Due to the recent volatility of the stock market, the last thing you want is high fees that reduce your earnings.
There is one type of "fee", however, that does not appear on your brokerage statement. This is the "spread" – the difference between the price you pay to buy a stock or exchange-traded fund and the amount you will receive at the same time to sell it.
The graph below shows the average cut for large and small stocks. Stocks with the lowest volume – the smallest companies in the Russell Microcap Index
– can cost you close to 8% if you buy shares at the opening of the market and you sell the same shares a moment later.
Unless you are an operator on high frequencies, your holding period is probably much longer than a second. But with a spread of 8%, selling a small stock and buying one nine times a year could absorb more than half of your invested capital – just by spreads.
How could you lose 8% each way? Suppose you buy 100 shares of Microcap Company X for $ 100 each, the "ask price". Even if the reference price of the stock is unchanged when you sell the shares – if any -, the "bid price" you receive may be only $ 92 per share.
Who decides that? A class of institutions known as "market makers".
Market Makers are brokerage firms and other financial actors. They buy and sell stocks and ETFs all day long. They will usually take care of your transaction, even if no other party is ready to take the opposite direction at this time.
Market makers are not bad – they are an essential "lubricant" if you want your trades to be processed quickly. The buyer-seller spread is the percentage that market managers charge to offset their risk. After all, a market maker who buys a security may lose money if the price of the action fluctuates in the wrong direction before the position is transferred.
The problem is that most investors do not realize the cost of the spread. No matter what stocks or ETFs you buy today, you or your heirs will eventually want to sell the shares. It is at this point that a high sales-demand gap can be a bad surprise.
A new study shows that microcaps-style spreads can be 100 times higher than market markers for ETFs and more liquid stocks. Hugh Todd, President and CEO of ETFScreen.com, a free backtest service on ETFs, recorded spreads for different securities and ETFs at my request.
Todd (with the support of web developer John W. Gelm) kept bid and ask prices every five minutes for two weeks, using Xignite data from December 10-21. The graph above shows the average of each 15-minute period. (Disclosure: ETFScreen also provides a financial analysis to MuscularPortfolios.com, a website that I manage.)
Spread differences can be shocking. Here is the amount you can lose each time you buy and sell a stock or ETF:
• The largest companies in the S & P 500
SPX, + 0.45%
Of course, these are names you know. Mega-corporations of Apple
AAPL, + 0.32%
V, + 0.19%
are in the top 10 with a market capitalization of over $ 300 billion. Being familiar words, these giant companies are trading tiny spreads. On average, you will only lose 0.07% if you trade early in the morning (7 cents per $ 100) or 0.02% at closing.
• The smaller companies in the S & P 500, of course, are still big names. For example, Urban Outfitters
with a market capitalization of less than $ 4 billion and Frontier Communications
at approximately $ 370 million, being one of the 10 smallest companies. They would cost you a little more than the big names: 0.41% in the morning or 0.12% at the end of the day.
• the Russell 2000
RUT, + 0.46%
is generally regarded as the index of "small capitalization" American. Smallest Russell 2000 Shares in ETFScreen Study Include Remark Holdings
MARK, + 3.21%
with a market capitalization of approximately $ 46 million, up to Vital Therapies
only $ 7 million. You can see in the chart how much the spreads have jumped: an average of 2.67% in the morning and 1.12% near the close of the market.
• The real story is the Russell Microcap Index. This group includes companies that trade so little that they can not even qualify as "small caps". You can be forgiven if you do not recognize the smallest names: companies like Rosehill Resources and Boxlight Corp.
Some companies in the Microcap Index may actually have market values above some of the components of Russell 2000. But the trading volume of the microcap is small. For example, Rosehill Resources'
the average daily volume is less than $ 1 million. In comparison, more than $ 2.6 million of the shares of the Russell 2000 Vital Therapies Association are changing hands daily.
There is nothing wrong with being small. However, the spreads can be enormous: the smallest values of the Microcap index allow you to reach an average of 7.89% close to the open market and a still very high value of 3.26% by the end of the day.
Worst of all, these averages hide variations that you could drive through a truck. In the ETFScreen study, some individual microcapsules displayed astounding differences of more than 14% at opening and 6% at closing.
Costs like these can make you want to stick your money under a mattress. At least no one charges you spread when you store your money. (However, you may need to lift a bedspread.)
• The popularity of index funds is partly due to their low costs. Some ETFs currently offer annual fees as low as 0.03%. The ETFScreen study now reveals that widely used ETFs also have lower bid / ask spreads than many S & P 500 companies. The average spreads of popular ETFs are very reasonable, close to 0.08% close to the market and 0.04% close to the end of the day. .
Problem: There are too many ETFs to watch – more than 2,000 in the United States alone. For example, the ETFScreen study focused on 19 ETFs recommended under "Muscle Portfolios". (Disclosure: I am the author of the book.)
If you are an individual investor, you can take advantage of the ETFScreen study with some simple rules:
• Look for bid and ask prices every time you buy or sell a security. Some prices you see on your online brokerage site may be "median prices", which are halfway between supply and demand. But remember, you do not get the average price, but the bid or ask price when you sell or buy a stock. If the gap is 3% or more, ask yourself if such a slowdown in your earnings could make your trading strategy unprofitable.
• Do not place market orders when the market is closed. Market makers can charge and charge huge spreads if more "sales" than "buy" orders (or the reverse) have been received before the market opens. That's why spreads are so high in the first 60 minutes of the market day. Some traders place limited orders, which specify acceptable prices. But many limited orders are never filled. If this happens to you and you are constantly changing a limit order to pursue a price, you may find yourself worse off than if you had used a market order at the outset.
• Pay attention to exchanges after hours. The ETFScreen study did not follow the spreads offered more than 15 minutes before and after normal market hours. But massive spreads affect certain values before 9:30 and after 16:00. AND.
• Consider buying ETFs rather than small stocks. All stocks in the Russell Microcap Index can be purchased using, for example, iShares IWC software.
CBI, + 0.12%
exchange-traded funds. The average gap of IWC is 0.58% in the morning and 0.32% at the fence, which is expensive but not ridiculous. Better yet, investors who follow the Lazy and Muscle portfolios can rely solely on very liquid ETFs, with minimal spreads, and eliminate the risks inherent in individual stocks.
Beware, the average spreads of the study are based on odds for as few as 100 stocks. What if you go crazy and place a market order for 100,000 shares of a small business? A market maker can happily charge you an astronomical spread – far greater than what your computer screen can say. The purchase of a large amount of a popular ETF, on the other hand, is not as subject to price gouging.
Technical note: The ETFScreen study is not yet public. However, if you are interested in raw data, you can download a spreadsheet here.