The bid-ask spread on an exchange-traded fund is as much an expense as broker commissions and operating expenses. If you buy and hold popular ETFs, the spread will not be much of a factor. If you like to trade at the fringes of the ETF universe, however, bid-ask spreads should be part of your checklist before executing a trade.
Stock Market Price Spreads
Every stock or ETF share that trades on the markets will have two prices being quoted. You can see these prices on the quote screen of your brokerage account. If you place a market order to buy shares, you pay the ask price. When selling with a market order you receive the bid price. The bid is always less than the ask, if only by a penny. The bid-ask spread is the amount an ETF share must increase to reach a break-even point -- not including commissions -- after you buy at the ask price. In April 2013, Vanguard reported average bid-ask spreads ranging from 1 cent to 21 cents on the 60 different ETFs the company offers, with many funds averaging 4 to 6 cents.
ETF Investing Costs
An ETF imposes several costs on you as an investor. A fund will have management expenses expressed as an annual percentage. ETF expenses are very low compared to those of mutual funds, but will still reduce the return by 0.20 percent to 0.50 percent compared the index. You also must pay a brokerage commission when you buy and sell, adding up to $20 to the cost of a specific ETF investment. The bid-ask spread is another cost, and an ETF with a wide pricing spread may add as much or more.
An example can show how the costs of ETF investing -- including the bid-ask spread -- affect your potential return. Say you buy 100 shares of an ETF with an ask of $10 and bid of $9.95 -- a 5 cent spread. Your broker charges a $5 commission. To buy the 100 shares, the cost is 100 times $10 plus the $5 commission. If the price does not change and you sell the shares, you receive 100 times $9.95 minus the $5 or $990. For the purchase to break even, the bid price must increase by 15 cents to cover the spread and commissions.
Bid-Ask Spread Considerations
The large, popular, actively traded ETFs will have narrow 1-cent or 2-cent bid-ask spreads. If you plan to actively trade ETFs, these are the funds you want to trade. Specialty or thinly traded funds will have wider spreads, which mean you need to buy and hold shares to allow the share price to rise enough to cover your costs and produce a profit. A 5-cent spread does not mean much if you are investing for the long term and expect to measure your gain in dollars per share.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.