Investors in Small ETFs: Be Wary of High Bid / Ask Spreads

Feb. 2.10 | About: Guggenheim Enhanced (GIY)

One advantage of investing in exchange traded funds [ETFs] is that they can be bought or sold throughout the trading day, unlike traditional mutual funds which only trade at the end of the day. On the other hand…that capability brings with it a potential flaw, particularly for smaller ETFs. Eleanor Laise at the Wall Street Journal lays out the issue [emphasis added]:

Risks Lurk for ETF Investors (Wall Street Journal, Feb. 1, 2010, Eleanor Laise)

The ease of buying and selling ETFs, which typically resemble index-tracking mutual funds but trade like stocks, has helped make them the darlings of investors big and small. But as ETFs delve into more esoteric areas of the market such as high-yield bonds and commodity futures, trading them has become more complex.

There are “a lot of dissatisfied customers” discovering snags in ETF trading, says Scott Burns, director of ETF research at Morningstar Inc.

I don’t know how Scott Burns at Morningstar quantifies a lot, but I’m not surprised that some investors are having trouble with smaller ETFs. There are other ETF investing issues we have seen — let’s call them growing pains — such as the divergence of commodity ETFs from the underlying index they track (see Natural gas ETF: Tanks for ‘09).

This problem will almost certainly be an ongoing problem for smaller ETFs and it will exacerbate the concentration in the largest, most liquid ETFs. The Wall Street Journal continues:

A lack of liquidity can lead to wide “bid-ask spreads,” or the gap between the price buyers are willing to pay for shares of an ETF and the price sellers are asking. The wider the spread, the bigger the bite taken out of investors’ returns every time they buy or sell. A lack of liquidity also may cause the ETF to trade at a large premium or discount to net asset value, or NAV—the value of the fund’s underlying holdings. That means an investor buying the fund may overpay for that portfolio, or an investor selling could get less than that basket of securities is worth…

The world of ETFs has been expanding rapidly (see Two thousand ETFs) and growing pains should be expected. I’m not sure what can be done about this one though, because there have always been much wider spreads in bid and ask prices on stocks that don’t trade frequently. The WSJ continues:

…ETF assets and trading volume are highly concentrated in just a handful of funds. The 10 largest ETFs account for almost 40% of total ETF assets, while the 10 funds with the largest dollar trading volume accounted for roughly 60% of the total volume for all ETFs in December, according to National Stock Exchange.

Investors trying to buy or sell these ultrapopular ETFs probably won’t run into problems. Consider the SPDR, which tracks the Standard & Poor’s 500-stock index. Almost 3 billion SPDR shares changed hands in December, according to NYSE Arca, with an average bid-ask spread of just a penny.

At the opposite end of the spectrum is the Claymore U.S. Capital Markets Bond ETF. Fewer than 12,000 shares traded in December, and the average spread was a whopping $2.56.

…Spreads of more than five to 10 cents “would concern me,” says Matt Hougan, editor of “If it’s 50 cents, I would run screaming.”

Investors in smaller ETFs need to look at the issue of bid / ask spreads and, if those spreads are high, that’s a good reason to, as Matt Hougan writes, ‘run [away] screaming.’

Disclosure: No positions