Although our era of discount brokers and commission free platforms has greatly reduced the cost of online trading, the cost of buy and selling stocks along with ETFs can still add up. This is especially true when stock market volatility (ChicagoOptions:^VIX) is rising.
The chart below illustrates how historical bid-ask spreads (also known as “bid-offer spreads”) have widened by more than 40% (from just 0.8% to 1.4%) during periods of 20% or greater one-month realized volatility in the SPDR S&P 500 ETF (NYSEARCA:SPY). What does this mean? It means that investors absorb higher trading cost when financial markets are gyrating.
For all investors that buy and sell securities on a stock market exchange, the two main components of transaction cost are brokerage commissions and bid-ask spreads.
The bid-ask spread is the difference between the highest price a buyer is willing to pay for a stock or ETF and the lowest price at which a seller is agreeable to selling it for. For example, an ETF with a bid price of $40 and an ask price of $40.75 has a bid-ask spread of 0.75 cents.
Although it’s rarely mentioned by ETF detractors, the cost of bid-ask spreads is not exclusive to ETFs. In fact, this real life trading cost impacts all investors who own individual stocks, closed-end funds, and even mutual funds. (For mutual funds, bid-ask spreads are embedded in the trading cost that fund shareholders absorb whenever portfolio managers buy and sell securities owned by the fund.)
How can investors immediately cut their trading costs?
First, you must realize that ETFs linked to certain asset classes like individual commodities (NYSEARCA:DBC), emerging markets (NYSEARCA:VWO), and high yield debt (NYSEARCA:HYG) are more likely to have higher bid-ask spreads compared to ETFs following widely held or conventional assets like blue chip stocks (NYSEARCA:DIA) or U.S. Treasuries (NYSEARCA:TLT). The formerly mentioned investments tend to be more volatile in nature, which contributes to more significant differences between bid-ask prices of the ETFs tracking them.
Second, it’s important to understand ETFs that use leverage will generally have larger bid-ask spreads compared to un-leveraged ETFs.
For instance, the Market Vectors Gold Miners ETF (NYSEARCA:GDX) has a current bid-ask spread near 0.15% compared to 0.33% for the Direxion Daily Gold Miners Bull 3x Shares ETF (NYSEARCA:NUGT). Although both funds track the same benchmark, NUGT’s bid-ask spread is more than double GDX, which makes it more expensive to trade. Bottom line: If you’re going to own leveraged ETFs, and it’s OK to do so inside your non-core portfolio, be ready to absorb higher trading costs.
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Third, reducing the frequency of trading activity can greatly reduce the cost of trading. It will also probably improve your portfolio’s performance. Academic studies show that low-frequency traders tend to outperform high-frequency traders over the long-run.
Fourth, if you own mutual funds, check out the portfolio’s turnover percentage or ratio in the fund’s semi-annual report. A low turnover ratio of 20% to 30% indicates a buy-and-hold strategy whereas high turnover of 100% or more indicates higher trading activity and cost.
Finally, the most obvious way to cut your trading costs is to avoid trading altogether when stock market volatility is spiking. Why? Because it’s during these stressful moments when bid-ask spreads are most likely to widen in all securities thus increasing the cost of buying and selling.