Tallying the total cost of owning an ETF
October 13, 2023
October 13, 2023
With the rise of commission-free ETF trading across most major platforms, clients may be wondering how to tally the total cost of owning an ETF. You can expect two major components to largely make up the cost of buying, holding, and selling an ETF: its expense ratio and bid-ask spread.
The expense ratio reflects the ETF's annualized operating expenses and is already factored into its net asset value (NAV). But the bid-ask spread—the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept—is at the center of every ETF trade. It is an explicit cost realized when buying or selling the ETF and is influenced by many market forces. Ultimately, the spread is set by market participants, which include the investing public as well as the institutions that make a market in that ETF.
At least three broad factors go into the bid-ask spread, which in turn reflects the overall characteristic of a market in a particular ETF. Those factors are:
Hedging costs and other inventory management considerations may also affect spreads as market makers seek to limit their exposure through derivatives and other offsetting positions.
And what about premiums and discounts? They are indeed important to a discussion about ETF trading costs. But their impact trade by trade is difficult to assess given the lack of visibility and timeliness of intraday net asset values (NAVs), and NAVs are required to determine the premium or discount of an intraday ETF trade. So we focus here just on the expense ratio and bid-ask spread, the more readily visible and measurable metrics.
Market makers sit at the center of trading, providing liquidity for all the client activity by buying from one client and selling to another. In between the buy and the sell, they carry a risk that the market could move on them, and they might also risk selling at a value below their purchase price.
If an ETF turns over quickly, the market maker carries less market-movement risk and can set the spread tighter. For securities with less turnover, the market-movement risk grows, because recycling that risk takes more time, leading to wider spreads. Wider spreads are the only way for a market maker to recoup the costs of holding securities for longer.
So the more volume/turnover an ETF has in the secondary market, the more narrow the bid-ask spread on that ETF will be.
Understanding the level of turnover is a key factor in determining where market makers are willing to set bids and offers for a security to ensure that they can make a profit or, at worst, break even.
Besides the time it takes to turn over that risk, the speed at which prices are changing is a crucial factor in determining where to set those bids and offers. In fast-moving markets, market makers need to provide a larger range between the prices at which they're willing to buy and sell a security. That's because if they buy and the market turns against them, they could end up selling for a lower price and taking a loss.
One of the beneficial aspects of an ETF's tradability is that it can tap two layers of liquidity. One is at the "secondary" level, after the shares have been created. The other is at the "primary" level, where a market maker or authorized participant will create or redeem shares by tapping into the liquidity of the underlying market to either buy shares of an underlying asset and deliver it to the issuer to create new shares of the ETF, or else to sell shares of the underlying asset in the case of a redemption.
About 85% of all ETF volume stays in the secondary market, with only 15% in the primary market resulting in creations or redemptions.1 This allows the ETF spread to be narrower than its underlying "basket spread," or the round-trip cost of the underlying securities.
There are times, though, when the underlying market conditions may change and the cost to create or redeem may widen. In these situations, you can expect wider spreads to affect the ETF as well.
An S&P 500 ETF, in which all the underlying stocks are readily tradable, would be relatively easy to buy or sell in any market. So we would expect such an ETF to trade with a tight spread that reflects the underlying basket of securities.
But other ETFs, such as one that holds small-capitalization stocks, might see more frequent liquidity-constrained environments that make it harder to buy and sell the underlying securities at a fair price. This could more significantly affect the ETF's spread.
The total cost of owning an ETF is effectively the sum of the expense ratio and the bid-ask spread. Be mindful of each of these major costs to ensure you are making the best product-selection decisions for your clients. Also, how often and in what amounts will you be trading? A once-a-year trade may mean that the expense ratio should be of paramount consideration to spreads. But for an ETF that's held in multiple accounts and is rebalanced quarterly, the trading costs may be just as important.
Finally, be mindful of the time at which you trade. You may want to avoid trading during the first 15–30 minutes of a trading session, as well as around market-moving news that breaks during a session, such as when the Federal Reserve announces changes to interest rates. Trading when markets are open makes it likelier that market makers will have more pricing precision, that bid-ask spreads will be tighter, and that trade executions will be more precise and predictable.
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1 Bloomberg, as of September 30, 2023.
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