We often talk about the impact of the total expense ratio (TER) or the total investment cost (TIC) on your investment. The index (a representation of the price performance of a group of companies) will always outperform the ETF (the product that tracks the index). That’s because the index is just a tool for tracking performance, while an ETF is a product that is made and managed by a company. The ETF issuer has to do all the administration around buying and balancing the underlying shares. These costs are deducted from the dividend income we earn in the ETF every year. Costs are a percentage of the money we have invested. For that reason, we favour ETFs whose percentage fees are low.
While the TIC of ETFs are far lower than most actively-managed funds, they don’t represent the full fees picture. When you buy and sell an ETF, there’s a once-off cost that’s not included in the TIC – the spread.
What is spread?
“Spread” refers to the difference in the price someone is willing to pay for a share and the price at which someone is willing to sell. With ordinary shares, the difference is determined by the number of shares for sale and the number of buyers interested in buying the share. When there are many buyers and sellers in the market, there’s not a big difference in the buy price and sell price. If you want to sound smart, you can say the spread is “tight”. This is because everyone is trying to get good value for money. A buyer won’t buy a share that is too expensive, so sellers who want to get rid of shares have to compete with each other by coming down in the price they want per share.
Spread is considered an investment expense, because the value of your investment immediately reflects the spread. Let’s say you bought a share at R100, but you change your mind and decide to sell it immediately. If the spread is 1%, buyers are only willing to pay R99 for your R100 share. To make back the spread, you would have to wait for the market price to go up by 1% before you are back to the R100 you started with. The time it takes for you to be in the same position in rand value is what makes this significant. The bigger the spread, the longer it takes for you to really begin earning money on your investment.
In the case of an ETF, however, buyers and sellers don’t determine the spread. A third party, called a market maker, can create new ETF shares as and when they’re needed. Prices are determined by the market maker based on the fair value, or net asset value (NAV) of the underlying shares.
However, if the market maker can buy shares for cheaper and sell them for more, they can keep the difference as profit. Let’s say the market maker buys 5,000 shares at R49.90, but then sells the same 5,000 units to you at R50.10. The R1,000 (20c per ETF unit) difference is how the market maker puts bread on the table. As an ETF buyer, however, you bought 5,000 shares at R51.10, but you can only sell them for R49.90. That means your investment is worth R1,000 less right off the bat.
However, spreads aren’t always the same. At times, the market maker is more efficient than others.
CoreShares recently explained differing spreads as follows:
“Spreads are a function of a few factors and can change:
- Underlying constituent liquidity (Less liquid = wider spreads)
- All Costs
- Volatility (Higher volatility = wider spreads)
- Time of day (opening and closing auctions and key economic events)”
What to do about it
Aside from keeping an eye out for big spreads, there’s not much us individual investors can do about spreads. Thankfully, it’s only a fee we have to be aware of when we buy and sell. If the market maker is really efficient, the spreads will be so tight that it won’t impact your performance in the long-term.
Investors using brokerage platforms that display bid and offer prices can get a better sense of the spread on an ETF. You could try to buy at the sell price by putting an offer in the market (also called a limit offer) and hoping that someone else picks it up. However, the cost of the ETF could move away from that price and you could end up paying more.