The bid-ask spread: what you pay the moment you buy an ETF

A fund's ongoing charge is taken a little every day from inside the fund. The spread is taken once, the moment your order fills, and appears on no statement. On a broad index fund bought at midday it is small. On a narrow fund, or on any fund bought at the wrong moment, it can be larger than a year of that fund's ongoing charge.

Most of it is within your control. This guide explains who sets the spread, what it costs in euros, when in the day it widens, and the two order types your broker offers.

Open an ETF in your broker's order screen and you see two prices. The bid is the highest price someone in the order book is currently willing to pay. The ask, sometimes called the offer, is the lowest price someone is willing to sell at. The spread is the gap between them, usually given as a percentage of the midpoint.

A buyer who wants to trade now pays the ask. A seller who wants to trade now receives the bid. Neither of those is the fund's value, which sits somewhere between the two, roughly at the midpoint.

Take a fund quoted at €99,95 bid and €100,05 ask. The spread is €0,10, or 0,10% of the €100 midpoint. Buy €10.000 of it and you pay about €5 more than the midpoint value of what you received. Sell it all later at an identical spread and you give up about another €5. The round trip costs the whole spread, and each half is paid at the moment of the trade.

Where units bought on an exchange cannot generally be redeemed from the fund, which is the ordinary case, ESMA requires a warning in the prospectus and the marketing material. It says the units cannot usually be sold directly back to the fund, that trading them through a broker may cost fees, and that investors “may pay more than the current net asset value when buying units / shares and may receive less than the current net asset value when selling them.” The spread is the main reason for that last sentence.

Most of the quotes in an ETF's order book come from market makers. They are firms that post a buying and a selling price at the same time and earn the gap. What lets them quote tightly is a mechanism you never see. Certain large firms can hand the fund a basket of the shares it holds and receive new ETF units, or do the reverse, so a market maker who sells you units can create more against the underlying shares. The UCITS guide explains why this ties the spread to what the fund holds, and not to how often the ETF itself trades.

Deutsche Börse's white paper gives two reference points. For the ETFs listed on Xetra since the start of 2013, about a quarter of the funds trading there, the average spread in 2022 was 23 basis points, or 0,23%. That year was a volatile one, and the exchange's chart shows the average falling over the decade despite it.

Its three examples of large index funds sit far lower. Measured on the price to buy or sell €10.000, a EURO STOXX fund averaged 5,9 basis points over twenty days, an MSCI Europe fund 5,5 and a EURO STOXX 50 fund 3,5. Those are large, long-established index funds. The paper notes that newer funds may trade less often.

The table puts four spreads into euros. Each purchase pays half the spread and each sale the other half.

For comparison, an ongoing charge of 0,20% on €10.000 is €20 a year. A 0,23% spread paid once in and once out comes to about one year of that fee across the whole life of the holding, which is small. A 1% spread costs five years of it. The ongoing charge and the tracking difference decide what the fund costs while you hold it. The spread decides what getting in and out costs, and it is the one you can shrink by choosing when and how you trade.

A market maker quotes tightly when it knows what the fund is worth and can hedge what it sells you. Take either of those away and the spread widens to pay for the uncertainty. Vanguard's guidance on trading ETFs describes the two moments that matter. At the open, “some of an ETF's underlying securities may not have begun trading”, so the market maker cannot price the fund with certainty. At the close, fewer firms may make markets as they try to limit their risk.

Xetra's day runs as follows. The table gives the phases in Central European Time.

A market order says buy now at whatever the book offers. In continuous trading it fills against the best ask in the book, and if that ask is for fewer units than you want, the rest fills at the next price up. Sent into an auction, it takes the auction price, whatever that turns out to be.

A limit order says buy, but pay no more than this price. If the ask is at or below your limit, it fills straight away exactly as a market order would. If the ask is above it, the order waits in the book until the price comes to it or you cancel it.

Vanguard puts the trade-off plainly. A limit order lets you set the maximum or minimum price, with “some risk that your order won't be fully executed”. Market orders “can be effective” for ETFs with significant liquidity and narrow spreads.

For a buy-and-hold investor the risk of a limit order not filling is a minor nuisance. You wait and try again. The risk of a market order is paying a spread you would not have chosen, at a moment you did not see. Set the limit at or a few cents above the current ask, and check it against the iNAV if your broker or the fund's website shows one. The order fills at the ask if that is lower than your limit, so a limit costs nothing when the market is normal.

A broker's savings plan buys on a day and at a time the broker chooses, on a venue it chooses, and you set neither. The case for a plan is still strong, and on €200 a month even a 0,23% spread is €0,23 a purchase. Ask the broker, or read its order execution policy, for when and where the plan's orders are placed. If they are bunched into the first minutes of the day, you know which spread you are paying.

Five checks, all of them on your broker's order screen or the fund's own website.