Bid-Ask Spreads in ETFs

Quick definition: The bid-ask spread is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask); it is a direct trading cost paid when buying or selling ETFs and varies based on the ETF's liquidity and trading activity.

When you buy an ETF, you pay the ask price—the lowest price at which someone is willing to sell to you. When you sell an ETF, you receive the bid price—the highest price at which someone is willing to buy from you. The difference between these two prices, the bid-ask spread, is a cost you pay immediately upon trading. For passive investors making periodic purchases or rebalancing trades, bid-ask spreads accumulate and are worth understanding.

Key Takeaways

• Bid-ask spreads are the cost of trading ETFs and are tightest for the most actively traded and liquid ETFs
• Wide spreads are typically only found in obscure or niche ETFs with minimal trading volume
• For the largest index ETFs (SPY, IVV, VOO, VTI), spreads are often a single penny ($0.01) on shares worth $100+, representing cost below 0.01%
• Placing limit orders instead of market orders can allow passive investors to trade closer to the midpoint and reduce spread costs
• Electronic communication networks (ECNs) and alternatives like dark pools may offer better execution in some circumstances

What Is a Bid-Ask Spread?

The bid-ask spread is the fundamental cost of trading any security on an exchange. Understanding what it represents is crucial.

Imagine an ETF tracking the S&P 500 currently trading with a bid of $100.00 and an ask of $100.05. The spread is $0.05.

If you place a market order to buy, you will pay $100.05 (the ask), the lowest price at which someone is willing to sell to you right now. You are essentially saying, "I will pay the lowest asking price available immediately."

If you place a market order to sell, you will receive $100.00 (the bid), the highest price at which someone is willing to buy from you right now. You are essentially saying, "I will accept the highest bidding price available immediately."

If you buy at $100.05 and immediately sell at $100.00, you lose the $0.05 spread, about 0.05% on a $100 share. On a $10,000 purchase and sale, this spread costs $5.

The spread compensates the market makers (typically authorized participants and broker-dealers) who facilitate trades by providing liquidity. The market maker buys from sellers at the bid and sells to buyers at the ask, capturing the spread as compensation for the risk of holding inventory and the cost of providing liquidity.

Spreads in Large, Liquid ETFs

For the largest and most actively traded ETFs, bid-ask spreads are extremely tight.

The SPY (SPDR S&P 500 ETF), the largest equity ETF with hundreds of billions in assets, typically trades with a spread of one penny ($0.01) on shares valued at approximately $600. This represents a cost of about 0.0017%.

The VOO (Vanguard S&P 500 ETF), another massive and highly liquid ETF, similarly trades with penny spreads, representing costs below 0.02%.

The VTI (Vanguard Total Stock Market ETF), tracking the entire U.S. stock market, also trades with minimal spreads.

The IVV (iShares Core S&P 500 ETF), another major S&P 500 tracker, offers similar tight spreads.

For these ETFs, the trading cost from the spread is negligible. On a $100,000 investment, you lose approximately $0.17 to the spread. This is immaterial.

The tight spreads in these ETFs reflect their enormous liquidity. Millions of shares trade daily. Market makers face low risk holding inventory briefly because it is easy to exit positions. The constant flow of buyer and seller orders keeps bid and ask prices close together.

Spreads in Mid-Size and Niche ETFs

For smaller or less-popular ETFs, spreads widen. An ETF tracking a specific sector or industry with billions in assets but less daily volume than SPY might have spreads of $0.02 to $0.05, representing costs of 0.02% to 0.05%.

An ETF tracking a small country or emerging market, with hundreds of millions in assets but lower daily trading, might have spreads of $0.05 to $0.20.

At this level, spreads become meaningful. On a $100,000 position, a 0.05% spread costs $50.

ETFs tracking very specific niches—a single industrial subsector, a narrow geographic region, or a particular commodity—may have spreads of $0.20 to $1.00 or wider. These ETFs might see only thousands of shares trade daily, and market makers face substantial risk holding inventory.

For a niche ETF with a $1.00 spread on a $50 share, the cost is 2%. On a $100,000 investment, the spread costs $2,000. This is substantial and argues for extreme caution with illiquid ETFs.

What Determines Spread Width?

Bid-ask spreads are determined by supply, demand, and liquidity.

Liquidity and volume: ETFs with high daily trading volume have tight spreads. The constant flow of buyer and seller orders means market makers can quickly offset positions. SPY, with millions of shares trading daily, has tight spreads. An ETF with hundreds of shares trading daily will have much wider spreads.

ETF size and popularity: Large, well-known ETFs attract more trading. Newer or less-known ETFs have wider spreads until they accumulate sufficient assets and familiarity.

Underlying market liquidity: An ETF tracking the S&P 500, composed of 500 large, highly liquid stocks, benefits from the underlying liquidity of those stocks. Market makers can assemble baskets of S&P 500 stocks quickly. An ETF tracking illiquid small-cap stocks has inherently wider spreads because the underlying securities are less liquid.

Time of day: Spreads typically widen during market open and close when volatility is highest and during very early morning or late afternoon trading. Spreads are usually tightest during the mid-day core trading period (10 AM to 3 PM Eastern).

Market stress: During market dislocations, spreads widen across all ETFs. In the COVID panic of March 2020, even SPY experienced wider spreads as normal market-making relationships broke down.

Creation-redemption mechanism: The availability of the creation-redemption mechanism, explained in article 5, helps keep spreads tight. If spreads widen too much, authorized participants can create or redeem shares to arbitrage the gap, pulling spreads back together.

Market Orders vs. Limit Orders

When trading ETFs, passive investors can reduce spread costs by using limit orders instead of market orders.

A market order to buy executes at the current ask price, accepting the full spread cost. If the spread is $0.05, you pay $0.05 per share.

A limit order to buy specifies a maximum price you are willing to pay. For instance, if the bid is $100.00 and the ask is $100.05, you could place a limit buy order at $100.02. If another investor places a market sell order, your limit order might fill at $100.02, saving you $0.03 per share compared to the market order.

The trade-off is that limit orders might not fill immediately or at all. If the ETF's price continues to rise, your limit order might never execute if the ask stays above your limit price.

For passive investors making periodic large purchases, this trade-off is usually worth it. Placing a limit order at the midpoint of the spread (bid plus ask divided by two) often executes within seconds or minutes and saves the full spread. If the order does not execute, you can place a market order.

For day traders or those trying to exit positions immediately, limit orders are less practical.

Measuring Spread Cost

To assess whether an ETF's spread matters, calculate it as a percentage:

Percentage spread = (Ask - Bid) / Midpoint × 100

If bid is $100.00 and ask is $100.05, the midpoint is $100.025, and the percentage spread is 0.05 / 100.025 = 0.0499%.

For a $100,000 purchase:

• Cost = $100,000 × 0.0499% = $49.90

For a $10,000 purchase:

• Cost = $10,000 × 0.0499% = $4.99

For very large ETFs like SPY, this cost is negligible. For niche ETFs with $1 spreads on $50 shares, the percentage spread is 2%, and the cost becomes very significant.

Minimizing Spread Costs

Invest in large, liquid ETFs: Choose ETFs with billions in assets and millions of shares traded daily. SPY, VOO, VTI, and similar mega-cap index ETFs have spreads so tight they are nearly costless.

Use limit orders: Place limit orders at or near the bid-ask midpoint. For passive investors, this often fills within minutes and saves the full spread.

Avoid illiquid niche ETFs: ETFs tracking obscure sectors, countries, or strategies may have justifiable spread costs that outweigh any benefit from their specific focus. Prefer broader ETFs even if they are not perfectly aligned with your tactical view.

Trade during core hours: If possible, trade ETFs during the 10 AM to 3 PM Eastern window when spreads are typically tightest.

Dollar-cost average: By investing in periodic increments rather than lump sums, you avoid the risk of placing a very large order that might impact spreads. However, this is a minor consideration.

Check real-time quotes: Before placing an order, verify the current spread. Different brokers may show different prices depending on order routing. Some brokers route orders to exchanges with tighter spreads.

The Bigger Picture

For passive investors in major index ETFs, bid-ask spreads are not a significant concern. The tight spreads in SPY, VOO, VTI, and similar funds mean spread costs are a rounding error.

The real spread-cost concern applies to investors in niche ETFs or those trading during unusual times. For these investors, understanding spreads and using limit orders is prudent.

The creation-redemption mechanism ensures that even as ETF spreads might widen temporarily, authorized participants arbitrage the gap, pushing prices back toward NAV. This mechanism works reliably in normal conditions and is one reason why ETF prices are reliable even in stressful markets (most of the time).

How it flows

Next

The next article examines premium and discount to NAV, a related concept to spreads that describes the deviation of ETF market price from its underlying net asset value.