An ETF’s expense ratio represents its annual operating expenses expressed as a percentage of the ETF’s average net assets. The expense ratio is already factored into the ETF’s net asset value (NAV). It includes management and administrative expenses, but it does not include the transaction costs of buying and selling portfolio securities.

By contrast, the bid-ask spread—the difference between the highest price a buyer is willing to pay to purchase shares (bid) and the lowest price a seller is willing to accept for shares (ask) on the secondary market—is at the center of every ETF trade. It is an explicit cost realized when buying or selling the ETF and is influenced by many market forces. Ultimately, the spread is set by market participants, which include the investing public as well as the institutions that make a market in that ETF.

The bid-ask spread reflects the overall characteristics of a market in a particular ETF, taking at least three broad factors into account:

• The ETF’s volume, or turnover; lower volume often points to wider spreads.
• Volatility of the ETF’s underlying securities; this is often affected by broader market volatility.
• Liquidity of the underlying securities; lower liquidity generates wider bid-ask spreads, especially when the ETF’s volume is lower.

Hedging costs and other inventory management considerations may also affect spreads as market makers seek to limit their exposure through derivatives and other offsetting positions.

And what about premiums and discounts? They are important to a discussion about ETF trading costs. But their impact, trade by trade, is difficult to assess, because of the lack of visibility and timeliness of intraday NAVs. The NAV is required to determine the premium or discount of an intraday ETF trade. So we focus here just on the expense ratio and bid-ask spread, the more readily visible and measurable metrics.

Market makers, or authorized broker-dealers, sit at the center of ETF trading, providing liquidity by buying from one investor and selling to another. In between the buy and the sell, the market makers carry a risk that the market could move on them, and they might also risk selling at a value below their purchase price.

If an ETF trade turns over quickly, the market maker carries less market-movement risk and can set the spread tighter. For securities with less turnover, the market-movement risk grows, because recycling that risk takes more time, leading to wider spreads. Wider spreads are the only way for a market maker to recoup the costs of holding securities for longer.

So the more volume/turnover an ETF has in the secondary market, the narrower the bid-ask spread on that ETF will be.

Understanding the level of turnover in an ETF is a key factor in determining where market makers are willing to set bids and offers for a security to ensure that they can make a profit or, at worst, break even.

Besides the time it takes to turn over that risk, the speed at which prices are changing is a crucial factor in determining where to set those bids and offers. In fast-moving markets, market makers need to provide a larger range between the prices at which they’re willing to buy and sell a security. That’s because if they buy and the market turns against them, they could end up selling for a lower price and taking a loss.

One of the beneficial aspects of an ETF’s tradability is that it can tap two layers of liquidity. About 85% of all ETF volume is at the “secondary” level, after the shares have been created. The other 15% is at the “primary” level, where a market maker or authorized participant will create or redeem shares.¹

The market maker taps into the liquidity of the underlying market to either buy shares of an underlying asset and deliver them to the issuer to create new shares of the ETF, or else to sell shares of the underlying asset in the case of a redemption.

The secondary market process allows the ETF spread to be narrower than its underlying “basket spread,” or the round-trip cost of the underlying securities.

There are times, though, when the underlying market conditions may change and the cost to create or redeem ETF shares may widen. In these situations, you can expect wider spreads to affect the ETF as well.

An S&P 500 ETF, in which all the underlying stocks are readily tradable, would be relatively easy to buy or sell in any market. So we would expect such an ETF to trade with a tight spread that reflects the underlying basket of securities.

But other ETFs, such as one that holds small-capitalization stocks, might operate more frequently in liquidity-constrained environments that make it harder to buy and sell the underlying securities at a fair price. This could more significantly affect the ETF’s bid-ask spread.

Because the total cost of owning an ETF is effectively the sum of the expense ratio and the bid-ask spread, be mindful of each of these major costs to ensure you are making the most cost-effective product-selection decisions. Also, consider how often and in what amounts you will be trading. A once-a-year trade may mean that the expense ratio should be of paramount consideration. But if you’ll make more frequent trades, transaction costs such as brokerage commissions may be just as important.

Finally, be mindful of the time of day at which you trade. You may want to avoid trading during the first 15 to 30 minutes of a trading session, as well as around the time that market-moving news is expected to break during a session, such as when the Federal Reserve announces changes to interest rates. Trading when markets are open makes it likelier that market makers will have more pricing precision, that bid-ask spreads will be tighter, and that trade executions will be more precise and predictable.