What are the factors that determinate the bid-ask spread?

When trading ETFs, we encounter two prices at any given time: The price an investor is willing to pay when purchasing the ETF (ask price) and the price an investor is willing to accept when selling the ETF (bid price). The different between these two prices is called the bid-ask spread, an important measure that provides insight into an ETF’s trading costs and liquidity.

An ETF’s bid and ask prices are closely tied to value of its underlying securities, but the bid-ask spreads can differ depending on many factors.

Primary influences include trading volume, competition among market makers, and market conditions for the ETF’s underlying assets.

Key drivers of the bid-ask spread

Volume and competition in the secondary market

The bid-ask spread often narrow with increased trading volume and competition between market makers. The presence of natural buyers and sellers – in addition to liquidity providers and market makers – supports the on-exchange liquidity of the ETFs and increases the depth of the order book.

On the other hand, if an ETF has limited trading interest, it may lack market depth, potentially resulting in a more volatile price and a widening bid-ask spread. 

Higher volumes and more active marker participants help tighten the spread, while low activity or limited competition tends to widen it.

Underlying assets 

Since an ETF is a basket of securities, its bid-ask spread is partly determined by the spread on those underlying assets. Global ETFs, for example, may experience wider spreads since it’s likely some of their underlying securities will be in markets that are closed for trading at any given time. For instance, for an ETF tracking a US equity index, placing an order in the morning UK time (before the US market open) might result in wider bid-ask spread.

ETFs that focus on specific sectors – like commodities, volatility futures, or small-cap stock – may also have wider bid-ask spreads. This is due to the heightened risks of market makers holding these assets, even for a short period of time. 

Public holidays in the underlying market can also affect the ETF spreads. A UK investor, for example, can buy or sell an ETF tracking a US equity index in the secondary market on 4th July. However, as the underlying market is closed (due to Independence Day) it would not be possible to create or redeem units in the primary market, leading to wider spreads.

Primary market cost

Another component affecting bid-ask spreads is the cost associated with the primary market, where ETFs shares are created or redeemed. Even if the underlying assets are liquid, an ETF may have a wider spread if it trades infrequently, as authorised participants (APs) need to weigh the cost of creating or redeeming ETF shares.

Primary market costs can include custody fees, FX costs, potential market impact, hedging costs and taxes1. However, if the ETF has a strong secondary market activity able to absorb the requested trading volume, an AP generally relies less on the primary market to hedge their ETF trades with clients. 

In the example below, the monthly average ratio of primary to secondary market activity for the ETF in question is 23%. This means that for example for every $10m traded in the ETF, approximately only $2.3m needs to be transacted in the primary market. This reduces the cost of transacting in the underlying market, creating savings that can be passed on to ETF investors through tighter bid-ask spreads compared to the underlying market.  

Market impact during periods of volatility

Market volatility can also impact the bid-ask spreads, as these tend to widen during times of heightened market risk or increased market volatility. Amid uncertainty, market makers might incur additional costs and take on increased risk. Spreads of the underlying securities may be wider, which would mean wider spreads on ETFs.

Understanding these variables that influence the bid-ask spread can help investors better gauge an ETF’s liquidity and potential costs when trading.

 

1 Financial Transaction Tax or Stamp duty are not applicable to ETFs; however, it may apply on the purchase of the underlying securities in the primary market.

2 Basket of securities that the ETF holds. The Fair Value represents the value of each share based on the current prices of its underlying assets.