Defining the Spread
The spread represents the difference between where an investor can buy or sell and is an additional cost when entering and exiting an ETF position. The spread is normally set by market makers around the intrinsic value2 of the portfolio and includes the transaction costs associated with creating or redeeming shares. For ETFs, the transaction costs 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 out of performance. Let’s take a further look at the breakdown of what is typically built into the spread of an ETF.
The Sum of Its Parts
The spread can be broken down into the various trading costs which include the creation/redemption fees, bid/ask spread of all securities in the basket, risk of hedging3 or carrying costs, taxes, and lastly, desired profit for the market maker.
Let’s look at a hypothetical example of the bid/ask spread for an ETF. The intrinsic value of the underlying basket is being calculated at $40. The market maker will set the secondary market spread around the intrinsic value. Let’s assume the bid/ask is $39.95/$40.05. In this case, $39.95 is the bid side of the market and $40.05 represents the asking price. The bid/ask spread is 10 cents and the investor would pay half the spread when buying and the other half when selling in this example. 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.
Prices Here and There
The more expensive the underlying portfolio is to trade, the wider the spread will be set, due to the fixed transaction costs. Generally speaking, one should expect an ETF with US equity to have a tighter spread than an ETF with international equity. This is because foreign markets are inherently more expensive to trade due to local taxes, local market bid/ask spreads, and different local market hours.
Additionally, as an ETF grows in size and popularity, an actively traded secondary market can actually reduce the spread inside the total transaction costs. This may seem impossible, but as natural two-way flows of buyers and sellers 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 ones new to market.
Know What You’re Buying
As previously mentioned, in the traditional mutual fund structure, trading costs are still present but not directly visible to the end investor. When dealing with daily cash flows, mutual fund managers buy and sell securities within the fund and these trading costs are aggregated and absorbed across all shareholders, coming out of performance. When comparing the cost of a mutual fund share to an ETF share it is important for investors to know they are paying an explicit transaction cost for an ETF share and this must be added to the expense ratio for a more realistic comparison.
Additionally, it’s key to understand that these trading costs occur outside the ETF fund structure and the end investor pays those costs when entering and leaving the ETF via the spread. Lastly, when buying an ETF share, the investor may incur a commission similar to what a broker would charge for a normal stock trade.
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.
2 The value of a company, based on the net present value of forecasted cash flows such as future earnings or dividends.
3 A hedge is an investment aimed at reducing the risk of adverse prive 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. Unlike typical exchange-traded funds, there are no indexes that the Fund attempts to track or replicate. Thus, the ability of the Fund to achieve its objectives will depend on the effectiveness of the portfolio manager. There is no assurance that the investment process will consistently lead to successful investing. 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.
All investing involves risk, including the risk of loss. Diversification does not guarantee a profit or protect against a 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.