When analyzing the total cost of purchasing exchange-traded funds (ETFs), an investor must not only consider the annual expense ratio but also be mindful of other variables – including the secondary market bid/ask spread, premiums/discounts, and brokerage commissions. Investors should analyze bid/ask spreads when buying or selling shares of an ETF in the secondary market, with the goal of executing trades at prices in line with the underlying security basket.

Defining the Spread
The bid/ask spread represents the difference between where an investor can enter and exit an ETF position on the secondary market. The spread is normally set by market makers around the intrinsic value1 of the portfolio and includes the transaction costs associated with creating or redeeming shares on the primary market. For ETFs, the transaction costs to trade the underlying security basket are passed on to investors via the spread. This is quite different from the traditional mutual fund structure, where transaction costs are absorbed within the fund by all shareholders and come directly out of fund performance. Let’s take a closer look at the breakdown of what is typically built into the spread of an ETF.

Prices Here and There
The spread can be broken down into the various trading costs which include the creation/redemption fees, bid/ask spreads of all securities in the creation basket, risk of hedging2 or carrying costs, taxes, and lastly, desired profit for the market maker.

For example, here’s a hypothetical bid/ask spread for an ETF:
  • The intrinsic value of the underlying creation basket is being calculated at $40. The market maker will set the secondary market spread around the intrinsic value.
  • Let’s now assume the bid/ask is $39.95/$40.05. In this case, $39.95 is the bid side of the market and is the highest quoted price an investor would receive in a sale. On the other hand, $40.05 represents the ask (or “offer”) price and is the lowest quoted price an investor would pay in a purchase.
  • The bid/ask spread is now calculated as the difference between the ask and the bid, which is 10 cents.
  • The investor would pay half the spread when buying and the other half when selling shares of an ETF.
  • Remember, this spread includes all the cost components mentioned above that are incurred by the market maker when effecting a creation or redemption of shares.
  • Lastly, it’s important to understand that spreads should be viewed as a percentage of the total ETF share price. A spread of 10 cents would represent a greater cost for an ETF with a share price of $40 (0.10/40=0.25% or 25 basis points) than an ETF with a share price of $100 (0.10/100=0.1% or 10 basis points).
The Sum of Its Parts
The more expensive the underlying portfolio is to trade, the wider the spread will be set, due to the fixed security transaction costs. Generally speaking, one should expect a US equity ETF to have a tighter spread than an international equity ETF. This is because foreign markets are inherently more expensive to trade due to local market bid/ask spreads, local taxes and different local market hours. This can also be true for certain fixed income ETFs that hold generally less liquid underlying securities, as these can be more costly to buy or sell when immediate execution is required.

Additionally, as an ETF grows in size and popularity, an actively traded secondary market can actually reduce the spread inside the total transaction costs. As natural two-way flows of buyers and sellers in the secondary market are matched off with existing shares of an ETF, market participants do not need to completely rely on trading the underlying basket. Therefore, those creation and redemption costs do not fully come into play. This phenomenon is one of the benefits of the ETF structure but is only achieved with more mature products that have size and scope and cannot be expected for all ETF products, especially those new to market.

Know What You’re Buying
As previously mentioned, in the traditional mutual fund structure, trading costs exist but are not directly visible to the end investor. When dealing with daily cash flows, mutual fund managers buy and sell fund securities with the trading cost aggregated and absorbed across all shareholders, which will adversely affect performance. When comparing costs of mutual fund vs. ETF shares, investors should remember they are paying an explicit transaction cost for an ETF share, which must be added to the expense ratio for a realistic comparison.

Investors should also understand that such trading costs occur outside the ETF fund structure, with the end investor paying those costs via the bid/ask spread when entering and leaving the ETF.
1 The intrinsic value of a company is based on the net present value of forecasted cash flows such as future earnings or dividends.

2 A hedge is an investment aimed at reducing the risk of adverse price movements in an asset. A hedge consists of taking an offsetting position in a related asset or security. It can reduce risk, but also decrease potential gains.

Exchange-traded funds (ETFs) trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than the ETF's net asset value. Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns. Active ETFs: Unlike typical exchange-traded funds, there are no indexes that an active ETF attempts to track or replicate. Thus, the ability of an active ETF to achieve its objectives will depend on the effectiveness of the portfolio manager. Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns. Active Semi-Transparent ETF Risk: Unlike traditional ETFs that provide daily disclosure of their portfolio holdings, active semi-transparent ETFs do not disclose the daily holdings of the Actual Portfolio. Instead, these Funds disclose a Proxy Portfolio that is designed to reflect the economic exposure and risk characteristics of the Fund’s Actual Portfolio on any given trading day. Although the Proxy Portfolio and Proxy Portfolio Disclosures are intended to provide Authorized Participants and other market participants with enough information to allow them to engage in effective arbitrage transactions that will keep the market price of the Fund’s shares trading at or close to the underlying NAV per share of the Fund, while at the same time enabling them to establish cost-effective hedging strategies to reduce risk, there is a risk that market prices will vary significantly from the underlying NAV of the Fund. ETFs trading on the basis of a published “Proxy Portfolio” may trade at a wider bid/ask spread than ETFs that publish their portfolios on a daily basis, especially during periods of market disruption or volatility, and therefore, may cost investors more to trade. Volatility management techniques may result in periods of loss and underperformance, may limit the Fund's ability to participate in rising markets and may increase transaction costs. Equity securities are volatile and can decline significantly in response to broad market and economic conditions. Foreign securities may involve heightened risk due to currency fluctuations. Additionally, they may be subject to greater political, economic, environmental, credit, and information risks. Foreign securities may be subject to higher volatility than US securities, due to varying degrees of regulation and limited liquidity. Currency exchange rates between the US dollar and foreign currencies may cause the value of the fund's investments to decline. Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.

All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided. Diversification does not protect against loss.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.

Before investing, carefully consider the fund's investment objectives, risk, charges, and expenses. Visit im.natixis.com for a prospectus or a summary prospectus containing this and other information. Read it carefully before investing.