Sponsors of exchange-traded funds (ETFs) continually blow our minds by announcing lower and lower fees, with expense ratios as low as 0.03%. (That’s an annual fee of a mere $3 on a $10,000 balance.)
But what if you learned that a “hidden fee” was costing you more than 1% of the sale price every time you bought and sold one of these securities?
You’d be mad as hell. But it happens every day.
I wrote in a recent column that the most popular ETFs ding you, on average, only 0.04% to 0.08% to buy and sell them. That isn’t the annual fee, it’s a cost some investors aren’t aware of called the “bid-ask spread.”
Looking beyond those popular ETFs, a study shows that some of these financial products are costing you as much as 1.39% every time you get in and out.
What’s a bid-ask spread? It’s the difference between the price you’d have to pay to buy a share of an ETF or a stock and the lower price you’d receive if you were selling it at the same time.
The “ask price” and the “bid price” are set by professionals called market makers. These financial intermediaries take the other side of buy and sell orders all day long. The asking price you’re required to pay to buy a share is always higher than the price you’ll be offered to sell it. The difference compensates market makers for the risk they take when holding a security until a buyer shows up. There’s nothing evil about this—market makers make instant buying and selling possible.
My column on the most popular ETFs piqued the interest of Hugh Todd, CEO of ETFScreen.com, who calculated the original numbers. (Disclosure: ETFScreen produces financial analysis for a website I own, MuscularPortfolios.com.)
Todd ran a new analysis over a period of several days. This time, he tracked the 1,000 most actively traded indexers. His study includes many well-known exchange-traded funds as well as some obscure exchange-traded notes (which we’ll look at more closely in a few moments). Although ETFs and ETNs are wildly different animals, both are collectively called exchange-traded products (ETPs).
The results of Todd’s new study were shocking. Half of the products had bid-ask spreads noticeably greater than 0.08%. Almost 12% had spreads higher than 0.25%. And a few dinged you as much as 1.39% for a single buy and sell. Furthermore, ETPs with less liquidity than the most-active 1,000 that were studied might subject you to even higher costs.
In the accompanying graph, the red columns on the right represent two securities. The Global X S&P 500 Covered Call ETF HSPX, -0.19% would have cost you 1.39% for each round trip. The second most costly product, an ETN called the UBS Enhanced Europe 50 FIEE, -0.07% imposed on you a bite of 1.23%.
What’s going on here? For an example, imagine this:
• Let’s say you buy shares of an ETF at $50.25, which is the “ask price.”
• If you immediately sold those shares, you’d receive $49.75, which is the “bid price.”
• The difference is 50 cents per share. That’s the bid-ask spread.
• Divide $0.50 by the $50.25 ask, and you see that the spread percentage is 1.0%.
“Huh,” you might say. “1% is nothing.”
Unfortunately, 1% is not nothing. Just consider this simple trading scenario:
• You buy shares of an ETF that has a 1% bid-ask spread on Dec. 31.
• On Jan. 31, you sell that ETF and buy shares of a different one with the same spread.
• You repeat this process at the end of every month for a year.
• When you finally sell on Dec. 31, you vaporized 11.36% of your capital from paying the spreads, completely aside from whether the share prices went up or down along the way.
That 11.36% haircut would be larger than the customary growth of the S&P 500 SPX, -0.33% (Over the long term, the index’s total return is about 9% annualized.) Good luck making a profit with a headwind of 11.36%.
Even if the ETF spreads were only 0.25%—and remember, almost 12% of the most-liquid ETPs have spreads worse than 0.25%—you’d lose 2.96% of your capital each year due to trading merely once a month.
Todd cautions that you can’t step into the same river twice. Spreads on exchange-traded products jump up and down all the time. Both HSPX and FIEE have lower spreads now than they did during Todd’s study. But the cost of their spreads today may still be higher than many investors would tolerate.
Therein lies the problem. Most financial websites don’t calculate a security’s bid-ask percentage for you. Your brokerage firm might not even show you the difference between a symbol’s raw bid and ask prices when you’re placing a trade. It’s definitely “buyer beware” concerning bid-ask spreads.
Those who are aware of the costs can take a few steps to watch out for high spreads:
• My website recalculates the spreads for several popular ETFs every 10 minutes while the market is open. The information is free of charge.
• To find spreads before you trade any ETF or ETP—not just the most popular ones—you can consult sites such as ETF.com. However, that site’s numbers show each security’s average spread over several recent weeks, not today’s current spread.
• Your brokerage firm may display a security’s bid and ask prices, but the website’s software usually doesn’t calculate the percentage for you. Good luck dividing numbers like $50.25 and $49.75 in your head.
• Be aware that spreads shown by brokerages with the typical 20-minute delay are only meaningful if viewed between approximately 10 a.m. and 4 p.m. Eastern Time. After that, brokerages may report spreads from after-hours trading. Liquidity after major markets close is limited, and bid and ask prices can soar.
• Sophisticated traders often place “limit orders,” proposing a deal halfway between a security’s bid and ask prices. But if an ETF has an ask of $101 and a bid of $100, no one is obligated to give you a price of $100.50. Many limit orders expire without being filled. If the market moves against you, and you must place a new order the next day, your eventual price could be worse than the day before.
Asked about possible reasons for HSPX’s high spread, a spokesperson for its sponsor responded, “Global X does not have any public comment.”
When I inquired about FIEE, Rishi Rajan, head of public distribution for the Americas at UBS Investment Bank, responded thusly:
“Bid/offer spreads vary with market conditions, generally tightening as trading volume increases and widening when trading volumes are lower. ETNs also provide investors with a second source of liquidity. Investors have the ability to create or redeem the securities at the Closing Indicative Value price, although they should be aware of any minimum size requirements and applicable fees to take advantage of this feature.”
An additional factor to consider is that some financial institutions create exchange-traded notes for a single customer. That client might represent more than 90% of the purchases of the ETN’s shares. With minimal daily trading volume, such an ETN isn’t really intended for the investing public at all. If, by chance, you liked the product’s name and decided to buy into it, you might be unpleasantly surprised by the ultimate cost.
As I stated earlier, exchange-traded notes are quite different beasts than ETFs. An ETN is an unsecured promissory note that holds no actual basket of securities. The net asset value does track an index but is backed only by the creditworthiness of the sponsor.
For instance, when the giant financial institution Lehman Brothers went bankrupt in 2008, the firm’s ETNs immediately collapsed. Holders received only 44.5 cents on the dollar when the remains of Lehman were finally disbursed years later.
With low annual fees and tiny spreads, the most popular ETFs are a relief for investors who used to bear high expenses. But take a minute to look up the spread between a security’s bid and ask prices before you click that Buy button.