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Must-know: Important costs involved in owning an ETF

Part 2
Must-know: Important costs involved in owning an ETF (Part 2 of 5)

Why bid-ask spread costs are so important to ETF investors

Bid-ask spread costs

Other than the operating costs of an ETF, the other hidden cost that affects the return for investors is the bid-ask spread. “Bid” is the price someone’s willing to pay for an investment vehicle like an ETF at a specific point in time. “Ask” is the price someone’s willing to offer for a sale. The amount by which the ask price exceeds the bid price is called the “bid-ask spread.” An ETF usually trades as closely to its net asset values, or NAV, as possible. The market provides a lot of liquidity to the system in order to ensure this. However, for some very-low-volume ETFs, bid-ask spreads may exist and widen. Trading ETFs with large spreads eats away at potential returns since they affect the ETF purchase and sales prices.

Liquid fundsEnlarge Graph

Investors may also purchase an ETF above its NAV, which essentially means paying a premium for the basket of securities.

 

Average Monthly Volume

Bid-Ask Spread (%)

SQQQ

813,956

0.62%

LQD

1.68 million

0.40%

SPY

121.2 million

0.02%

EEM

66.9 million

0.15%


We’ve considered four ETFs in our graph above: two highly liquid ETFs, SPY and EEM, and two ETFs with low average volume, SQQQ and LQD. We note that bid-ask spread is higher for the less-liquid ETFs, while it’s lower for liquid ETFs. We’ve considered price movements from February 14, 2014, to February 25, 2014. We find that on February 19, 2014, the price of SQQQ went up by around 2%, while the prices of other ETFs remained nearly unchanged. Similarly, on February 14, 2014, SQQQ moved 2%, with other ETFs changing very little. So investors should be aware of the liquidity of an ETF, as the bid-ask spread may take away a large chunk of the fund’s return.

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