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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.

Market middle-men make a nice profit from the bid-offer spread.

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! []
{ 7 comments… add one }
  • 1 Nanette Byrnes February 8, 2011, 4:34 pm

    super post — ETFs are generally described as cheaper alternatives to mutual funds, but it’s obviously more complicated than just the straight asset based fess.

  • 2 Alan February 8, 2011, 7:35 pm

    Great post. Regarding ‘numbers speak volume’, I am guessing the reference for comparing these numbers is ‘peergroup’ and not ‘index’.

    CS MSCI UK small cap is not the ETF for me.

    I must say that I find the world of ETF’s rather bewildering (despite a very helpful post on your blog in the past:(. I feel more comfortable with Index tracker funds. As an aside, after doing my research(!) I have decided that Vanguard offers the best deal (slightly better than HSBC and L & G).

  • 3 The Accumulator February 9, 2011, 11:06 pm

    Thanks Nanette. Often ETFs aren’t even cheaper than mutual fund equivalents in the UK. Especially when you add in trading costs. What they are is more diverse. So for certain market categories, ETFs are the only choice.

    @ Alan – Spot on about the peer group. Agreed that Vanguard are the cheapest, if you hold for long enough and you invest sums large enough to dilute the trading costs. I wrote a post about it here: http://monevator.com/2010/10/12/cheap-vanguard-index-funds/

  • 4 Alex February 10, 2011, 11:13 am

    1. As ever, thanks for another excellent post.

    2. I understand why a smaller bid-offer spread is better for buyers. But high trading volumes in an ETF are one cause of tight spreads – and trading in a fund raises transaction costs for the fund. Long-term investors in an ETF are surely adversely affected by short-term trading in it.

    3. In fact, it seems to me that short-term traders in ETFs get a better deal than long-term investors in several ways. For instance, the former depend on the latter: fund managers use size of fund (assets under management) to decrease total cost of ownership for investors (e.g. through stock lending or decreasing the TER). A fund only exists if it has assets. Are short-term traders parasites on the buy-and-hold brigade?!!

  • 5 The Accumulator February 10, 2011, 8:28 pm

    Hi Alex,

    Trading volumes are apparently nowhere near as important as the liquidity of the underlying assets. Trading volumes are an indicator of liquidity, which should lead to a tighter spread, but there are ETFs out there that defy that logic.

    Trading in an ETF only creates transaction costs for the fund if we’re talking about redemption and creation in the primary market. In the secondary market, where you and I fish, trading is a good thing as it provides us with liquidity. Which leads into your third point. Short-term traders are more symbiotes than parasites. We need ’em. Not just for liquidity, but also for their role in determining fair value.

  • 6 Jacob @ My Personal Finance Journey April 2, 2011, 9:45 pm

    I often forget to mention bid ask spreads when I talk about the few downfalls of ETFs vs. mutual funds. But, this is a good reminder! Thanks for submitting this to the Carnival of Passive Investing.

  • 7 Lawrence April 14, 2016, 8:56 am

    Brilliant post. Quick question: how can I determine the current bid-offer spread, so I can monitor it for several days, as you suggest?

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