Aside from comparing holdings and expense ratios in selecting ETFs, also watch out for wide spreads, which tend to vary with an ETF’s average daily trading volume and the amount of assets.
ETF providers are loath to admit that liquidity or average daily trading volume matter because they can theoretically create and redeem shares as necessary to meet demand.
They claim an ETF’s liquidity is based on the liquidity of the holdings. If the underlying components are thinly traded and have wide bid-to-ask spreads, so will the ETFs.
(The bid-ask spread is the difference between the price sought by buyers, i.e. the bid, and the price at which they’re being offered in the market, the ask.)
But in reality, the more thinly traded an ETF, the wider its spread. Wide spreads can dramatically affect your returns because you could be automatically in the red by the amount of the spread once you buy, even if the stock’s price remains the same.
The most highly traded ETFs such as the S&P 500 SPDR (NYSEArca:SPY – News), ProShares QQQ (NasdaqGM:QQQQ – News), the iShares MSCI EAFE (NYSEArca:EFA – News) and the sector SPDRs have spreads of just one or two pennies.
But the most thinly traded ETFs, in which only a few hundred shares change hands a day, have spreads of as much as $1 to $5.
For example, the spread on the thinly traded Claymore U.S. Capital Markets Bond (NYSEArca:UBD – News) showed a gap in bid-ask prices of more than $8 at the close on May 1, according to NYSE Arca. Divide the spread by the spread’s midpoint, and that works out to 23%.
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