Tricks of the Trade

Low expense ratios clearly make ETFs attractive for a low-cost, long-term core portfolio but what about trading costs?

Ben Johnson 6 April, 2010 | 3:44PM
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There is little question that low expense ratios make ETFs attractive building blocks for a low-cost long-term core portfolio, but what about the price of admission? In order to get a better sense of the total cost of ETF ownership investors need to understand the costs involved in trading ETFs.

Between a Solid and a Gas, We Have…
..Liquid. But for our purposes we will not be discussing water--nor ice, nor steam for that matter. Rather, we are concerned with investments. Securities are often described as being liquid (or illiquid), but what exactly does this mean? Liquid securities are very cheap to trade and it is always possible to find a buyer or seller for them. These assets, such as shares of mega capitalisation equities like Royal Dutch Shell, change hands rapidly and individual transactions have a minimal effect on the going market price. Illiquid assets are starkly different from their liquid cousins. They typically have fewer buyers and sellers. Furthermore, buyers and sellers might diverge substantially on their opinion of a fair price, making the notion of a "market price" murky at best.

But the differences do not have to be so extreme; liquidity is a continuum. Even frequently-traded individual corporate bonds tend to have less liquidity than the shares of that same company, because there are frequently one or two classes of stock versus dozens of different bond issues. Shares in a small-cap firm, even though they are quite easy to buy or sell over time, would look relatively illiquid compared to giant-cap stocks or gilts if you tried to buy a large order off the exchange in one go.

Sources of Liquidity in ETFs
ETFs have two key sources of liquidity: the primary and secondary markets. The primary market is where ETFs are born. Within the primary market, authorised participants (APs) can create new ETF shares by forking out cash or securities to the ETF provider in exchange for shares in a given fund. APs can hold these shares and ultimately redeem them for cash or securities from the provider, or they can turn around and sell them on the secondary market. For individual investors looking to buy an ETF off the exchange, secondary market liquidity is all that matters. There are readily-available factors to assess when sizing up the liquidity of an ETF on secondary markets: assets, exchange-traded volume, number of market makers, and bid-offer spreads.

First, take a look at the ETF's assets under management (AUM). This figure is listed under the name "Share Class Size" on an ETF's quote page on our site. Larger ETFs--as measured by AUM--tend to be more liquid than their smaller peers.

Second, find the volume for the ETF on the exchange you plan to trade on. This information can typically be found on both the fund provider's and the relevant exchange's Web sites. The volume represents the number of shares of the fund that traded on the exchange during a specific time period and serves as a key measure of secondary market liquidity. To compare volume more directly across funds, you may need to account for differing share prices (i.e., an ETF with a price of 800p that trades 500,000 shares a day is much more liquid than an ETF with a price of 100p that trades 1,000,000 shares a day, because more total money flows in and out of the first ETF).

Third, look at the number of market makers that there are for the ETF (some providers will include this information on a fund's fact sheet, usually available on their Web sites). The larger the number of market makers, the more likely that competitive bidding amongst them will serve to drive down bid-offer spreads.

Finally, take a look at the bid and offer prices for the ETF in question using the websites of the ETF sponsor, the exchange, or through your brokerage's quotes. With these prices in hand and the current market price, you can calculate the bid-offer spread (using the maths we'll outline in a moment). The bid-offer spread is essentially a product of the first three factors. Again, narrower spreads are reflective of more active buyers and sellers, and hence a more liquid fund.

Some secondary market participants will also trade off-exchange or over the counter (OTC). OTC transactions are dominated by institutional buyers and sellers dealing in large amounts. These transactions are a very important--and underreported--source of secondary market liquidity, probably accounting for 50% or more of all trading volume. Because ETFs fall outside of Markets in Financial Instruments Directive (MiFID) reporting requirements, OTC transactions are not required to be reported. Therefore, official on-exchange volume statistics tend to underestimate secondary market liquidity. For those looking to execute a large trade or place an order for a thinly-traded fund, a call to one of the ETF's market makers may be in order. Generally, if an investor is looking to place an order that represents over 30% of a fund's average daily volume, it is best to deal directly with a market maker to ensure more cost-efficient execution.

The Bid-Offer Spread
Out of the proxies for liquidity given above, the bid-offer spread is probably the most precise measure of costs to trading an ETF. This spread is the difference between the highest price someone is willing to pay for a given security (the bid) and the lowest price that someone is willing to sell that same security for (the offer). The difference between these two prices is pocketed by a market maker--a third party to the transaction that is in the business of connecting buyers and sellers.

The bid-offer spread is a cost associated with trading securities. All else equal, a lower bid-offer spread means lower transaction costs for both buyers and sellers. The bid offer spread is commonly quoted as a percentage of the relevant security's market price. For example, if the bid price for shares of an ETF is 99p, the market price is 100p, and the offer price is 101p, then the bid-offer spread is 2p or 2%. It is important to note that we use these numbers strictly for illustrative purposes. In practice, the bid-offer spreads for most ETFs are a fraction of this amount.

Tying it all together, more liquid securities tend to have lower (often called tighter or narrower) bid-offer spreads. It then follows that it is less expensive to transact in more liquid assets--all else equal. Also, it is worth noting that differences in liquidity partially explain why the expense ratios for ETFs tracking more liquid indices (comprised of more liquid shares), like the DJ EuroSTOXX 50, are far lower than those for ETFs tracking less liquid benchmarks, like the MSCI Emerging Markets Index. Let's now take a closer look at the sources of ETF liquidity.

How to Manage Liquidity
Before we discuss some of the ways that you can tackle liquidity issues associated with trading ETFs, it is worth placing liquidity concerns within their appropriate context. First, marginal differences in liquidity become more important the shorter one's time horizon might be. Someone looking to trade into and out of a position before lunch will be far more concerned with bid-offer spreads than an investor with a multi-year time horizon. This is simply because a hypothetical 0.01% difference in bid-offer spreads is going to have more impact on a trader with a two hour time horizon and a theoretical expected return of 0.10% than it would for a long-term investor. Also, it is important to remember that liquidity is equally important whether you are considering either buying or selling a security. An issue that was highly liquid on the way in, as investors piled onto an idea that was in vogue, might become highly illiquid should spooked holders stampede towards the exits all at once.

Having put liquidity into its appropriate context, let's move on to the ways in which you can navigate potential liquidity concerns. The first tactic is obvious: invest in the most liquid options at your disposal. You can size up which of your options is the most liquid by scanning some of the measures we touched on above. Next, if you would like to trade shares of a less liquid ETF, you can use limit orders. Using limit orders will allow you to take control of your execution price when dealing in less liquid funds with wider bid-offer spreads. A buy limit order will ensure that you purchase shares at your specified price or lower, while a sell limit order will let you unload your shares at your desired price or better.

Finally, before investing in an ETF that tracks a foreign index--first check your watch. The pricing of ETFs tracking foreign benchmarks is going to be most accurate during their domestic markets' regular trading hours, when all of their component securities are being feverishly bought and sold. So prior to pulling the trigger on that S&P 500 ETF first thing in the morning, think twice. It may pay to wait until the US market has opened to ensure more accurate pricing.

Brokerage Fees
Lastly, when it comes to trading costs, brokerage commissions can be a big expense. Commissions can vary depending on a number of considerations including but not limited to: your brokerage of choice; the frequency with which you trade; whether you are executing an order through an adviser, over the phone, or on the Web; and the market where the security in question is traded (some brokers charge higher commissions to execute trades on foreign markets). One way to keep commissions under wraps is to do the research required to find a brokerage that best suits your specific circumstances. But the best way of all to keep commissions from eating into your returns is to simply adhere to a buy and hold discipline. Now we are not saying that you should never trade, but minimising the number of trades that you execute is a surefire way to keep costs under control.

By clicking here you will find we have included a sampling of current commission rates amongst some of the largest online brokerage platforms. The commission rates assume an online trade of £1,000 in UK-listed shares executed by an infrequent trader in a non-ISA account.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.

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