spot and keep away from illiquid ETFs

The newest instance got here from a dialogue I had with a good friend in regards to 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 prices 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, in contrast, had traded greater than 3 million shares. On the floor, that comparability makes XIU look much more liquid.

Illiquidity is usually a real threat for ETF traders. With thinly traded ETFs, market orders might execute at unfavourable costs, and even restrict orders might not fill shortly or on the desired degree.

The issue is that day by day buying and selling quantity shouldn’t be what in the end determines ETF liquidity. Actually, it is likely one of the most misunderstood points 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 screen.

Right here’s a proof of how ETF liquidity truly works behind the scenes, what really issues if you end up inserting a commerce, and the actual dangers, if any, of proudly owning a lower-volume ETF.

What truly determines ETF liquidity?

My good friend was not completely unsuitable. 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 typically means tighter spreads and simpler execution.

With ETFs, nevertheless, buying and selling quantity is a secondary consideration. A very powerful determinant of ETF liquidity is the liquidity of the underlying securities the ETF holds.

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While you purchase or promote an ETF, you might be transacting on the market value. The true worth of the ETF, nevertheless, is measured by one thing referred to as web asset worth, or NAV. NAV is just the whole worth of the ETF’s property minus its liabilities, divided by the variety of shares excellent.

The ETF’s market value doesn’t all the time equal its NAV. It may well 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 entails specialised establishments referred to as approved individuals. These are sometimes giant monetary companies or buying and selling homes which have formal agreements with the ETF issuer. (Whereas some approved individuals may act as market makers, the roles are usually not the identical. Market makers present steady bids and affords on the trade to facilitate day-to-day buying and selling. Licensed individuals function within the major market, the place ETF models are created or redeemed. Their perform is structural moderately 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 models in trade. These models can then be offered 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.

The reverse occurs when an ETF trades beneath its NAV. Licensed individuals should 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.

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, resembling the massive Canadian shares of the S&P/TSX 60 index, approved individuals can simply assemble or unwind baskets. Meaning new ETF shares may be created or redeemed shortly to fulfill 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 property with restricted buying and selling exercise, the creation and redemption course of turns into extra pricey and fewer environment friendly. That’s when liquidity considerations turn into significant.