What Is the Bid–Ask Spread in ETFs?

Introduction

Exchange-traded funds (ETFs) are celebrated for their low costs, intraday liquidity, and tax efficiency, but there is an often-overlooked cost that can quietly erode returns: the bid–ask spread. Understanding how the bid price and ask price converge to form this spread, and why it varies from one ETF to another, is essential for any investor who wants to optimize trade execution. This article breaks down the concept of the bid–ask spread in ETFs, explains why it exists, and offers practical strategies for minimizing its impact.

Defining the Bid and the Ask

The bid price represents the highest amount buyers are willing to pay for an ETF share at a given moment. Conversely, the ask price (or offer price) is the lowest amount sellers are willing to accept. The spread is the numerical difference between these two prices. For example, if an ETF has a bid of $35.98 and an ask of $36.02, the spread is $0.04. Although the figure may seem trivial, small differences add up quickly, especially for frequent traders or large orders.

Why Does a Bid–Ask Spread Exist?

In any marketplace, a spread compensates liquidity providers—often called market makers—for the risk they assume by quoting buy and sell prices. When you place an order, these intermediaries may step in to execute your trade with their own capital. The spread covers the cost of inventory risk, hedging, and operational expenses while also offering a profit incentive for maintaining tight, continuous markets.

How Bid–Ask Spreads Work in ETFs

ETFs are unique because they trade on an exchange like stocks yet hold a basket of underlying assets that have their own prices. Market makers for ETFs consider not only supply and demand for the ETF shares themselves, but also the liquidity, spreads, and volatility of the underlying securities. As a result, the bid–ask spread for an ETF can be narrower—or wider—than that of its individual components, depending on how easily those components can be traded or hedged in real time.

The Role of Authorized Participants

Authorized Participants (APs) create and redeem ETF shares in large blocks called creation units. When an ETF’s market price deviates materially from its Net Asset Value (NAV), APs exploit the difference through the creation/redemption mechanism, keeping the ETF’s price in line with its underlying holdings. This arbitrage activity also contributes to tighter spreads because it ensures that ETF prices track fair value.

Factors That Influence the Size of the Spread

Several variables determine how wide or tight an ETF’s bid–ask spread will be at any given time:

• Trading Volume: ETFs with higher average daily volume generally boast tighter spreads because more buyers and sellers are competing to transact.
• Underlying Liquidity: An ETF that invests in highly liquid large-cap stocks will usually have a smaller spread than one holding thinly traded small-cap or emerging-market securities.
• Market Volatility: During turbulent periods, spreads often widen as market makers demand more compensation for the risk of rapid price swings.
• Time of Day: Spreads are typically wider at the market open or just before close when price discovery is more difficult. Midday trading can offer tighter spreads.
• Fund Structure and Strategy: Niche or complex strategies—such as leveraged or inverse ETFs—often see wider spreads due to specialized risks and lower trading volumes.

How to Measure an ETF’s Bid–Ask Spread

The most straightforward measurement is the absolute dollar difference between the bid and ask. For deeper analysis, investors often convert that difference to a percentage of the midpoint price. For instance, a $0.04 spread on a $36.00 midpoint equals approximately 0.11%. Many brokerage platforms display this percentage automatically, and some even show an estimated “cost of round-trip trade,” which multiplies the spread by two to account for both buying and selling.

Why the Spread Matters to Investors

Even though expense ratios receive more attention in marketing materials, bid–ask spreads can overshadow management fees for short-term or high-frequency traders. Imagine two ETFs, each with a 0.10% expense ratio, but one has a spread of 0.05% while the other’s spread is 0.30%. A trader who buys and sells the latter ETF three times in a year will pay roughly 1.8% in total spread costs—eighteen times the advertised expense ratio. Therefore, investors should evaluate spreads alongside fees, tracking error, and tax implications when selecting an ETF.

Strategies to Minimize Bid–Ask Spread Costs

Fortunately, investors are not powerless against spread-related costs. The following best practices can significantly reduce impact:

Trade During Peak Volume

Plan trades near the middle of the trading day when liquidity is highest and spreads are generally narrowest. Avoid the first and last 15 minutes of the session when price discovery is still unfolding.

Use Limit Orders

Market orders guarantee execution but do so at the prevailing ask (for buys) or bid (for sells), instantly locking in the spread. A limit order placed at or near the midpoint gives you a chance to capture a better price, although execution is not guaranteed.

Monitor Underlying Market Conditions

Check for earnings announcements, Federal Reserve meetings, or geopolitical events that could spike volatility. If the broader market is jittery, consider delaying trades until conditions stabilize and spreads tighten.

Select Highly Liquid ETFs

All else equal, choose ETFs with consistently high average daily volume and narrower historical spreads. Screening tools on brokerage platforms often rank funds by liquidity metrics.

Avoid Trading in Crisis Mode

Spreads can widen dramatically during market sell-offs or flash crashes. If the trade is not time-sensitive, waiting even a few hours or days can save meaningful spread costs.

Special Considerations for Institutional Investors

Large orders introduce additional complexity because filling them can move the market and widen spreads. Institutions frequently break orders into smaller slices or work with liquidity providers for negotiated block trades. Algorithms that adapt to real-time volume and volatility can help institutions achieve better price improvement without revealing intent.

Conclusion

The bid–ask spread may look like a minor detail on your trading screen, but it is a real, ongoing cost of ETF investing. By recognizing what drives spreads, measuring their impact, and implementing smart trading tactics, investors can keep more of their returns intact. Whether you are a casual investor or an active trader, incorporating spread analysis into your ETF selection and execution process will help ensure that the promise of low-cost, liquid investing translates into tangible, long-term gains.