Understanding how bid-ask spreads work does not require a background in financial markets. It does require knowing what you are looking at when you open an order screen in your broker account.
Key takeaway
The bid-ask spread is the gap between what buyers are willing to pay and what sellers are willing to accept. For ETFs, a narrow spread relative to the price indicates better liquidity and lower implicit trading cost.
This article explains how ETF liquidity works, what bid-ask spreads are, and how to estimate execution cost before trading.
This is general educational content, not personal financial advice. Speak with a registered financial adviser or financial services professional for guidance specific to your situation.
What Liquidity Means for ETFs#
Liquidity describes how easily an asset can be bought or sold without significantly affecting its price. A highly liquid ETF can be bought and sold quickly, in large quantities, at prices close to its stated value. An illiquid ETF is harder to trade without accepting an unfavourable price.
ETF liquidity operates at two levels:
Primary market liquidity refers to the ability of authorised participants (large institutional traders) to create or redeem ETF units in exchange for the underlying assets. This mechanism is what keeps ETF prices close to the net asset value (NAV) of the underlying holdings. When an ETF trades at a premium to NAV, authorised participants can create new units and sell them to profit from the difference. When it trades at a discount, they can redeem units and profit similarly. This arbitrage process keeps premiums and discounts narrow for well-functioning ETFs.¹
Secondary market liquidity refers to how easily ordinary investors can trade ETF units on the stock exchange. This is influenced by the volume of trading, the number of active market makers, and the liquidity of the underlying assets.
For most Australian investors trading broad-market ETFs, primary market liquidity is robust and the main consideration is the secondary market bid-ask spread.
What a Bid-Ask Spread Is#
When you open a stock or ETF in your broker's interface, you may see two prices:
- Bid price: the highest price a buyer in the market is currently willing to pay.
- Ask price (or offer price): the lowest price a seller is currently willing to accept.
The spread is the difference between these two numbers.
If an ETF has a bid of $99.95 and an ask of $100.05, the spread is $0.10.
When you place a market buy order, you pay the ask price ($100.05). When you place a market sell order, you receive the bid price ($99.95). By the time you have bought and immediately sold, you have paid $0.10 per unit in implicit cost, without any movement in the underlying market.
The spread represents compensation to the market maker (the entity willing to buy and sell continuously) for providing liquidity. It is not profit for your broker and it does not appear on your brokerage statement as a fee, but it is a real cost.
How to Estimate Execution Cost#
The most useful way to express spread cost is as a percentage of the purchase price.
Spread percentage = Spread ÷ Midpoint price × 100
Where midpoint = (bid + ask) ÷ 2.
Using the example above: midpoint = ($99.95 + $100.05) ÷ 2 = $100.00.
Spread percentage = $0.10 ÷ $100.00 × 100 = 0.10%.
A 0.10% spread means you effectively pay 0.10% above the midpoint price to buy, and receive 0.10% below the midpoint to sell. On a round trip (buy then sell), the total cost is 0.20%.
For a long-term buy-and-hold investor, this round-trip spread cost is incurred once at entry and once at exit. Over a ten-year holding period, a 0.20% round-trip cost is relatively minor. For a frequent trader who enters and exits positions regularly, spread costs accumulate quickly.
What Affects Spread Size#
Several factors influence how wide or narrow the spread is for a given ETF:
Volume. Higher trading volume generally means narrower spreads because more buyers and sellers are active in the market simultaneously. Well-established ETFs with high daily turnover tend to have tighter spreads.
Underlying asset liquidity. An ETF tracking large-cap Australian or global equities has more liquid underlying assets than one tracking small-cap or frontier market stocks. More liquid underlyings make it easier and cheaper for market makers to hedge, which they pass on as tighter spreads.
Time of day. Spreads in Australian ETFs tend to be wider at market open (when price discovery is still settling) and in the first and last thirty minutes of the trading day. Mid-session trading often produces tighter spreads. Spreads may also widen during periods of global market volatility.
ETF size and age. Larger, more established ETFs typically have more active market makers competing for order flow, which compresses spreads.
International ETFs listed locally. ETFs that hold international assets have a challenge: the underlying assets may be trading in a different time zone and be closed while the ASX is open. During these periods, market makers bear more uncertainty about the true NAV, which can widen spreads.
Comparing Spreads Across ETFs#
When comparing two ETFs that track similar or identical indices, the bid-ask spread is a meaningful differentiation point alongside the management expense ratio (MER).
Consider two hypothetical ETFs:
| ETF | MER | Avg Spread |
|---|---|---|
| ETF A | 0.07% p.a. | 0.05% |
| ETF B | 0.04% p.a. | 0.20% |
ETF B has a lower MER but a wider spread. For a buy-and-hold investor holding for ten years:
- MER cost: ETF A costs 0.07% × 10 = 0.70% over the period. ETF B costs 0.04% × 10 = 0.40%.
- Spread round-trip cost: ETF A = 0.10%. ETF B = 0.40%.
Total estimated friction: ETF A = 0.80%. ETF B = 0.80%.
In this example, the costs are roughly equal despite the MER difference. The numbers would shift depending on holding period, trading frequency, and actual spread at the time of trade.
This comparison is illustrative, not a recommendation for any ETF. The point is that MER and spread should both be considered, not just one.
Limit Orders and Spread Management#
One practical tool for managing spread cost is using limit orders rather than market orders.
A limit buy order specifies the maximum price you are willing to pay. A limit sell order specifies the minimum price you will accept. If placed at or near the midpoint of the spread, a limit order may execute at a better price than a market order (which simply takes the ask or bid immediately).
The trade-off is that limit orders may not execute if the price moves away from your limit. For small investors buying broad-market ETFs, this risk is usually minor, especially during calm mid-session periods.
Limit orders also protect against unusual widening of spreads, particularly at market open or during periods of stress.
Premium and Discount to NAV#
For ETFs listed in Australia, the market price can differ slightly from the net asset value (NAV) of the underlying holdings. When the market price is above NAV, the ETF trades at a premium. When below, it trades at a discount.
For most broad-market ETFs, these deviations are small, typically well under 0.5%, and short-lived due to the arbitrage mechanism described earlier. However, they can widen for less liquid ETFs or during extraordinary market conditions.
Checking whether an ETF is trading at a significant premium or discount before purchasing is a reasonable practice, particularly for less common ETFs. Some ETF providers publish indicative NAV (iNAV) data during trading hours.
Summary#
The bid-ask spread is the difference between the price buyers are willing to pay and the price sellers are willing to accept. It is an implicit transaction cost present in every ETF trade that does not appear on fee schedules but affects the real cost of entering or exiting a position. Spreads are narrower for high-volume, liquid ETFs tracking large-cap assets, and wider for smaller or more exotic products. Comparing total cost, including both the MER and the expected spread round-trip, gives a more complete picture of ETF efficiency. For most long-term buy-and-hold investors, spread costs are a modest consideration relative to the much larger impact of asset allocation and time in the market.
Sources#
- Australian Securities and Investments Commission. (2023). Exchange traded products: An ASIC guide for retail investors. https://asic.gov.au/regulatory-resources/financial-services/exchange-traded-products/
- BlackRock. (2023). Understanding ETF bid-ask spreads. iShares. https://www.ishares.com/us/literature/whitepaper/a-comprehensive-guide-to-etfs-en-us.pdf
- ASX. (2024). How ETFs work. https://www.asx.com.au/investors/investment-options/exchange-traded-funds