How to use bid-ask spread data when trading ETFs.
By Bradley Kay | 02-03-09 | 04:00 PM | Email Article

In today's liquid markets, most investors don't spend much time thinking about liquidity and bid-ask spreads. Given that several of the largest ETFs are the most traded and liquid securities in the world, the ETF market is no exception. However, not all ETFs are as heavily traded as the ubiquitous "Spider" ( SPDRs ). Thus, not paying attention to the bid-ask spread when purchasing a fund is a quick way to ensure that your portfolio produces underwhelming performance. Recognizing this, Morningstar.com has enhanced its ETF Quote page to include real time bid-ask spreads.

Bradley Kay is Director of the European ETF Research team.

Even Pennies Matter
The bid-ask spread is an approximate measure of how much trading activity is occurring on a particular ETF, and how likely an investor is to get a reasonable price. The "bid" and "ask" are two prices given for every security traded on an exchange at any time; traders are willing to buy shares of that security for the announced "bid" price and sell for the higher "ask" price.

The way we calculate a bid-ask spread is by taking the difference (or spread) between the two prices, and then expressing it as a percentage of their average (which itself is a fresh estimate of the security's market value). For market makers, this represents the "guaranteed return" from buying shares on the market at the bid price and then selling them instantaneously at the ask price, but this guaranteed return compensates for two major risks. If a security trades very infrequently, the market maker takes the risk of holding on to any shares it buys for a long time. If a fund or stock is particularly volatile or holds assets of uncertain value, the market maker would take on even more price risk when it holds the shares. Either of these risks leads market makers to demand a higher guaranteed return on their sales and purchases of shares, and thus a larger bid-ask spread.

This datapoint shines a light onto yet another aspect of the slippery trading concept of "liquidity." No one has a very precise definition of liquidity, but it roughly boils down to how easy it is to buy or sell a particular security and how much agreement there is in the marketplace upon the security's fair value. The most liquid funds or stocks have miniscule bid-ask spreads, where the prices differ by only a penny. On the other side, a brand new ETF tracking a selection of more thinly traded mortgage-backed securities has a bid-ask spread near 0.80% as I write this. That means that buying and selling the fund at market prices, even without any commissions charges or price changes, would result in a 0.80% loss. Not exactly a terrifying loss, especially compared with what we all saw in 2008, but still an unwelcome drag on portfolio returns if it can be avoided.

How to Use It
The most important part is determining how you can use this measure to invest more effectively. Anyone looking to buy into a smaller or more exotic ETF should first look at the bid-ask spread to see if their prospective investment has much liquidity. Luckily, our review of the spreads thus far has mostly confirmed what we already suspected, that ETFs are remarkably liquid and user-friendly for individual investors. Bid-ask spreads rarely move above 0.50% during the trading day, even on tiny funds with less than $5 million in assets and difficult-to-price fixed-income ETFs. Still, if you see a spread of 0.20% or more during the trading day, that means you are likely dealing with a less liquid fund. Even though the bid-ask spread might not look like a big price to pay, it might hide bigger potential costs for those looking to trade larger blocks of shares. Large market orders might end up purchasing or selling shares at substantially worse prices as market makers demand premium prices to compensate for their risk in holding the illiquid fund. Investors looking to protect themselves when trading a less-liquid ETF should use a limit order to ensure that their purchases or sales all occur at the same price.

A Final Note
We update this data in real time, so it provides poor estimates of an ETF's or ETN's liquidity when checked outside of the trading day. At the end of the day, market makers generally remove their bid and ask prices for ETFs so that they will not get caught in an unprofitable trade first thing in the morning if an index moves overnight. This causes the bid and ask prices to move away from one another and the bid-ask spread to balloon. As an example,  ELEMENTS S&P CTI ETN , one of the least-liquid of our recommended funds, had a bid-ask spread around 0.35% during most of Jan. 29, 2009. This spread is larger than that of most ETFs, but it can be minimized by using a limit order. Additionally, the spread is not a huge drag on the expected returns over our anticipated multiyear holding period. After the trading day completed, that spread jumped to an incredible 10.24% as market makers rescinded their offer prices. This does not represent a true trading cost for the ETN, but instead is just an example of how little trading occurs in the after hours markets where individual investors rarely tread.

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Bradley Kay does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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