing ETFs. They’re all suggestive of a more liquid fund and hence a tighter bid-offer spread. (Although it’s admittedly a bit like using the Met Office’s 5-day weather forecast to decide whether you should wear waterproof trousers next Tuesday).

5. Not so fast, cowboy

Trade less. A one-off cost of 0.3% is easy to take if you’re investing for the long-term, whereas the bid-offer spread matters far more if you’re tempted to trade frequently. If you buy and hold (or buy and sell-only-rarely) then it’s much less of an issue.

Bonus tip: Use limit orders

You can avoid nasty surprises caused by sudden price movements and yawning bid-offer spreads by using limit orders when buying and selling less liquid ETFs.

Here you place a limit order with your broker, specifically stating your maximum buying price, or your minimum selling price. A limit order puts you in control. If the offer price exceeds your limit then you won’t buy.

Once you’ve monitored the ETF’s price for a few days then you’ll have a good idea at what level you should set your limit order.

I personally don’t use limit orders because I buy my ETFs using a regular investment scheme. The broker bundles up my order along with countless others and buys on a pre-determined day. I lose control over the bid-offer spread but gain by slashing the cost of the broker’s commission.

Take it steady,

The Accumulator

1. Technically, it also reduces the risk to the market maker of making a market in those securities, by risking being lumbered with the baby! [↩]