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Understanding ETFs: The bid-ask spread

19 December 2016 | Topical insights

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This video is an excerpt from a live Vanguard webcast that aired in the United States in September 2016.

Amy Chain (moderator): The bid-ask spread is something we heard a lot about ahead of this evening's event. So we asked Jessica, a senior trader in Vanguard's Investor Trading Services Group, to talk to us about bid-ask spread. Jessica?

Jessica Clancy (Vanguard Investor Trading Services): Thanks, Amy, I'm happy to. The bid is simply the highest price that buyers are willing to pay for shares of that ETF at a given time. The ask, on the other hand, which is sometimes called the offer, is then the lowest price that sellers are willing to sell those same shares at. The spread is simply the difference between those two numbers. So if you have an ETF that is bidding $110.50 and asking $110.55, then the spread would simply be 5 cents.

Amy Chain: Thank you, Jessica. Now why is that important?

Jessica Clancy: Yes, the spread is important to know because it can give you an indication of what your total trade costs are going to be. Additionally, it can give you an insight into how liquid or illiquid an ETF is, meaning how easy it is to buy or sell that ETF. So an ETF with a narrower spread or a smaller spread like a penny, for example, would be a pretty liquid ETF and probably easy to buy and sell. But an ETF with a wider spread, 5 cents, 10 cents, that gives you an indication that it's a bit illiquid and maybe could be more difficult to buy and sell.

Amy Chain: All right, Jessica, thank you. Brian, let's pick up where Jessica left off. Let's talk about liquidity.

Brian McCarthy (Vanguard Investor Trading Services): So liquidity, you know, it's important to understand how the pricing is determined, first and foremost. So to say something's liquid or illiquid, it might be liquid or less liquid. But if you have an ETF as an example that's made up of large-cap securities that trade very actively throughout the day and have, as Jessica described the bid-ask spread, a narrow bid-ask spread, that's how the price of the ETF is derived. So, generally, you'll see a correlation where the portfolio, if it trades with a narrow spread, the ETF will trade with a narrow spread. If there's a lot of shares available in the underlying securities making up that fund, then the ETF may have more available in the market.

So the contrary would be, a contrary example would be if you have a high-yield corporate bond fund – generally spreads on high-yield corporate bonds are a little bit wider, a little bit harder to invest in some of those securities – and, therefore, you would find a high-yield corporate bond fund ETF may have a wider spread than say a large-cap equity security.

Amy Chain: But compared to another high-yield corporate bond fund ETF, the spreads might be comparable?

Brian McCarthy: They might be comparable, and I know Rich and I have talked about this before. All things being equal, if you had two high-yield corporate bond ETFs, that's where you would want to say if one had a narrower spread, my implementation costs are lower, and, therefore, I may lean towards that issuer's ETF versus another issuer's ETF.

Amy Chain: And information about the bid-ask spread is available when you're looking at information about ETFs.

Brian McCarthy: Absolutely. You know, all the financial service firms or what have you when you're looking to invest, you can get that information.

Amy Chain: Now we talked about liquidity. Jessica mentioned it, you mentioned it. Let's pause for a minute and define what liquidity means for our audience.

Brian McCarthy: Liquidity is, Jessica talked about how the bid is somebody willing to buy and the offer or ask is someone willing to sell. And I would just think of it as someone's willing to buy or sell a certain number of shares, that's how many shares they have available. There's other market participants that may be willing to take risk, so there's a certain amount of shares that they're willing to buy or sell at the price that's indicated.

Liquidity would be the number of shares that are available, and when you invest, you would want to make sure that the number of shares you're trying to purchase are available at that price. And that's also, you asked about can customers find that information. You will see that information represented.

Amy Chain: Anything to add?

Rich Powers (Vanguard Portfolio Review Department): I think Brian covered it there. I think liquidity is a common piece of conversation that we have with investors. Where it's perhaps most important is for the institutional investors who are transacting very large blocks who may want to trade at levels that are greater than the liquidity that's available on the website or on some other type of application.

In general, you know, for the investors we're talking to here today, I'd say what they would find is that they would generally be for kind of broad-based portfolios, ample liquidity at the levels they want to transact at.

Amy Chain: Large, sort of easily accessible, popular ETFs wouldn't be faced with the same liquidity concerns than say smaller, more, say, thinly traded. Is that a reasonable –?

Rich Powers: Yes, that's right. And Brian talked about this more, a broad index fund that covers U.S. stocks, international stocks, or a large segment of those universes is going to probably have a high level of liquidity. As you get narrower and narrower, that's when you may see less liquidity, and, therefore, it's just a really important data point to have at your fingertips.

Important information

This video is directed at professional investors and should not be distributed to or relied upon by retail investors.

It is designed for use by, and is directed only at persons resident in the UK.

This video was produced by The Vanguard Group, Inc. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

The opinions expressed in this video are those of individual speakers and may not be representative of The Vanguard Group, Inc.

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

VAM-2016-11-30-4133

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