Should investors be worried about the wide spreads on some ETPs?

A recent report on Australia’s exchange-traded product (ETP) industry from the Australian Securities and Investments Commission (ASIC) is positive, confirming that it is functioning well for investors. However, ASIC’s report highlights how bid-offer spreads – and therefore costs – can vary between ETP products.

ASIC’s Review of Exchange-Traded Products found that Australia’s ETP trading is generally liquid and bid-ask spreads for ETPs are typically narrow so investors are generally buying and selling at prices close to the value of the ETP unit. 

However, ASIC warned that this does not necessarily apply to all ETP products. In particular, ASIC observed that spreads temporarily widen in some circumstances, meaning individual transactions may involve a higher spread than an investor may consider desirable.

The impact of spreads

Related News:

When a share or ‘unit’ in an ETP is bought or sold on market there is a spread between the ‘bid’ or ‘offer’ price (price at which people are wanting to buy) and the ‘ask’ price (price at which people are willing to sell). Spreads are important as they impact the investor’s overall return in the same way management costs do. 

Or, as ASIC puts it: “Spreads are important to ETP investors as they are, effectively, a hidden cost that reduces an investor’s return.”

While ETP spreads are generally narrow, ASIC observed that spreads temporarily widen in some circumstances.

“The ETP spreads generally reflect the liquidity of the underlying assets so that ETPs holding less liquid assets, such as bonds or emerging market shares, usually have higher spreads. Spreads may also be higher for a new fund until it becomes more established,” ASIC said.

ASIC found that the number of individual market makers and greater relative share of market turnover are associated with tighter spreads. This points to the role of competition as a driver for smaller or ‘tighter’ spreads. 

Before trading, investors should investigate the bid-ask spread on any ETP in which they are considering an investment by reviewing both the bid price and the ask price and assessing the difference between the two.

ETP spreads less than unlisted funds

In a positive for ETP investors, ASIC found that spreads on ETPs are generally narrower than those on unlisted managed funds. 

"We found from empirical evidence that, most of the time, market spreads for quoted ETPs are not excessive. Across all ETPs, as expressed on an effective turnover-weighted basis, ETPs are quoted on a spread of nine basis points or less, approximately 50 per cent of the time,” ASIC’s report said. 

“By comparison, buy–sell spreads on unlisted funds vary, but will typically range from approximately zero to 50 basis points, depending on the investment strategy and asset classes held,” ASIC said.

“We found that ETPs over Australian equity securities are quoted with the tightest spreads — at six basis points or less, around 50 per cent of the time. ETPs over global products tend to have spreads that are approximately three times as wide — at 20 basis points or less, around 50 per cent of the time.”

Active ETFs also have much higher spreads 

As the industry has grown, the range of ETPs has increased from plain-vanilla index-tracking exchange-traded funds (ETFs) to complex managed funds and now so-called ‘active ETFs’ which allow investors to access the capabilities of active investment managers on ASX. 

ASIC found that active ETFs are more likely to have higher spreads than ETFs which track an index. In addition, active ETFs do not track an index and they are not required to publish their full holdings at any time, so investors never know, at any time, what stocks or how much cash active ETFs hold. 

By contrast, ETFs which track an underlying index provide full transparency of all their holdings on a daily basis and their spreads are generally narrower than those on active ETFs.

The size of the ETP issuer is also important, as larger global ETP providers tend to have better relationships with market makers, providing better liquidity.

This is another challenge for active ETFs where the issuer is also the market maker. ASIC’s report rightly highlights that in addition to liquidity constraints, internal market making also leads to additional fees of which investors need to be aware.

What it all means

Differences in spreads and market maker arrangements impact investors’ fees and costs and may significantly affect investors’ returns, therefore, it is important that investors understand the spread on ETFs and on any managed fund in which they are considering investing.

Given the current scandals in financial services, it is good news for investors that there is at least one investment product that investors can trust because of its greater transparency and low cost: index-tracking ETFs. 

Arian Neiron is the managing director and head of Asia Pacific at VanEck.




Related Content

A ticking clock: SMSFs and MiFID II regulatory requirements

Notwithstanding another extension of relief by the Australian Securities and Investments Commission (ASIC), the deadline for legal entities, including...Read more

UK and Australia enter post-Brexit agreement

The United Kingdom (UK) Financial Conduct Authority (FCA) and Australian Securities and Investments Commission (ASIC) have agreed to strengthen cooper...Read more

ASIC takes action against SMSF auditors

The Australian Securities and Investment Commission (ASIC) has disqualified and suspended or added conditions to the registration of a number of audit...Read more

Author

Comments

Add new comment