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Estimating Index Transaction Costs from Component or Futures Spreads

Article Quant Q&A · Author: Michael Bergstrom
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Summary

This note asks how to estimate implicit transaction costs for a newly launched portfolio under an approach that uses average bid–ask spreads for reference indexes. The author points out that broad indexes such as the S&P 500 or FTSE 100 are calculated benchmarks rather than directly traded instruments, and therefore do not have their own executable bid and ask quotes. An exchange-traded fund is considered as a possible proxy.

The response says an index spread cannot be observed directly and offers two alternatives: use a related futures contract as a proxy, or estimate the spread from a weighted average of the bid–ask spreads of the index constituents. It characterizes the constituent-weighted approach as more accurate, while noting that futures can track the index through a lead–lag relationship. The short exchange gives no calculation details, assumptions, or comparison data, so the appropriate proxy would still depend on the index and the cost-estimation context.

Key ideas

  • A calculated index does not have a directly observable bid–ask spread.
  • An index futures contract can serve as a spread proxy because it tracks the underlying index.
  • A weighted average of constituent bid–ask spreads is offered as a more accurate estimate.
  • The note frames proxy selection in the context of estimating portfolio transaction costs.
  • No numerical procedure or empirical comparison of the alternatives is provided.

Tags

ExecutionMarket microstructureEquities
Full text
# How to calculate bid/ask spread for an index?


# How to calculate bid/ask spread for an index?












I am trying to calculate implicit transaction costs for a newly launched portfolio, as per the definition from ESMA: "transaction costs may be calculated either by multiplying an estimate of portfolio turnover in each asset class with the costs calculated according to the methodology referred to in point (c)"

Point C is effectively describing how to get estimated transaction costs using bid/ask spread. Here is the point in question: "To estimate the cost, one or more reference indexes shall be identified for each asset class. Then, the average bid-ask spreads of the underlying indexes shall be collected."

I interpret this to mean that you should select an appropriate benchmark for your fund, and calculate that benchmark's bid/ask spread. So for example, if I was launching an S&P500 fund, I would use the S&P 500.

My issue is that as far as I understand, one cannot calculate bid/ask spread for an index (i.e. S&P 500, FTSE 100, etc). Is this understanding correct? And if so, any advice on how to proceed? I was thinking of trying to find an appropriate reference ETF. Or, alternatively, just writing a letter of complaint to the ESMA authority.

Thanks!

## Answer by Phantom (score 1, accepted)

https://quant.stackexchange.com/a/60411

You can't get Bid/Ask for an index. To get a proxy for this, either use a futures instrument (that generally has a lead-lag relation with the index, but replicates the index) on that index or use a weighted average of all the components' Bid/Ask (would be the more accurate way).

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.