The most up-to-date example comes from a discussion I had with a friend concerning the BMO S&P/TSX 60 Index ETF (ZIU). I highlighted it as a lower-cost alternative to the iShares S&P/TSX 60 Index ETF (XIU), noting that it charges a management expense ratio (MER) of 0.15% versus its competitor’s 0.18%.
Since they each track the identical underlying index and hold the identical exposure, the cheaper option just appeared like it, right?
The investor referred to the trading volume. On February 17, 2026, just minutes before the market closed, ZIU had traded around 2,700 units that day. XIU, then again, had traded greater than 3 million shares. On the surface, this comparison makes XIU appear way more liquid.
Illiquidity can pose an actual risk for ETF investors. For calmly traded ETFs, market orders could also be filled at unfavorable prices and even limit orders will not be filled quickly or to the specified extent.
The problem is that every day trading volume doesn’t ultimately determine ETF liquidity. In fact, it’s one of the misunderstood elements of ETF investing. Unlike individual stocks, ETFs have a novel structure that permits liquidity to increase beyond what you see on the screen.
Here’s a proof of how ETF liquidity actually works behind the scenes, what really matters when placing a trade, and what, if any, actual risks include owning a lower volume ETF.
What actually determines ETF liquidity?
My friend had a degree. Trading volume plays a job. For most securities, especially individual stocks, every day volume is the first indicator of liquidity. Higher volume generally means tighter spreads and easier execution.
However, with ETFs, trading volume is secondary. The primary determinant of ETF liquidity is the liquidity of the underlying securities the ETF holds.
The article continues below promoting
X
When you purchase or sell an ETF, you trade on the market price. However, the true value of the ETF is measured by what’s referred to as its net asset value, or NAV. NAV is solely the overall value of the ETF’s assets minus its liabilities, divided by the variety of shares outstanding.
The market price of the ETF doesn’t at all times correspond to its net asset value. It can trade at a small premium or discount. What brings these two values into harmony is a mechanism called creation and redemption in kind.
This process involves specialized institutions called authorized participants. These are often large financial corporations or trading houses which have formal agreements with the ETF issuer. (While some Authorized Participants may additionally act as market makers, the roles should not the identical. Market Makers continually provide bids and offers on the exchange to facilitate every day trading. Authorized Participants operate in the first market where ETF shares are created or redeemed. Their function is structural quite than transactional.)
If an ETF is trading above its net asset value because of high demand, a licensed participant can step in, purchase the underlying stocks that make up the ETF, deliver that basket to the ETF provider, and receive newly created ETF shares in exchange. These units can then be sold available on the market at a better price. The arbitrage profit could also be small, but the chance is low. At the identical time, the extra supply of ETF shares pushes the market price back towards NAV.
TFSA contribution room calculator
Find out how much you possibly can contribute to your TFSA today with our calculator.
The opposite happens when an ETF trades below its net asset value. Authorized Participants may purchase ETF shares available on the market, exchange them for the underlying securities and sell those securities. This removes the ETF supply from the market and the worth rises back towards the web asset value.
Therefore, ETF liquidity ultimately is dependent upon how efficiently the creation and redemption of in-kind assets can occur on the backend, quite than on visible trading volume.
When the underlying securities are highly liquid, reminiscent of the foremost Canadian stocks of the S&P/TSX 60 Index, authorized participants can easily make or break baskets. This implies that recent ETF shares may be created or redeemed quickly to satisfy demand, even when the ETF itself only trades a couple of thousand share units on a given day.
On the opposite hand, if an ETF holds illiquid assets with limited trading activity, the creation and redemption process becomes dearer and fewer efficient. Then liquidity concerns turn out to be significant.
