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Of the different costs involved with trading or investing in exchange-traded funds, the bid/ask spread may be the most misunderstood or even ignored. The effect of the bid/ask spread on your investment results depend on several factors including the ETFs you choose to trade and the frequency of your trading. As a result, your returns from a specific ETF may not match the published performance results.
ETF Investing Costs
Several costs are involved with the purchase of ETF shares that must be overcome before a profit is realized. ETFs are exchange traded, so a brokerage commission is usually paid to buy shares and again when shares are sold to lock in a profit. The operating expenses or expense ratio of an ETF eats into the return compared to the results of the underlying assets tracked by the ETF. The bid/ask spread is the difference in share prices between the best offer to buy and the best offer to sell are being quoted for a particular ETF. The bid price will always be lower than the ask price.
Cost of Bid/Ask Spread
If you bought ETF shares at the ask price and immediately sold at the bid price, you loss would be the bid/ask spread times the number of shares traded. If the spread was 2 cents and you traded 1,000 shares, the bid/ask spread would have cost you $20. On the Charles Schwab website, examples of a hypothetical $10,000 trade produced bid/ask spread costs ranging from $3 to $132 for a round trip -- buying and selling -- trade.
Variation by ETF
The typical bid/ask spread for a specific ETF depends on several factors. A popular ETF with a large asset base, heavy trading volume and tracking a broad-based index will have a narrow spread. Move away from these factors -- such as low trading volume or a focused market sector -- and the spread will be wider. The best way to check on the bid/ask spread is to observe the price quotes of a fund over a period of time. Your online brokerage account quote page will give the bid and ask prices.
If you trade ETFs frequently, bid/ask spreads could be a significant drag on your results. The necessity to overcome $20 or $30 or more of spread costs on each trade could make it difficult to get the results you want. Long-term investors are much less affected by the spread, since the whole bid/ask bracket will move significantly as time goes buy. If you trade ETFs frequently, spend some extra time to search out the ETFs with the narrowest bid/ask spreads.
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