The bid-ask spread is the variation between the price at which a buyer is willing to purchase a security and the price at which the seller is willing to offer the same security. The market structure and liquidity of the underlying basket of securities are the major factors affecting ETF bid-ask spreads. Securities such as the US equity and fixed-income ETFs are said to have tighter spreads.
Factors Affecting ETF Bid-Ask Spreads
- The liquidity of the security: Some stocks are traded more regularly than others. Securities that have a bigger trading volume have a tighter bid-ask spread than the ones that are traded less frequently. Having a tighter spread implies that the market is highly liquid. Therefore, we can simply state that the bid-ask width of a fund is a measure of the underlying market liquidity.
- Amount of order flow in the ETF: An increase in the volume of shares being traded results in lower spreads. The number of shares implies the level of liquidity, i.e., the bigger the size, the higher the liquidity, and the narrower the bid-ask spread.
- Competition among market makers: Some ETFs trade on low-priced securities. Stocks with low prices attract more buyers; thus, the market spread will tend to be narrower. On the other hand, if securities are highly-priced, the market spread becomes narrower. Therefore, it is clear that a smaller spread is achieved when the demand for security is high, and supply is low.
- Actual costs and risks for the liquidity provider: The bid-ask spread for ETFs is influenced by the costs and risks faced by liquidity providers. A low ETF price does not necessarily imply less liquidity; rather, the spread is typically narrower when the ETF is more liquid and market risks are lower. Higher liquidity and lower volatility generally result in a smaller bid-ask spread, while higher costs, risks, and uncertainties faced by market makers widen the spread.
- Volatility: Bid-ask spread widens with an increase in volatility. During times of recession, bid-ask spread tends to expand because many sellers would want to profit from it. In contrast, if the market is blossoming, the volatility decreases hence causing a tighter bid-ask spread. Therefore, the level of volatility and spread are directly related.
ETF bid-ask spreads are generally less than or equal to the combination of the following:
- ± Creation or redemption fees and other direct trading costs.
- + Bid-ask spreads of the underlying assets held in the ETF.
- + Compensation for the risk of hedging or carrying positions for the remainder of the trading day.
- + Market makers’ desired profit spread.
- – Discount for the likelihood of receiving an offsetting ETF order in a short time interval.
Large actively traded ETFs have a small bid-offer spread and the liquidity for large transaction sizes. Further, for highly liquid ETFs, ETF trades do not involve the creation or redemption process as they are matched quickly. Therefore, the first three factors do not contribute heavily to their spread.
Question
Which of the following is least likely to influence the bid-ask spread for very liquid, high-volume ETFs?
- The desired profit spread of the authorized participant.
- Discount related to the likelihood of receiving an offsetting ETF order in a short time frame.
- Bid-ask spread of the underlying securities held by the ETF.
Solution
The correct answer is C.
ETF bid-ask spreads are generally less than or equal to the combination of the following:
- ±Creation or redemption fees and other direct trading costs.
- + Bid-ask spreads of the underlying assets held in the ETF.
- + Compensation for the risk of hedging or carrying positions for the remainder of the trading day.
- + Market makers’ desired profit spread.
- – Discount for the likelihood of receiving an offsetting ETF order in a short time interval.
For very liquid and high-volume ETFs, buyers and sellers are active throughout the trading day. Therefore, because most of these ETF trades are matched very quickly and do not involve the creation or redemption process, the first three factors listed do not contribute heavily to their bid-ask spreads.
So, the bid-ask spread of the underlying securities held by the ETF is unlikely to have much influence on these ETFs’ bid–ask spreads.
Reading 39: Exchange Traded-Funds, Mechanics and Applications
LOS 39 (d) Describe factors affecting ETF bid-ask spreads.
