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Beyond commissions: An ETF’s price matters

Commission-free ETFs are a great way to save money, but watch the bid-ask spread too.

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What you pay for buying and selling any security matters. ETF investors have much to cheer about the availability of commission-free ETF trades—Fidelity is now offering 65 iShares ETFs and 10 Fidelity sector ETFs for purchase commission-free.

Commissions aren’t the only cost to consider when buying an ETF. Most investors compare expense ratios, but a less appreciated—yet important factor—is the bid-ask spread, which is the difference between the highest price a buyer is willing to pay for an asset (bid) and the lowest price at which a seller is willing to sell (ask). While investors should consider the Net Asset Value (NAV) of an ETF, the price you pay is a seller’s ask price, which can be at a discount or premium to the NAV.

“It’s important to remember that not all ETFs are created equal,” says Ram Subramanium, president of Fidelity brokerage services. “So, investors may want to look for ETFs with established track records and low bid-ask spreads relative to their peers.”

Behind the bid-ask spread

Purchase commission-free details

Free commission offer applies to online purchases of 65 iShares© ETFs and Fidelity ETFs in a Fidelity brokerage account with a minimum opening balance of $2,500. The sale of ETFs are subject to an activity assessment fee (of between $0.01 to $0.03 per $1000 of principal) by Fidelity. After September 30, 2013, 65 iShares ETFS are subject to a short-term trading fee by Fidelity, if held less than 30 days. After January 31, 2014, Fidelity ETFs are subject to a short-term trading fee by Fidelity, if held less than 30 days.

Bid-ask spread is largely a function of liquidity, or the volume of buyers and sellers for an asset during a particular moment in time. Highly liquid assets are heavily traded and can be bought and sold quickly and relatively inexpensively. Think Bank of America (BAC), the most heavily traded stock on October 11, 2013, with 63 million shares changing hands at a miniscule average bid-ask spread of 0.01% (this is calculated as the ask price less the bid price, divided by the ask price).

Alternatively, it may be more difficult to trade certain assets that are less liquid, where bid-ask spreads can be higher. Think some penny stocks.

Liquidity is also an important factor to consider when buying and selling ETFs. The most heavily traded ETF on October 11, 2013 was the SPDR® S&P 500® ETF (SPY), with a bid-ask spread of 0.01%.1 A similar ETF, the iShares Core S&P 500 ETF (IVV), also had a bid-ask spread of 0.01%. But some newer ETFs, or ones that target more obscure asset classes, can be very illiquid and can have much wider bid-ask spreads.

All things being equal, it makes sense to seek more liquid ETFs with narrower bid-ask spreads, because the narrower the spread, the lower price.

Understanding liquidity

The composition of the underlying securities of an ETF is one of the more important factors in determining its liquidity. In general, ETFs whose underlying assets are broad market indexes, large-cap stocks, or government bonds tend to be the most liquid and heavily traded.

If you are investing in these types of ETFs, you have many highly liquid choices with relatively low bid-ask spreads. Still, there can be discrepancies, which is one reason why we picked many highly liquid ETFs for our online commission-free iShares offer.

Now, let’s compare bid-ask spreads on a similar set of ETFs. Let’s say you want to invest in the broad market, but are looking for a range of choices. In addition to SPY and IVV, we found several alternatives using Fidelity’s research tools.2

Although each of these ETFs attempts to track the S&P 500, their volumes and bid-ask spreads vary (see screenshot above). The average bid-ask spread for iShares Core S&P 500 ETF (IVV) was 0.01%—the same as SPY, but lower than VOO (0.02%), RSP (0.02%), and EQL (0.09%). IVV also has the added benefit of trading commission-free at Fidelity.

It’s all relative

When it comes to more thinly traded ETFs, the bid-ask spreads can vary even more widely than with broad market-based ETFs. So, picking the ETF with the lower bid-ask can be even more impactful.

Suppose a U.S.-based investor wants to invest in the Japanese stock market. When the Asian markets are closed, the underlying Japanese securities can’t be traded. As a result, Japan ETFs can be relatively illiquid for U.S. investors.

However, the results of the screen below show some broad-based Japanese equity ETFs can have a much wider bid-ask spread than others. For example, iShares MSCI Japan Index ETF (EWJ) had a bid-ask spread of 0.1%, versus DBX ETF Trust (DBJP) of 1.04% and SPDR Russell Nomura PRIME Japan ETF (JPP) 1.09%.

Liquidity should be viewed in the context of similar securities
ETP Name Symbol ETP Type Default: Leveraged/Inverse Country Objective Index Objective Equity: Capitalization Objective Average Monthly Bid/Ask Spread Volume (90 Day Average)
DB-X MSCI Japan Currency-Hedged Equity Fund DBJP ETF No Japan Cap-weighted Broad/Multi Cap 1.04% 14.8K
iShares MSCI-Japan EWJ ETF No Japan Cap-weighted Broad/Multi Cap 0.10% 33.4M
SPDR Russell/Nomura Prime Japan ETF JPP ETF No Japan Cap-weighted Broad/Multi Cap 1.09% 9.7K

Source: Fidelity.com as of March 8, 2013. Screenshot is for illustrative purposes.

Even though the bid-ask spread of 0.10% for EWJ may seem high, in comparison to the very narrow spread of the SPY and IVV (0.01%), it is significantly lower than similar ETFs tracking the Japanese stock market. Bottom line: When comparing bid-ask spreads, make sure you are comparing apples to apples.

Choose carefully

Investor demand for ETFs has never been stronger: $191 billion in flows during 2012 marked a new all-time yearly high, and 2013 is shaping up to be a strong year as well.3 Plus, ETF choices have proliferated across asset classes and styles. But remember, pricing counts, too. So, consider commissions and bid-ask spreads when deciding which ETF might be right for you.

Learn more

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Free commission offer applies to online purchases of 65 iShares© ETFs and Fidelity ETFs in a Fidelity brokerage account with a minimum opening balance of $2,500. The sale of ETFs are subject to an activity assessment fee (of between $0.01 to $0.03 per $1000 of principal) by Fidelity. After September 30, 2013, 65 iShares ETFS are subject to a short-term trading fee by Fidelity, if held less than 30 days. After January 31, 2014, Fidelity ETFs are subject to a short-term trading fee by Fidelity, if held less than 30 days.
Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest-rate, currency-exchange-rate, economic, and political risk, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility as well as the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risk. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV), or indicative value in the case of ETNs. Each ETP has a unique risk profile, which is detailed in its prospectus, offering circular, or similar material, and which should be considered carefully when making investment decisions.
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Investment comparisons are for illustrative purposes only and are not meant to be all-inclusive. There may be significant differences in investments that are not discussed here.
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1. Source: Fidelity.com

2. This list was generated by navigating to the SPY snapshot page, selecting “Compare” on the left hand side navigation tool, and then on the following page clicking the “Show Similar ETPs” link .

3. Source: Morningstar.
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