ETF Investors Have Hidden Costs Through the Bid-Ask Spread

From the earlier discussion, you can infer that the price you pay for your ETF depends on the balance of supply and demand for that ETF at the time your order hits the trading floor. An ETF’s share price is usually slightly different from the market value of the fund’s underlying holdings. Moreover, the price a buyer pays is generally higher than the price a seller receives.

Selling a used car is a useful analogy. If you know how much you want for your car, you can sell it yourself. If a willing buyer sees your advertisement, he may take the car off your hands at a price you both feel is fair. However, you might not be able to locate a buyer. If that is the case, you might decide to sell your car to a dealer.

The dealer then pays a price low enough for him to expect to turn a profit when he resells your car. The dealer’s knowledge of the car’s value comes from observing the used-car market. Ideally (for the dealer), he would like to offer you as little as possible, but if the offer is too low for your liking, you will simply look for another dealer. On the other hand, if your demands are too high to leave room to profit, the dealer will let you walk.

If you accept the dealer’s offer on your car, he will try to resell it at a higher price. Suppose the dealer is extremely lucky—the second after you leave the lot, a buyer enters, looking for exactly the car you just sold. Naturally, the dealer will sell it at a profit. The same car on the same day was worth less to you, the seller, than it was to the buyer.

Trading ETFs on exchanges works much the same way. If you as an ETF buyer are offering the same price that a different seller is demanding, the stock exchange is supposed to match up the two of you so that each of your orders can be filled. (However, exchanges have not always functioned this way, giving rise to periodic scandals and investigations. As a result, you should pay attention to the quality of your trade execution.)

However, suppose you want to buy an ETF at a time when a willing seller is not around. In that case, a dealer or specialist in a stock exchange offers to fill your order. Just as with a car dealer, a stock dealer transacts with you only at a price that allows him to make a profit. With the advent of electronic trading, you (through your broker) can look for the best price available for the ETF you want on more than one exchange. This is analogous to shopping around for the best price at multiple car dealerships.

If the dealer sells you the shares you want, he immediately tries to repurchase them from someone else at a lower price. If you turn around and try to resell your shares to a dealer (or specialist, or market maker), you receive less than you paid, even if the market has not moved one iota in the interim.

The price you pay to buy shares at the lowest available price is called the asking price, or ask. The price you receive when you sell shares at the highest available price is the bid. As with cars, stock dealers stand ready at any time to sell you shares at the ask price or to buy shares from you at the bid price.

The difference between the price you have to pay to buy shares and what a seller would receive to sell shares is called the bid-ask spread. The bid-ask spread is no less a cost to you than a broker’s commission, despite being less visible. But to the unwary investor, the bid-ask spread is a hidden cost. Before you decide to buy an ETF, you should ask your broker for both the bid and ask so that you can get a feel for the cost per trade.
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What Is The Effect Of Short Selling And Risk Management Activity On ETF Trading Volume And Trading Costs?

The facts that QQQs are the most actively traded equity security in the
world (in terms of number of shares) and that SPDRs are the most actively
traded securities (in terms of trading value) are not the result of frenetic
trading by the average investor in these fund shares. That the total number
of SPDR and QQQ shares outstanding turns over every few weeks
simply reflects that these ETFs have become extremely popular risk management
instruments, and have taken significant risk management market
share from futures contracts. The effect of these hedging applications on
trading spreads and share volume makes the nature of the markets in a
few actively traded ETFs with large short interests very different from the
markets in less active ETFs and more traditional securities.

At first thought, widespread use of ETFs in risk management applications
should not have a material effect on the quality of the markets
in the ETF shares. Other things being equal, the bid/asked spread that
an investor or trader faces in an ETF should be largely a function of
spreads in the markets for the underlying basket of securities that make
up the ETF portfolio. However, if the ETF’s portfolio becomes a standard
portfolio or basket trade and if ETF market makers experience a

high level of trading activity in the ETF shares, they may trade the ETF
at a tighter spread than an investor trading in a similar basket or less
active ETF would experience. A benchmark index portfolio basket,
whether for the S&P 500, the QQQs or the Russell 2000, is a standard
basket and will trade more cheaply as a basket than an investor or
trader can trade the individual securities separately. If an ETF is
extraordinarily active like the SPDRs and QQQs, a consistent high level
of trading activity in the ETF shares may further reduce trading costs.

Tight spreads on these baskets and on some of the related ETFs are
not just the result of a large number of orders interacting. In today’s markets,
the presence of a number of market centers—on exchanges, on NASDAQ,
and on the trading books of a variety of electronic communication
networks (ECNs)—permits some market participants who can access multiple
market centers to trade the most active ETF shares at very low cost.

The interaction of multiple ETF market places with futures contracts
on the ETFs themselves and, more importantly, with futures contracts on
the indices underlying the ETFs, leads to active trading in what we call an
index “arbitrage complex” that facilitates active trading on tight spreads
for online traders and traders at hedge funds and broker-dealers. As the
pattern of growth and decline in capitalization reflected in the shares outstanding
for each of the 10 largest ETFs listed in Exhibit 4.2 illustrates, the
number of shares an ETF has outstanding is not stable. Short selling and
other risk-management-related ETF activity varies greatly in importance
depending, in large measure, on how widely the underlying index for the
ETF is used in risk management applications. Ultra-tight trading spreads
from the interaction of competing markets and competing instruments
have had a major effect only on the S&P 500 SPDRs and the QQQs. The
growing short interests for the DIAMONDS, based on the Dow Jones
Industrial Average, and the iShares Russell 2000 fund suggest that these
funds might ultimately experience some similar trading effects.

Two funds based on the same underlying index—the S&P 500 SPDR,
the largest ETF in terms of assets, and the iShares 500 ETF, the third largest
ETF in terms of assets—vary greatly in trading activity, and in the absolute
and relative size of the funds’ short interests. This particular case is
interesting because the iShares 500 has a very slightly lower expense ratio
than the 500 SPDR. Also, the two funds have had very similar performance
for most of the period they have competed, with the SPDRs showing the
better performance earlier and the iShares 500 fund having done a little

better more recently. Trading activity and the short interest are concentrated
in the S&P 500 SPDR, probably because it was the first ETF on the
market and its trading and risk management applications are better established.
The short interest in the 500 SPDRs is worth nearly twice as much
as the value of all shares outstanding in the iShares 500 fund.

As Exhibit 4.2 illustrates, short interest, a good indicator of risk
management applications for an ETF, varies considerably over funds and
indices and over time. Substantial differences in short interests also will
be found among smaller ETFs. In smaller ETFs, measurements like the
short interest or the percentage of institutional ownership may be determined
by a few large shareholders or large short sellers. For example, it
is theoretically possible for securities lending and relending to lead to a
short interest in excess of the share capitalization of a fund. Furthermore,
in at least one case, (the iShares MSCI Taiwan Fund) institutional
ownership reported under rule 13-F once accounted for more than 100%
of the shares outstanding as a result of securities lending among a few
large institutional investors combined with dealer trading facilitation.
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