Learn about the ETF bid/ask spread

Vanguard investing experts Josh Hirt and Rich Powers explain the dynamic pricing of ETFs and what you should consider.

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Talli Sperry: That’s helpful, and we actually have a really good chart for you on this. So I’d love to bring that up right now if you’re okay with that. And on that note, we have Mitch asking, “Can you explain the bid-ask spread for ETFs?” So I think this is perfect timing, Mitch. We’ve got our visual for you, and then, Josh, I’m going to ask you to just walk us through a little bit, how to understand the visual.

Josh Hirt: Yes, sure. I think so. And Mitch, write back if we don’t clarify here as well, but I think part of my initial answer gets to some of that. What really is the bid-ask spread and what are you paying for? Again, it’s a function of you trading on exchange, and so, to match these orders, there is a service that’s paid for that. Essentially, looking at what out there in market is the best offer, the best that someone is willing to sell at, or the best bid, the best offer that someone is coming and saying, “I will buy this security at this price.” In between there, there is that spread that’s charged to really facilitate that.

Talli Sperry: So in our visual, the top half is that sell space you were talking about, right? And the buyer would probably be asked if we’re actually buying the ETF, and then the spread you were talking about, that middle space in the chart, that’s our bid-ask spread we keep referencing. Is that correct?

Josh Hirt: Correct.

Talli Sperry: All right. Good. So feel free to let us know if you’d like to see that visual again or if you’d like more clarity there.

Right now we’re going to jump to another live question, and this one is from Jan. And she’s asking, “Can ETFs be used in conjunction with IRAs and Roth IRAs?” So, Rich, you’re nodding at me. I’ll give that question to you.

Rich Powers: Yes. ETFs can fit the bill for really nearly every investment account you could think of. Because they’re just like mutual funds, they fit in those types of portfolios. What you would probably want to do first is think about what the investment strategy is of the portfolio that you’re choosing. So, for instance, and this is where Josh is maybe even more expert than me, but if you’re thinking about making an investment in a fixed income ETF, you probably want to think about putting that into an IRA investment because that’s tax-sheltered and there is a greater tax incidence with fixed income investments because they’re constantly paying dividends. With an equity index fund, it could fit in an IRA or could also fit pretty well in a taxable account. So, yes, ETFs have utility in nearly every account you can really think of: IRAs, long-term investment accounts for kids’ educations, or just a general taxable account.

Josh Hirt: I was just going to say, it seems like we’re getting a lot of questions about, is it appropriate for this? Is it appropriate in this instance? And I think, again, really come back and think about the two structures: we’re much more familiar with mutual funds and ETFs facilitating some very similar things. And we think about a question about retirement, one of the most important things you can get right in that scenario is your asset allocation, and ETFs can certainly be used to facilitate that in the same way.

Talli Sperry: Yes. I like where you were going both of you in this. Focus on your goals and why you’re doing what you’re doing, because at some point, it’s a little bit less about the exact vehicle that is being your first choice but really knowing why you’re doing what you’re doing being your first choice, and then the vehicle support that choice.

Josh Hirt: I think we would say that the ETF or the mutual fund or any other vehicle is a choice about implementation, not about strategy. So an ETF is not a strategy, but it is a tool for implementing a strategy.

Talli Sperry: I love that verbiage. That’s really good.

So let’s jump to one more question. This is from Richard from Chicago, Illinois, and he’s asking, “Please walk me through the mechanics of the trade and break down the different ways an order is specified.” So, Rich, you got into this a little bit with the market order and the limit order, but what more can you tell us about some of the specifics and the way those are executed?

Rich Powers: Sure. Again we’re assuming investors have done their homework and decided this is the right type of investment strategy. At that point, they’re going to go to the order path within a given brokerage firm’s platform, and they’re going to say, “Well, I value speed and execution.” And in that case, they’ll choose a market order, and that market order will go to the market and very likely be filled relatively quickly within a few minutes’ time. In the case of a limit order, that investor’s saying, “I want to be really careful about the price I actually receive for the order than I’m placing.” And so, it might take a little while for that ETF’s price to get across into that area in which the investor said, “That’s where I want to get involved.”

And so, the risk that investors run is that their order may not be filled in a given day and may kind of stretch out over a couple days, but they prioritized the price they pay over speed. And that’s perfectly acceptable. And I’d say we would generally caution investors to think about using limit orders. Actually, encourage investors to think about using limit orders over market orders given the volatility you might see in the market and in a security’s price kind of moving away from you rather rapidly.

The other thing you have to do with an ETF that you don’t necessarily have to do with a mutual fund is specify the number of shares you want to trade. So with a mutual fund, if you wanted to buy shares of a mutual fund, again coming back to our example, send your thousand dollar check in, whatever the price of that mutual fund is on the day your check arrives, that’s how many shares you get. With an ETF, you have to look at your brokerage account and say, “What’s my balance? What do I have available to spend?” And then look at the price of the ETF and identify what number of shares are you willing to purchase given what you have available. So that’s another step, not complicated, and most brokerage firms have a calculator for you on their site to allow you to quickly go through that math. But that’s a difference relative to what people are used to with mutual funds.

Talli Sperry: That’s great. And I want to go back to something you said about the price moving away from us quickly and the importance of that limit order, because for many of us, we’re cost-conscious and we know what we want to spend. So just keeping that top of mind, so things don’t move quickly beyond where you wanted them to, is really an important point I want to draw out for us.

Rich Powers: Absolutely.

Talli Sperry: Great. So let’s go to one more live question. This is from Steve—thank you—and he’s asking, “Since the spread between bid and ask is the cost of closing the deal, does the spread always stay the same or is the spread dynamic? And if it’s dynamic, what drives the change?” Josh?

Josh Hirt: It’s a very good question. Absolutely, it is dynamic. So it’s as much in the capital markets; it is extremely dependent on the environment in which we are living currently at that point in time. So it would also be affected by just overall volatility in the market. If they have something that is going on in the market—events such as Brexit, elections, geopolitical events—these are things that can certainly affect how bid-ask spreads could change, widen, narrow, etc.

Maybe a helpful way to think about the bid-ask spread as well is [that] this is the price that is being charged, essentially, for the risk that is being borne in facilitating this trade. So as environments tend to get more risky or more uncertain, that can be a scenario that causes the bid-ask spread to widen out. Even within a specific asset class, while that could be the case, you’ll have changes within asset classes in general as well. So you may see much tighter bid-ask spreads for a very liquid, very efficient asset class such as U.S. equities. That would be a different level of bid-ask spread for something such as corporate fixed income. So, absolutely very dynamic and it can change.

Certainly, there are levels that are in ranges that tend to be where things come back to, but they are dynamic and can change.

Rich Powers: It’s really important, too, to talk about that the spread of an ETF is driven by the spread of the underlying basket of securities that it represents, right? So, as Josh was alluding to, large-cap U.S. stocks probably have a tighter spread than, say, small-cap U.S. stocks because the spread of blue-chip types of companies ends up being tighter because those stocks are traded very frequently and by a wide array of market makers. And so, the ETF is always going to reflect the underlying security exposure from a spread standpoint.

And, in fact, the ETF might actually be able to give an investor tighter spreads than they would experience if they went out and bought the underlying individual securities, and that’s because, as we were talking about before, you’re not interacting with the ETF fund sponsor, right? You’re interacting with other market participants. So that level of trading that’s happening will necessitate, potentially, a tighter spread versus going out and assembling those 50, 100, 500 stocks yourself.

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