Beware of ETF Bid-Ask Spreads

When the average Joe (or Jane) looks at transactions costs from trading, they typically focus on the commission charged by the broker. But in the case of some thinly-traded ETFs (exchange-traded funds), the bid-ask spread can add significantly to that cost. Here's a good piece on the topic from Morningstar:

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.

Read the whole thing here.

Comments

[AndrewBaker:]

People need to take more interest in the bid/ask spread on ETF/N. In some cases they are horrifying: you can get the trades right and over time make next to nothing by the time the dealers have taken their cut. Why is it that the trades you want to make cost so much? The financial sector have got more than their fair share of greedy self-interested workers, and those dealing in ETF are definitely amongst them. Ideas please as to how to cut down the spreads so that we who risk our money get the right return without paying out on both sides of the trade so much to the shopkeeper.

Feb 05 01:20 PM

[bigmoney:]

I trade through a discount broker, and the bid / ask drag is not very obvious. I typically do a limit order based on some arbitrary number, such as "last", and I don't know if that improves the situation.

What happens in a "stop", or a "stop limit" ? If the price is falling fast, and you want out now, then you will be vulnerable to the spread.

Feb 05 01:27 PM