With the volatility in the stock market lately, the last thing you want is high fees cutting into your gains.
There’s one kind of “fee,” however, that doesn’t show up on your brokerage statement. It’s the “spread” — the difference between the price you pay to buy a stock or exchange-traded fund and the amount you’d receive at the same time to sell it.
The graph below shows the average haircut for large and small stocks. The stocks with the lowest volume — the smallest companies in the Russell Microcap Index /zigman2/quotes/210598141/delayed XX:RMIC -1.98% — can cost you almost 8% if you purchase shares when the market opens and sell the same shares a moment later.
Unless you’re a high-frequency trader, your holding period is probably a lot longer than one second. But with an 8% spread, selling a small stock and buying another one nine times a year could eat up more than half of your invested capital — just from the spreads alone.
How might you lose 8% in each round trip? Let’s say you buy 100 shares of Microcap Company X for $100 each, which is the “ask price.” Even if the stock’s headline price is unchanged when you sell the shares — whenever that may be — the “bid price” you receive could be only $92 per share.
Who decides this? A class of institutions known as “market makers.”
Market makers are brokerage firms and other financial players. They buy and sell stocks and ETFs all day long. They’ll usually handle your trade, even if no other party is willing to take the opposite side at that exact moment.
Market makers aren’t evil — they’re an essential “lubricant” if you want your trades to be filled quickly. The bid-ask spread is the percentage that market makers charge to offset their risk. After all, a market maker that buys a security might lose money if the share price moves the wrong way before the position is handed off.
The problem is that most investors don’t realize how much the spread costs them. No matter what stocks or ETFs you buy today, you or your heirs will want to sell the shares eventually. That’s when a high bid-ask spread can be an unpleasant surprise.
A new study shows that the spreads on microcap stocks can be 100 times the spreads market markers charge for the most liquid ETFs and stocks. Hugh Todd, the CEO of ETFScreen.com , a free service that backtests ETFs, recorded the spreads for different stocks and ETFs at my request.
Todd (with support from Web developer John W. Gelm) preserved bid and ask prices every five minutes for two weeks, using Xignite data from Dec. 10 through 21. The graph above shows the average of every 15-minute period. (Disclosure: ETFScreen also provides financial analysis to MuscularPortfolios.com , a website I manage.)
The differences in spreads can be shocking. Here’s the amount you can lose every time you buy and sell a stock or an ETF:
• The largest companies in the S&P 500 /zigman2/quotes/210599714/realtime SPX -1.89% , of course, are names you know. Mega-corporations from Apple /zigman2/quotes/202934861/composite AAPL -1.28% to Visa /zigman2/quotes/203660239/composite V -3.93% are in the top 10, with market capitalizations over $300 billion or so. Being household words, these giant companies trade for tiny spreads. On the average, you’ll lose only 0.07% if you trade first thing in the morning (7 cents per $100) or 0.02% near the close.
• The smallest companies in the S&P 500, of course, are still big names. For example, Urban Outfitters /zigman2/quotes/208403734/composite URBN -0.15% , with a market cap under $4 billion, and Frontier Communications , at about $370 million, count among the smallest 10 companies. They would cost you a bit more than the top names: 0.41% in the morning or 0.12% late in the day.