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ETF Investors Have Hidden Costs Through the Bid-Ask Spread

From the earlier discussion, you can infer that the price you pay for your ETF depends on the balance of supply and demand for that ETF at the time your order hits the trading floor. An ETF's share price is usually slightly different from the market value of the fund's underlying holdings. Moreover, the price a buyer pays is generally higher than the price a seller receives.

Selling a used car is a useful analogy. If you know how much you want for your car, you can sell it yourself. If a willing buyer sees your advertisement, he may take the car off your hands at a price you both feel is fair. However, you might not be able to locate a buyer.

If that is the case, you might decide to sell your car to a dealer. The dealer then pays a price low enough for him to expect to turn a profit when he resells your car. The dealer's knowledge of the car's value comes from observing the used-car market. Ideally (for the dealer), he would like to offer you as little as possible, but if the offer is too low for your liking, you will simply look for another dealer. On the other hand, if your demands are too high to leave room to profit, the dealer will let you walk.

If you accept the dealer's offer on your car, he will try to resell it at a higher price. Suppose the dealer is extremely lucky—the second after you leave the lot, a buyer enters, looking for exactly the car you just sold. Naturally, the dealer will sell it at a profit. The same car on the same day was worth less to you, the seller, than it was to the buyer.

Trading ETFs on exchanges works much the same way. If you as an ETF buyer are offering the same price that a different seller is demanding, the stock exchange is supposed to match up the two of you so that each of your orders can be filled. (However, exchanges have not always functioned this way, giving rise to periodic scandals and investigations. As a result, you should pay attention to the quality of your trade execution.)

However, suppose you want to buy an ETF at a time when a willing seller is not around. In that case, a dealer or specialist in a stock exchange offers to fill your order. Just as with a car dealer, a stock dealer transacts with you only at a price that allows him to make a profit. With the advent of electronic trading, you (through your broker) can look for the best price available for the ETF you want on more than one exchange. This is analogous to shopping around for the best price at multiple car dealerships.

If the dealer sells you the shares you want, he immediately tries to repurchase them from someone else at a lower price. If you turn around and try to resell your shares to a dealer (or specialist, or market maker), you receive less than you paid, even if the market has not moved one iota in the interim.

The price you pay to buy shares at the lowest available price is called the asking price, or ask. The price you receive when you sell shares at the highest available price is the bid. As with cars, stock dealers stand ready at any time to sell you shares at the ask price or to buy shares from you at the bid price.

The difference between the price you have to pay to buy shares and what a seller would receive to sell shares is called the bid-ask spread. The bid-ask spread is no less a cost to you than a broker's commission, despite being less visible (see Table 1.1). But to the unwary investor, the bid-ask spread is a hidden cost. Before you decide to buy an ETF, you should ask your broker for both the bid and ask so that you can get a feel for the cost per trade.

Table 1.1. Bid-Ask Spreads as a Percentage of the Share Price for Selected U.S. Equity ETFs During Normal Midday Market Conditions in the Fall of 2005*

ETF Name

ETF Ticker Symbol

Investment Objective

Bid Price ($)

Ask Price ($)

Bid-Ask Spread as % of Midpoint

Size of Market (Shares in 100s, BidxAsk)

S&P 500 Depository Receipts

SPY

Large cap

123.81

123.83

.02%

750x400

iShares Russell 100 Index Fund

IWB

Large cap

67.08

67.16

.12%

100x132

Vanguard Large Cap ETF

VV

Large cap

54.77

54.84

.13%

500x600

Diamonds Trust

DIA

Large cap

107.06

107.08

.02%

600x300

iShares Russell 1000 Growth Index Fund

IWF

Large growth

50.62

50.69

.14%

100x600

iShares S&P 500 Growth Index Fund

IVW

Large growth

58.71

58.81

.17%

600x900

Vanguard Growth ETF

VUG

Large growth

53.06

53.11

.09%

300x379

iShares Russell 1000 Value Index Fund

IWD

Large value

68.40

68.49

.13%

600x620

iShares S&P 500 Value Index Fund

IVE

Large value

64.40

64.51

.17%

300x600

Vanguard Value ETF

VTV

Large value

56.39

56.44

.09%

491x94

iShares S&P 400 Midcap Index Fund

IJH

Midcap

72.12

72.16

.06%

30x30

S&P Midcap SPDR

MDY

Midcap

131.46

131.49

.02%

300x125

Vanguard Extended Market Index ETF

VXF

Midcap

89.13

89.25

.13%

600x600

iShares Russell Midcap Index Fund

IWR

Midcap

85.83

85.91

.09%

490x1000

iShares Russell Midcap Growth Index Fund

IWP

Midcap growth

90.99

91.10

.12%

300x900

iShares S&P 400 Midcap Growth Index Fund

IJK

Midcap growth

73.33

73.43

.14%

300x300

iShares Russell Midcap Value Index Fund

IWS

Midcap value

122.22

122.28

.05%

10x74

iShares S&P 400 Midcap Value Index Fund

IJJ

Midcap value

69.34

69.45

.16%

300x300

iShares S&P 600 Index Fund

IJR

Small cap

57.42

57.47

.09%

50x50

iShares Russell 2000 Index Fund

IWM

Small cap

66.21

66.22

.02%

500x32

iShares Russell Microcap Index Fund

IWC

Small cap

50.51

50.59

.16%

200x300

Vanguard Small Cap ETF

VB

Small cap

58.93

59.02

.15%

300x300

Vanguard Small Cap Growth ETF

VBK

Small cap growth

56.99

57.15

.28%

500x500

StreetTracks Small Cap Growth

DSG

Small cap growth

79.71

79.87

.20%

50x50

iShares S&P 600 Small Cap Growth

IJT

Small cap growth

114.60

114.70

.09%

3x25

iShares Russell 2000 Growth

IWO

Small cap growth

68.55

68.59

.06%

130x60

Vanguard Small Cap Value ETF

VBR

Small cap value

61

61.11

.18%

900x600

StreetTracks Small Cap Value

DSV

Small cap value

62.01

62.17

.26%

50x100

iShares S&P 600 Small Cap Value

IJS

Small cap value

63.89

63.98

.14%

300x300

iShares Russell 2000 Value

IWN

Small cap value

65.88

65.92

.06%

95x40

Select Energy Sector SPDR

XLE

Sector energy

47.6

47.65

.10%

200x315

iShares Dow Jones U.S. Financial Index Fund

IYF

Sector financial

100.77

100.91

.14%

300x900

iShares Dow Jones U.S. Financial Services Index Fund

IYG

Sector financial

113.54

113.68

.12%

300x900

Select Financial Sector SPDR

XLF

Sector financial

31.58

31.59

.03%

600x1000

Vanguard Financial ETF

VFH

Sector financial

55.78

55.87

.16%

300x300

Vanguard Health Care ETF

VHT

Sector health care

53.07

53.16

.17%

300x600

Select Health Care Sector SPDR

XLV

Sector health care

30.96

30.98

.06%

900x100

iShares Dow Jones U.S. Healthcare Index Fund

IYH

Sector health care

61.76

61.85

.15%

300x600

iShares Cohen & Steers Realty Majors Fund

ICF

Sector REITs

73.28

73.37

.12%

110x120

iShares Dow Jones U.S. Real Estate Index Fund

IYR

Sector REITs

64

64.02

.03%

56x130

Vanguard REIT ETF

VNQ

Sector REITs

59.79

60.04

.42%

100x100

iShares Dow Jones U.S. Technology Index Fund

IYW

Sector technology

49.55

49.62

.14%

900x100

Select Technology Sector SPDR

XLK

Sector technology

21.10

21.12

.09%

330x1400

iShares Goldman Sachs Technology Index Fund

IGM

Sector technology

46.97

47.04

.15%

101x230

Vanguard Information Technology ETF

VGT

Sector technology

48.03

48.12

.19%

600x600

Utilities HOLDRs

UTH

Sector utilities

109.22

109.30

.07%

100x65

Select Utilities Sector SPDR

XLU

Sector utilities

30.45

30.48

.10%

1200x800

Vanguard Utilities ETF

VPU

Sector utilities

63.34

63.46

.19%

900x600

iShares Russell 3000 Index Fund

IWV

Total market

74.32

74.42

.13%

100x100

iShares Dow Jones Total Market Index Fund

IYY

Total market

62.51

62.59

.13%

100x100

Vanguard Total Market ETF

VTI

Total market

121.95

122.07

.10%

100x900

iShares Lehman Aggregate Bond Index Fund

AGG

Bond

99.39

99.79

.40%

300x350

iShares Lehman 7-10 Year Treasury Note Fund

IEF

Bond

82.47

82.55

.10%

350x1000

iShares Lehman TIPS Fund

TIP

Bond

102.26

102.46

.20%

400x400

iShares Goldman Sachs Investop Corp Bond Fund

LQD

Bond

106.09

106.76

.63%

300x250

iShares Lehman 20-Year Treasury Bond Fund

TLT

Bond

88.72

88.82

.11%

2500x2500

iShares 1–3 Year Treasury Note Fund

SHY

Bond

80.08

80.13

.06%

1000x1000

Bid-ask spreads and brokers' commissions are disadvantages of ETFs compared to regular mutual funds, which you can purchase without incurring either expense. However, mutual fund investors also bear these costs, albeit in a less visible way.

If the mutual fund must make transactions as a result of share purchases or redemptions from any shareholder or on the basis of investment decisions that the portfolio manager makes, the fund bears the costs of a bid-ask spread in addition to the brokerage commissions for whatever stocks it trades. These expenses of the fund are not reported as part of its expense ratio. The typical equity mutual fund turns over 100 percent of its portfolio each year.

Because ETFs are passively managed, the underlying stock portfolios turn over slowly compared to most mutual funds. Therefore, ETF performance is far less impaired by transactions in the underlying stocks than is the case with most mutual funds. (This advantage somewhat offsets the burden that an ETF investor has of paying for his own transaction costs.) The extent to which mutual funds suffer from transaction costs in their stock portfolios varies widely, depending on the manager's investment style, the type of stocks in which the fund invests, and the level of shareholder additions and redemptions. Information about how much a regular mutual fund spends on brokerage commissions and adverse market impact is difficult to uncover and is not included in the mutual fund's expense ratio.

As you might expect, dealers respond to changes in the balance between supply and demand. If everyone wants to sell at the same time but no one wants to buy, the price falls. That is to say, the bid price drops. Again, all this is independent of the actual market value of the underlying stocks that the ETF holds.

The question then arises, what is to stop ETFs from trading well above or below the market value of the underlying stocks? The next section discusses the unique feature of ETFs that keeps them in line with fair market values.

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