ASIC warns on wide spreads on some ETPs

ASIC’s recent Review of Exchange Traded Products found that Australia’s ETP trading is generally liquid, bid-ask spreads for ETPs are generally narrow so investors are generally buying and selling at prices close to the value of the ETP unit. However, ASIC warned that this does not necessarily apply to all products, at all times. In particular, ASIC observed that spreads do temporarily widen in some circumstances, meaning individual transactions may involve a higher spread than an investor may consider desirable.

The difficulty for investors is knowing what to look out for and why this is important. We set that out here.

The impact of spreads

To consider the impact of higher or lower spreads on investors, let’s start at the beginning. When a share or ‘unit’ in an ETP is bought or sold on market there is a spread between the ‘bid’ price (price at which people are wanting to buy) and the ‘ask’ price (price at which people are willing to sell. ASIC refers to the ‘ask’ price as the ‘offer’ price throughout its report. The bid-ask or bid-offer spread is the difference between these prices. These bid-ask spreads along with the broker’s cost are the ETP investor’s transaction costs. Spreads are important to ETP investors as they impact the investor’s overall return in the same way management costs do.

Or as ASIC said: “Spreads are important to ETP investors as they are, effectively, a hidden cost that reduces an investor’s return.”

According to ASIC’s report, bid-offer spreads for ETPs are generally narrow so investors are generally buying and selling at prices close to the fair value of the ETP unit.

However, ASIC warned that this does not necessarily apply to all products, at all times. In particular, ASIC observed that spreads do temporarily widen in some circumstances.

“The ETP spreads generally reflect the liquidity of the underlying assets so that ETPs holding less liquid assets, such as bonds or emerging market shares, usually have higher spreads. Spreads may also be higher for a new fund until it becomes more established,” ASIC said.

ASIC found that both the number of individual market makers and greater relative share of market turnover are associated with tighter spreads. This points to the role of competition as a driver for smaller or ‘tighter’ spreads. Before trading investors should investigate the bid-ask spread on any ETP in which they are considering an investment by reviewing both the bid price and the ask price and assessing the difference between the two.

ETP spreads less than unlisted funds

“We found from empirical evidence that, most of the time, market spreads for quoted ETPs are not excessive. Across all ETPs, as expressed on an effective turnover-weighted basis, ETPs are quoted on a spread of nine basis points or less, approximately 50% of the time,” ASIC report said.

“By comparison, buy–sell spreads on unlisted funds vary, but will typically range from approximately 0 to 50 basis points, depending on the investment strategy and asset classes held,” ASIC said.

“We found that ETPs over Australian equity securities are quoted with the tightest spreads—at six basis points or less, around 50% of the time. ETPs over global products tend to have spreads that are approximately three times as wide—at 20 basis points or less, around 50% of the time.”

Active ETFs also have much higher spreads

However, not all products are created equal and this is true of ETPs.

As the industry has grown, the range of ETPs has increased from simple index-tracking ETFs (exchange traded funds) to complex managed funds to now so-called ‘Active ETFs’ which allow investors to access the capabilities of active investment managers on ASX.

ASIC found that Active ETFs are more likely to have higher spreads than ETFs which track an index. In addition, Active ETFs do not to track an index and they are not required to publish their full holdings at any time, so investors never know, at any time, what stocks or how much cash is being held in the fund.

By contrast, ETFs which track an underlying index and provide full transparency to all of its underlying holdings on a daily basis have spreads that are generally narrower than Active ETFs.

The ETP issuer is also important to consider as larger global ETP providers have better relationships with market makers providing better liquidity. This is a challenge for Active ETFs where the fund is also the market maker. ASIC's report rightly highlights that in addition to liquidity constraints, internal market making also leads to additional fees that investors need to be aware of.

What it all means

Differences in spreads and market maker arrangements impact investors’ fees and costs and may significantly affect investors’ returns, therefore it is important that investors understand the size of the spread and any market making fees paid by the fund and the potential impact on their return when buying and selling ETPs, and indeed any fund, including unlisted managed funds.

Given the current scandals in financial services it is heartening that there is at least one set of products that investors can trust because of their transparency and low cost – index tracking ETFs.

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