The newest instance got here from a dialogue I had with a buddy concerning the BMO S&P/TSX 60 Index ETF (ZIU). I had highlighted it as a lower-cost different to the iShares S&P/TSX 60 Index ETF (XIU), noting that it expenses a 0.15% administration expense ratio (MER) versus 0.18% for its competitor.
Since each observe the identical underlying index and maintain the identical publicity, the cheaper possibility appeared easy, proper?
The investor pointed to buying and selling quantity. On February 17, 2026, simply minutes earlier than market shut, ZIU had traded roughly 2,700 models that day. XIU, against this, had traded greater than 3 million shares. On the floor, that comparability makes XIU look much more liquid.
Illiquidity could be a real danger for ETF buyers. With thinly traded ETFs, market orders could execute at unfavourable costs, and even restrict orders could not fill rapidly or on the desired stage.
The issue is that day by day buying and selling quantity shouldn’t be what in the end determines ETF liquidity. In actual fact, it is without doubt one of the most misunderstood features of ETF investing. Not like particular person shares, ETFs have a singular construction that permits liquidity to increase past what you see buying and selling on the display screen.
Right here’s an evidence of how ETF liquidity really works behind the scenes, what actually issues if you end up putting a commerce, and the actual dangers, if any, of proudly owning a lower-volume ETF.
What really determines ETF liquidity?
My buddy was not solely incorrect. Buying and selling quantity does matter. For many securities, particularly particular person shares, day by day quantity is the first indicator of liquidity. Greater quantity usually means tighter spreads and simpler execution.
With ETFs, nonetheless, buying and selling quantity is a secondary consideration. Crucial determinant of ETF liquidity is the liquidity of the underlying securities the ETF holds.
If you purchase or promote an ETF, you’re transacting on the market value. The true worth of the ETF, nonetheless, is measured by one thing referred to as web asset worth, or NAV. NAV is solely the entire worth of the ETF’s belongings minus its liabilities, divided by the variety of shares excellent.
The ETF’s market value doesn’t all the time equal its NAV. It could actually commerce at a small premium or low cost. What retains these two values aligned is a mechanism referred to as in-kind creation and redemption.
This course of includes specialised establishments referred to as approved members. These are sometimes massive monetary corporations or buying and selling homes which have formal agreements with the ETF issuer. (Whereas some approved members may act as market makers, the roles usually are not the identical. Market makers present steady bids and presents on the trade to facilitate day-to-day buying and selling. Licensed members function within the main market, the place ETF models are created or redeemed. Their perform is structural reasonably than transactional.)
If an ETF is buying and selling above its NAV as a result of demand is excessive, a certified participant can step in, purchase the underlying shares that make up the ETF, ship that basket to the ETF supplier, and obtain newly created ETF models in trade. These models can then be bought out there on the greater value. The arbitrage revenue could also be small, however it’s low-risk. On the identical time, the extra provide of ETF models pushes the market value again towards NAV.
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The reverse occurs when an ETF trades beneath its NAV. Licensed members can purchase ETF models out there, redeem them for the underlying securities, and promote these securities. That removes ETF provide from the market and pushes the value again up towards NAV.
Due to this fact, ETF liquidity in the end will depend on how effectively in-kind creation and redemption can happen on the again finish, and never on seen buying and selling quantity.
If the underlying securities are extremely liquid, comparable to the big Canadian shares of the S&P/TSX 60 index, approved members can simply assemble or unwind baskets. Meaning new ETF shares may be created or redeemed rapidly to satisfy demand, even when the ETF itself solely trades a couple of thousand share models on a given day.
In distinction, if an ETF holds illiquid belongings with restricted buying and selling exercise, the creation and redemption course of turns into extra pricey and fewer environment friendly. That’s when liquidity issues turn into significant.
