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.
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.