Understanding bid and offer spreads in Active ETFs
Among the issues investors need to consider when buying and selling Active ETFs are buy-sell (or "bid-offer") spreads.
Spreads are often seen as an unavoidable cost of trading and investing, and are not unique to Active ETFs per se. What’s more, the competitive nature of open exchange markets – as well as the impact of the fund as market maker – seek to ensure bid-offer spreads are as tight as possible.
What are buy-sell spreads, and why should I pay them?
An Active ETF’s bid-offer spread is the difference between the price at which investors can buy the fund on the exchange and the (lower) price at which it could be sold back to the market. This ‘spread’ can be seen when looking at the websites of online brokers and is also displayed by the ASX on the market data pages of its website.
Clearly, the narrower the spread the better, as this reduces the trading costs associated with buying and selling Active ETFs. That said, the fact that fund trading is subject to buy and sell spreads should not be considered a major negative for investors. After all, the issue of buy and sell spreads is not unique to Active ETFs.
Indeed, it should be remembered that all securities traded on the ASX are subject to buy and sell spreads, as this is the way the professional trading houses that invest their time and financial risk by standing ready to buy and sell these securities at an investor’s behest – effectively making markets and enhancing liquidity – are compensated. What’s more, even unlisted investment funds are subject to buy and sell spreads, which can be a combination of entry/exit fees levied by the fund manager and/or an allowance for estimated transaction costs incurred in buying and selling underlying investments.
How are spreads calculated?
It should be noted that, unlike the situation with unlisted funds, the buy and sell spreads for Active ETFs are not static.
Instead, exchange based spreads as on the ASX are determined by the fund itself acting as market maker and investors buying and selling the funds on market.
Unlike ETFs, which rely on third party market makers, with Active ETFs the fund itself is able to act as market maker. By acting as market maker, the fund will set bids/offers for investors during the day which reflect the fund’s view of “fair value” as referenced by the indicative net asset value (iNAV), market conditions and the supply and demand for fund units during the trading day.
At the end of each trading day, the fund as market maker will then issue or cancel units according to its net position in units bought or sold on the exchange that day. Any gains or losses from the market making process will accrue to the relevant fund.
As in the case of company shares more broadly, the size of the spreads that the fund as market maker is able to competitively maintain naturally depends on liquidity factors, such as the frequency and average size of trades involved. For that reason, spreads on larger companies – which are subject to more extensive trading activity – are typically tighter than for smaller companies.
The same considerations apply to Active ETFs. Funds that invest in liquid underlying securities (like AMP Capital’s Active ETFs available on the ASX), which have a large number of investors and a large total value of units outstanding, may have more liquidity than a fund that does not have some or any of these features. This should result in relatively tighter bid-offer spreads. Conversely, funds which invest in relatively illiquid underlying assets such as small companies, may have a wider spread than a fund which invests in larger, more liquid, “blue chip” stocks.
Due to the fund’s role as market maker, it is expected that the bid-offer spread of AMP Capital’s Active ETFs will generally be comparable to the buy-sell spread of the equivalent existing unlisted AMP Capital managed fund.
When to buy?
To further reduce the impact of bid-offer spreads, investors should also consider the time of the day in which they trade. As regards Active ETFs, it is advisable to avoid trading near market opens or closes, as this is when the fund as market maker and investors face more risk in pricing funds correctly (as they can be less sure of the market prices of the underlying securities). For this reason, bid-offer spreads may tend to be widest at these times of the day.
Find out more about AMP Capital's Active ETFs - Learn more here.
About the author
Paul Gambale is Senior Product Owner - Innovation and New Ventures at AMP Capital
Note: adapted from BetaShares Blog article “ETFs 101: understanding ETF Bid and Offer Spreads” by David Bassanese, 14 July 2015.