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The importance of spreads in assessing ETFs

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Jason Xavier (pictured), head of EMEA ETF Capital Markets at Franklin Templeton has written a note on the significance of bid/ask spreads in assessing the attractiveness of ETFs.

Xavier says: “In many instances, ETFs display some similar characteristics to stocks and mutual funds. The bid/ask spread is one of them.

“We would argue that the transparency of the bid/ask spread as it operates in the ETF ecosystem contributes to the democratisation of this style of investing. Put simply, the bid is the highest amount at which a person is willing to buy and the offer (or ‘ask’) is the lowest amount at which they are willing to sell. The difference between those prices is the ‘spread’. This spread usually factors in the cost of executing the underlying basket of assets, plus any hedging costs for the market maker.

“At first glance, it may seem obvious that a tighter spread is better than a wider spread. A small difference between what buyers are willing to pay and what sellers are offering implies the market is highly liquid, with intense price competition and high demand for the asset in question.”

Xavier believes that the situation is a bit more nuanced and uses two examples of ETFs with identical underlying securities. “ETF A has a bid price (what the buyer is willing to pay) of EUR21.02 and an ask price (what the seller is offering) of EUR21.05.

“ETF B has a bid price (what the buyer is willing to pay) of EUR98.73 and an ask price (what the seller is offering) of EUR98.79.

“So, the spread of ETF A is three cents, while the spread of ETF B is six cents. However, considering the spread in euro/cents terms only gives us one dimension of the story. We get a very different view if we look at the spread in percentage terms, considering the price of the stock.

“In that instance, the spreads look like this: ETF A: 100 x (EUR21.05 – EUR21.02)/EUR21.05 = 0.14 per cent or approximately 14 basis points. ETF B: 100 x (EUR98.79 – EUR98.73)/EUR98.79 = 0.06 per cent or approximately six basis points.”

Xavier explains that put more simply, a three-cent spread is a larger proportion of the lower stock price than the six-cent spread is of the higher stock price.”

Xavier also recognises that the bid/ask spread does not reflect what the ETF is worth. “To us, this is an important aspect that merits more discussion. The price of an ETF—especially a newly launched ETF—is driven by the costs associated with assembling the underlying basket of securities.

“Let’s look at another example. This time we will assume two separate ETFs with identical underlying securities held at equal weights. Based on the price of the basket of securities, both ETFs are worth EUR27.50. The market for ETF A: EUR27.39 Bid x EUR27.53 Ask. The market for ETF B: EUR27.48 Bid x EUR27.55 Ask. 
 
“We can see the spread of ETF A (at 14 cents) is almost twice as wide as ETF B (at seven cents). “But despite the wider spread, investors might consider ETF A to be more desirable because its shares are offered closer to the price of the underlying basket.

“In other words, if the two ETFs are identical and have the same underlying basket of securities, the value of the securities is also the same, so it makes sense that an investor would want to buy the one offered at a lower price – i.e. to pay less for the same security.”

Xavier asks: “What does all this mean to potential investors? One of the main functions of our ETF Capital Markets team is to work with the market participants to discuss the costs of assembling the basket and what that means to the price of the ETF.

“The goal is for potential investors to have confidence that shares can be purchased at levels that are in line with the price of the underlying basket.”

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