Understanding ETF Costs and Trading Strategies

Investors have increasingly turned to funds traded on aggressive exchanges, often focusing on the fees that, while they might initially seem lower than those of the cheapest mutual funds, don’t tell the whole story. The expense ratio is just one part of the equation. Ownership costs also include trading fees, such as the bid-ask spreads.

To break it down, spreads are the difference between what the buyer pays and what the seller receives. Mutual fund investors don’t deal with this directly since they trade once daily at a net asset value. In contrast, ETF investors incur this spread every time they execute a trade. Frequent traders might absorb these costs, but for long-term holders, narrow spreads are generally better.

What Spreads Represent

Spreads can be seen as the cost of liquidity. Market makers act as intermediaries between buyers and sellers, providing quotes and holding inventory, which allows them to stay prepared for transactions. A spread compensates for several factors:

• Inventory risk: Holding an ETF or its assets means market makers are exposed to price changes. More volatile or less liquid assets lead to greater risk and wider spreads.
• Basket trading costs: Creating or redeeming ETF shares involves buying and selling the underlying assets, which incurs brokerage fees and operational costs reflected in the ETF’s spread.
• Profit margin: Naturally, market makers aim to earn more than they spend.

The Impact of Market Conditions on Spreads

The ease or difficulty of assembling baskets varies significantly; for example, widely traded US stocks or Treasury securities are relatively cheap to assemble, while more obscure assets like microcap stocks or specialized bonds can be much pricier. This variability explains why, as of September 19, 2025, the median spread for US large-cap Active ETFs was 0.12%, compared to 0.20% for small-cap Active ETFs.

ETFs that are frequently traded often do so at lower costs. Higher trading volume attracts market makers, who seize the opportunity for quick turnover, thus minimizing risk. Increased trading activity sharpens competition, which can lead to tighter spreads.

When Spreads Widen

Spreads tend to tighten in calm markets but can widen during periods of volatility. Key events like economic reports or geopolitical developments can trigger this. Inventory risk becomes more significant when market fluctuations spike, which can negatively impact prices. For instance, a drop in the S&P 500 by 10% in early April 2025 due to newly imposed tariffs resulted in spreads for large-cap active ETFs jumping to about 0.35%.

Widened spreads typically occur during market openings and closings when information may be lacking, causing market makers to adjust the spread for safety. Similarly, when trading ETFs with foreign equities, spreads can widen when the respective foreign markets are closed, leaving market makers to rely on older price data.

Smart Trading Practices

1) Check the Spread: Before buying an active ETF, compare its bid spread to that of its peers. Most ETF websites provide this information under sections like “Fund Details” or “Price.”

2) Use Limit Orders: Setting limit orders allows you to control what you pay and can shield you from paying an unfavorable spread.

3) Time Your Trades: Avoid the first and last 30 minutes of trading; this is when spreads can be most unpredictable.

4) Be Aware of Foreign Market Hours: If trading international ETFs, keep an eye on foreign market closures to avoid wider spreads.

5) Favor Sponsors with Strong Market Presence: The issuers’ reliability impacts the quality of the transaction. Companies with a good track record in your category likely have effective market maker relationships.

Conclusion

While active ETFs often have lower fees than mutual funds, all-in costs, including trading friction, remain relevant. Understanding spreads can improve your investment strategy. Prioritize ETFs with solid holdings and attentive management. Adopt smart trading habits, as these can enhance your long-term portfolio performance. For deeper insights into selecting effective funds, consider checking out guides on active ETF due diligence.