Look out for bid-ask spreads

Shared costs

With mutual funds, investors buy and resell their units at net asset value (NAV). This price is reported each day after the markets close.

“For this reason, many people think they don’t bear the costs of the bid-ask spread, which is an illusion,” says Daniel Straus, vice president of ETFs and financial products research at Montreal-based National Bank Financial.

Frédéric Viger, managing director, ETF and options – sales at National Bank Financial Markets, agrees. “Every day, when new units are created or redemptions occur, the fund manager has to buy and sell the fund’s underlying securities and pay the bid-offer spread, along with the transaction costs [commissions]. These costs are shared daily by all unitholders,” he says. That’s the case even though some unitholders keep their funds over a longer horizon than others.

For ETFs, the bid-ask spread is a one-time cost that applies when the ETF is bought or resold. Further, since an ETF is publicly listed, investors can control the bid-ask spreads of the funds they trade, such as by using limit orders. “ETF Facts” documents also detail an ETF’s average bid-ask spread as a percentage for transactions with a notional value of $50,000 or more in the past 12 months.

The ETF’s NAV is not affected by investors entering and leaving the fund. “The cost associated with investor inflows and outflows is externalized. A mutual fund is different because all unitholders bear the costs associated with a fund manager’s activities, like buying and selling securities using cash,”  Straus says.

On the mutual fund side, the costs of the bid-ask spread borne by mutual fund holders have little to do with investors entering and leaving the fund, says James Gauthier, head of fund research at Quebec City-based iA Securities. “Above all, we need to understand the universe we’re investing in. Some asset classes, such as very small caps, are much less liquid, which may result in higher spreads,” Gauthier says.

Portfolio managers can often “neutralize” same-day purchases and sales by matching them to minimize transaction costs, he adds. “Frictional costs such as spreads can be generated at certain times, during waves of fund unit purchases or redemptions. This can be a challenge for the manager,” Gauthier says.

Furthermore, unlike broker commissions incurred when portfolios buy and sell securities—which are disclosed in the trading expense ratio section—the costs related to the bid-ask spread don’t appear anywhere.

“While these fees directly reduce the mutual fund’s performance, they’re not accounted for. To do this, we’d need to detail the transactions, one by one, which is not easy,” Straus says.

So, what’s the cost?

How much does the bid-ask spread cost investors each year? Straus agreed to take a closer look for our sister publication, Finance et Investissement.

“From our database of over 1,000 mutual funds, we tried to extract the most relevant funds based on assets under management, the asset classes represented and the type of management mandate to calculate the bid-ask spreads for all underlying securities,” Straus says. His research team analyzed about 20 equity mutual funds.

Producing a spread estimate meant making assumptions. His team multiplied the weighted average bid-ask spread (a snapshot of underlying share prices at the end of April 2019) by the portfolio’s turnover rate. The turnover rate was extracted from each fund’s 2018 year-end Management Report of Fund Performance.

“For large-cap mutual funds in Canada and the U.S., the costs associated with bid-ask spreads were very low and ranged from 4 to 10 [basis points] per year. This was also the case for diversified funds with liquid securities and low asset turnover rates,” Straus notes.

For funds with smaller-cap names, a sector focus or with really high turnover, costs ranged from 20 to 50 basis points annually. “There is such a thing as an illiquidity premium in the world of investing,” Straus adds. “Asset classes like small-caps, emerging markets and small niche sectors may indeed provide extra return that’s over and above these annual costs, because — theoretically at least — investors should be rewarded for bearing illiquidity risk in the long term.”

Straus acknowledges that the cost estimates have limitations. “Sometimes a high asset turnover results mainly from the highly liquid section of the portfolio where spreads are lower, while low-liquidity securities are rarely replaced. Similarly, some managers use market-close prices to group and set off purchases and sales of the same security,” he says.

Note that these estimates do not account exclusively for bid-ask spreads on investors’ new unit purchases or sales; they also include the manager’s trades.

A bona fide cost?

Considering Straus’s analysis, is the bid-ask spread an actual cost? Not according to the Investment Funds Institute of Canada (IFIC). “This spread is not a cost, but rather a market indication of the price buyers are willing to pay to buy a security or the price they’re willing to sell it at,” says Minal Upadhyaya, vice president, policy and general counsel at IFIC.

“Investors don’t actually pay a bid-ask spread, but instead get an exercise price that will depend on a number of factors, including trader execution,” she adds. Brokers have an obligation to obtain best execution, Upadhyaya says.

As mentioned, managers often match purchases and sales in their funds to neutralize them. And if they have a certain cash level, they can avoid selling securities under pressure.

“Some managers keep a percentage of assets in cash — let’s say 2% — so they don’t have to trade the fund’s underlying securities,” Viger says. But, he adds, a cash allocation that is too high can lead to benchmark tracking errors.