The most recent instance got here from a dialogue I had with a pal 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 fees a 0.15% administration expense ratio (MER) versus 0.18% for its competitor.
Since each monitor the identical underlying index and maintain the identical publicity, the cheaper choice 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 items that day. XIU, in contrast, had traded greater than 3 million shares. On the floor, that comparability makes XIU look way more liquid.
Illiquidity could be a real threat for ETF traders. With thinly traded ETFs, market orders might execute at unfavourable costs, and even restrict orders might not fill rapidly or on the desired stage.
The issue is that every day buying and selling quantity isn’t what in the end determines ETF liquidity. In reality, it is without doubt one of the most misunderstood elements of ETF investing. In contrast to particular person shares, ETFs have a singular construction that enables liquidity to increase past what you see buying and selling on the display.
Right here’s a proof of how ETF liquidity truly works behind the scenes, what actually issues if you find yourself inserting a commerce, and the true dangers, if any, of proudly owning a lower-volume ETF.
What truly determines ETF liquidity?
My pal was not fully unsuitable. Buying and selling quantity does matter. For many securities, particularly particular person shares, every day quantity is the first indicator of liquidity. Greater quantity usually means tighter spreads and simpler execution.
With ETFs, nevertheless, buying and selling quantity is a secondary consideration. An important determinant of ETF liquidity is the liquidity of the underlying securities the ETF holds.
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Whenever you purchase or promote an ETF, you’re transacting on the market worth. The true worth of the ETF, nevertheless, is measured by one thing referred to as web asset worth, or NAV. NAV is solely the full worth of the ETF’s belongings minus its liabilities, divided by the variety of shares excellent.
The ETF’s market worth doesn’t all the time equal its NAV. It will possibly 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 licensed contributors. These are usually massive monetary companies or buying and selling homes which have formal agreements with the ETF issuer. (Whereas some licensed contributors might also act as market makers, the roles will not be the identical. Market makers present steady bids and provides on the change to facilitate day-to-day buying and selling. Approved contributors function within the main market, the place ETF items are created or redeemed. Their operate is structural reasonably than transactional.)
If an ETF is buying and selling above its NAV as a result of demand is excessive, a licensed 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 items in change. These items can then be offered out there on the larger worth. The arbitrage revenue could also be small, however it’s low-risk. On the identical time, the extra provide of ETF items pushes the market worth again towards NAV.
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The reverse occurs when an ETF trades beneath its NAV. Approved contributors should purchase ETF items 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.
Subsequently, ETF liquidity in the end is dependent upon 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, equivalent to the big Canadian shares of the S&P/TSX 60 index, licensed contributors can simply assemble or unwind baskets. Which means new ETF shares might be created or redeemed rapidly to satisfy demand, even when the ETF itself solely trades a number of thousand share items 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 expensive and fewer environment friendly. That’s when liquidity issues grow to be significant.
