For advisors familiar with mutual funds but just getting started with ETFs, there’s some comfort in seeing that both types of investment funds publish net asset values (NAV) at the market close. But that’s where the similarities end.
All mutual fund transactions take place at these end-of-day NAVs. Not so with ETFs, which trade throughout the day. What appears on trading screens are two prices that will fluctuate: the bid price that a buyer is prepared to pay and the ask price that the seller demands.
In educating advisors, “there’s that whole extra layer of conversations you have to have from the ETF side,” said Ahmed Farooq, senior vice-president and head of retail ETF distribution with Toronto-based Franklin Templeton Investments Corp.
The difference between the price that buyers are offering and what sellers are seeking is the bid-ask spread. Market makers or designated brokers will make bid-ask adjustments continuously as they update their calculations of the value of the ETF’s holdings — stocks, bonds, etc.
Depending on the liquidity and price transparency of the securities the ETF holds, the bid-ask spread can vary from negligible to more than 200 basis points.
“The bid-ask spread is representative of the underlying portfolio,” said Mario Cianfarani, head of sales and key accounts for Toronto-based Vanguard Investments Canada Inc. “So if you have an underlying portfolio that is deep and liquid, let’s say something like the S&P 500, that bid-offer spread will reflect the deepest, most liquid companies in the U.S.”
An ETF has two layers of liquidity. One is the bid-ask spread of the underlying securities. There’s also the liquidity built up in the secondary market from the trading bid-ask spread.
“Oftentimes with liquid ETFs, you’ll get better liquidity in the ETF than you’ll get in some of the components of the underlying basket,” said Cianfarani, who was formerly Vanguard Canada’s head of capital markets trading.
Securities regulations require ETF providers to publish the average daily bid-ask spread in the ETF Facts disclosure document. The spread is shown in percentage terms over a 12-month period. An example of a very liquid ETF is the Vanguard S&P 500 Index ETF, whose average spread was only three basis points (0.03%). Similarly, the average spread of the iShares S&P/TSX 60 Index ETF, the largest in the Canadian equity category, was only four basis points.
At the other extreme are specialty mandates such as alternative strategy funds that employ short-selling and leverage. For example, the Picton Mahoney Fortified Multi-Strategy Alternative Fund has a whopping average bid-ask spread of 2.89% for the 12 months ended July 5.
Among the more mainstream asset classes, fixed income ETFs tend to have wider spreads because bonds are sold over the counter and their prices can sometimes be opaque, Farooq said. The magnitude of spreads also depends on the types of bonds the ETF holds. The lower the credit quality, the wider the spreads tend to be.
During the market volatility in March of last year, fixed-income ETF trades were taking place at discounts to their posted NAVs, which were based on the previous day’s market close. But Cianfarani said this reflected the fact that the day-old price quotes for the underlying bond holdings were out of date. “The ETF was actually a better indicator of where the market was than the underlying portfolio,” he said. “The ETF was reacting in real time.”
Among equity ETFs, bid-ask spreads tend to be wider for products with overseas holdings, especially if they’re bought or sold when the markets they invest in are closed. Spreads can also be wider for ETFs that hold shares of smaller companies.
“The mega-caps tend to have a lot more trading volume,” Farooq said. “As you go down the spectrum to small caps, you’re going to have wider spreads based on the individual stocks’ bid-ask spreads.”
An ETF’s size is not a major factor in bid-ask spreads. What matters more is the liquidity of the underlying holdings. ETF companies can arrange to create or redeem ETF units, depending on market demand. They’ll buy the underlying securities if more units are needed. Alternatively, units can be broken up by redeeming securities holdings on the exchange. This process serves to keep bid-ask spreads fairly narrow, at least for those ETFs that invest in very liquid securities.
Trading volume can be a factor in bid-ask spreads for ETFs, said Cianfarani: “The more it trades, the more there are other investors, traders or arbitrage firms that can tighten that bid-offer spread.”
However, trading volume becomes less of a factor if the holdings are similar to those of other ETFs. Because of arbitrage opportunities, “that offer spread will coalesce around the spread that is consistent with other similar mandates,” he said.
Advice for advisors
The challenge for advisors in getting the best order execution for clients is to minimize the impact of bid-ask spreads while still getting trades done. Here’s how:
- Always use limit orders, specifying the most you’re willing to pay to buy the ETF or the lowest price you’ll accept if selling. Though a market order ensures that your trade will be completed, you give up control over the transaction price. If you must ensure the order is filled, Cianfarani suggests using a marketable limit order. This type of order is priced slightly above the offer price if you’re buying, or slightly below the bid price if you’re selling. “But at least you introduce certainty into your trade.”
- Avoid trading shortly after the market opens or before it closes. For at least 15 minutes, allow the market to settle in from the latest news developments, market sentiment or early-morning block trades, said Farooq. Toward the end of the day, a late-breaking rally or selloff could also cause spreads to widen, he added. Farooq also recommends avoiding trading during U.S. holidays. Spreads will be wider on U.S. equity ETFs listed in Canada, he said. Reduced trading volumes will also tend to widen spreads on Canadian stocks, and by extension the ETFs that hold these stocks.
- When buying or selling European equity ETFs, do so in the morning when spreads tend to be narrower because market makers are better able to calculate the value of the underlying holdings. This doesn’t apply to trades in Asian equity ETFs, since there’s no overlap in trading hours.
- If you wish to trade a block of stock for a single large client or on behalf of multiple clients, don’t be deterred by insufficient bid and ask volume. Contact the block-trading desk for the ETF, either directly or with the help of the ETF company’s capital markets professionals. Cianfarani said advisors might be able to negotiate a price that’s right on the posted bid or offer. “Sometimes they may not, but you’ll generally make sure that the market maker is aware and able to accommodate your size, so you’re not disrupting the market and getting the best possible fill.”