Set out what influences the bid–ask spread on an ETF
The idea
The bid–ask spread on an ETF reflects the cost to a market maker of taking the other side of a trade and laying the risk off. It is roughly bounded by the creation or redemption fee and other trading costs, the spread on the underlying securities, compensation for the risk of adverse price moves while a position is held, the cost of hedging, and a normal profit for the market maker, less any saving when offsetting orders arrive. Funds holding liquid large-cap stocks, with heavy trading and many competing market makers, have narrow spreads; funds holding illiquid bonds or foreign stocks whose markets are closed have wider ones. The trap is assuming a low-volume ETF must have a wide spread.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Exchange-Traded Funds: Mechanics and Applications
- Explain how ETF shares are created and redeemed and what role authorized participants play
- Set out how ETF shares change hands on the secondary market
- Set out where ETF tracking error comes from
- Set out why an ETF can trade above or below its NAV
- Set out what an ETF costs to hold
- Set out the risks ETFs carry
- Recognise and explain the ways ETFs can be used in a portfolio