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liquidity of the underlying components that really matters.
S&P 500 Example
Consider, for instance, the S&P 500 SPDR (SPY) and the
RevenueShares Large-Cap ETF (RWL). Both funds hold the
exact same stocks—all 500 components of the S&P 500. The
only difference is that SPY weights those components by market
cap, while RWL weights them by revenues.
That shouldn’t impact the liquidity of the underlying, as all
500 stocks in the S&P 500 are deeply liquid.
When you look at the spreads data, however, there’s no
comparison. For the time period studied, SPY had spreads
of less than 0.01 percent, while RWL’s spread averaged 0.9
percent—90 times wider.
SPY, of course, is the largest ETF in the world, with over
$70 billion in assets; RWL is a newly launched fund, with little
in the way of assets or trading interest so far.
Muni Bond Example
Another example comes from the muni bond space. The muni
bond market is notoriously illiquid, and different ETF providers
take different approaches to handling this illiquidity.
Both BGI and SSgA offer broad-market, nationally oriented
muni bond funds. The two funds—the iShares S&P
National Municipal Bond ETF (MUB) and the SPDR Lehman
Municipal Bond ETF (TFI)—hold roughly equivalent portfolios
with roughly equivalent returns. But they have very
different creation methodologies.
In MUB, APs must go out into the market and buy specific
bonds in order to create new shares. Even though iShares designs
these creation baskets to hold only the most liquid muni bonds,
it is still a hurdle that APs must negotiate to create new shares.
TFI, by contrast, uses what’s called a “cash creation basket.”
In other words, the only thing APs have to do to create
new shares is send cash to SSgA. It couldn’t be easier.
However, for the time period studied, MUB had much tighter
spreads (0.10 percent) compared with TFI (0.30 percent). The reason?
MUB is a larger fund with more inherent trading volume.
It’s interesting to note that the spreads on TFI have shrunk
as the fund has grown. As of early May, TFI had more than
$250 million in assets and higher trading activity, and from
May 1 through May 15, 2008, the average spread on the fund
was down to 0.20 percent. As the fund continues to grow, its
spreads will likely continue to narrow.
Conclusion
Spreads aren’t as simple as ETF proponents make them
out to be. Most ETFs have tight spreads, but not all of
them do, and spreads represent a real cost to investors.
Especially for newer ETFs with low assets under management,
investors would do well to pay attention to spreads
when they trade, and use limit orders to avoid paying too
much above fair value.
Spreads should be incorporated into every ETF trading
decision, much the way that brokerage commissions are.
Their impact will be felt most by short-term traders, but even
long-term investors should consider their planned holding
period and incorporate spreads into their trading decisions.
[This article expands on an article published in the May
2008 issue of the Exchange-Traded Funds Report.]
Figure 5
Net Assets
Number of
ETFs
Source: NYSE Arcavision. Data for January 1, 2008 through March 31, 2008.
ETF Spread Percentage By Assets Under Management
Average Spread Percentage Decile
0.1% 0.2% 0.3% 0.4% 0.5%
$10+ billion 10 100% 0% 0% 0% 0% 0%
$1-$9.9 billion 90 56% 43% 1% 0% 0% 0%
$500-$999 million 53 13% 72% 15% 0% 0% 0%
$100-$499 million 146 4% 53% 31% 8% 2% 1%
Figure 6
$51-$99 million 75 0% 25% 47% 15% 8% 5%
$10 billion 50 80% 20% 0 0 0 0
$1-$9.9 billion 88 38% 63% 3% 0 0 0
$100 - $999 million 194 2% 53% 31% 9% 4% 2%
$10 - $99 million 236 0% 16% 41% 18% 9% 14%
0.5%
>0.5%
www.journalofindexes.com July/August 2008
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