How to spot and avoid illiquid ETFs
Today’s column addresses a persistent concern I continue to hear from readers: the liquidity of exchange-traded funds (ETFs) or, more specifically, the fear of owning an ETF that appears thinly traded.
The latest example came from a discussion I had with a friend about the BMO S&P/TSX 60 Index ETF (ZIU). I had highlighted it as a lower-cost alternative to the iShares S&P/TSX 60 Index ETF (XIU), noting that it charges a 0.15% management expense ratio (MER) versus 0.18% for its competitor.
Since both track the same underlying index and hold the same exposure, the cheaper option seemed straightforward, right?
The investor pointed to trading volume. On February 17, 2026, just minutes before market close, ZIU had traded roughly 2,700 units that day. XIU, by contrast, had traded more than 3 million shares. On the surface, that comparison makes XIU look far more liquid.
Illiquidity can be a genuine risk for ETF investors. With thinly traded ETFs, market orders may execute at unfavourable prices, and even limit orders may not fill quickly or at the desired level.
The problem is that daily trading volume is not what ultimately determines ETF liquidity. In fact, it is one of the most misunderstood aspects of ETF investing. Unlike individual stocks, ETFs have a unique structure that allows liquidity to extend beyond what you see trading on the screen.
Here’s an explanation of how ETF liquidity actually works behind the scenes, what truly matters when you are placing a trade, and the real risks, if any, of owning a lower-volume ETF.
What actually determines ETF liquidity?
My friend was not entirely wrong. Trading volume does matter. For most securities, especially individual stocks, daily volume is the primary indicator of liquidity. Higher volume generally means tighter spreads and easier execution.
With ETFs, however, trading volume is a secondary consideration. The most important determinant of ETF liquidity is the liquidity of the underlying securities the ETF holds.
When you buy or sell an ETF, you are transacting at the market price. The true value of the ETF, however, is measured by something called net asset value, or NAV. NAV is simply the total value of the ETF’s assets minus its liabilities, divided by the number of shares outstanding.
The ETF’s market price does not always equal its NAV. It can trade at a small premium or discount. What keeps those two values aligned is a mechanism called in-kind creation and redemption.
This process involves specialized institutions called authorized participants. These are typically large financial firms or trading houses that have formal agreements with the ETF issuer. (While some authorized participants may also act as market makers, the roles are not the same. Market makers provide continuous bids and offers on the exchange to facilitate day-to-day trading. Authorized participants operate in the primary market, where ETF units are created or redeemed. Their function is structural rather than transactional.)
If an ETF is trading above its NAV because demand is high, an authorized participant can step in, buy the underlying stocks that make up the ETF, deliver that basket to the ETF provider, and receive newly created ETF units in exchange. Those units can then be sold in the market at the higher price. The arbitrage profit may be small, but it is low-risk. At the same time, the additional supply of ETF units pushes the market price back toward NAV.
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The reverse happens when an ETF trades below its NAV. Authorized participants can buy ETF units in the market, redeem them for the underlying securities, and sell those securities. That removes ETF supply from the market and pushes the price back up toward NAV.
Therefore, ETF liquidity ultimately depends on how efficiently in-kind creation and redemption can occur on the back end, and not on visible trading volume.
If the underlying securities are highly liquid, such as the large Canadian stocks of the S&P/TSX 60 index, authorized participants can easily assemble or unwind baskets. That means new ETF shares can be created or redeemed quickly to meet demand, even if the ETF itself only trades a few thousand share units on a given day.
In contrast, if an ETF holds illiquid assets with limited trading activity, the creation and redemption process becomes more costly and less efficient. That is when liquidity concerns become meaningful.
So, while daily ETF trading volume does have some impact, it is not the primary driver of liquidity. The true foundation is the liquidity of the underlying holdings and the ability of authorized participants to create and redeem ETF shares efficiently.
How do I know if an ETF is liquid?
We have established that you cannot simply glance at daily trading volume and declare an ETF liquid or illiquid. The real mechanism sits behind the scenes. So how can a retail investor assess liquidity in a practical way without digging into institutional plumbing?
Think like an analyst and look at what the ETF actually owns. Liquidity ultimately flows from the underlying basket. While there are exceptions, certain asset types tend to be more liquid than others.
For example, stocks that trade on major exchanges such as the New York Stock Exchange, NASDAQ, and Toronto Stock Exchange generally have deep, active markets. Liquidity typically improves as market capitalization increases and as companies are included in major indices. Thus, ETFs tracking benchmarks such as the S&P 500, NASDAQ 100, or S&P/TSX 60 rarely face structural liquidity concerns.
As you move down the market-capitalization spectrum into small caps, liquidity can deteriorate. The same applies to international equities, especially in emerging markets. If those securities are not available as American Depositary Receipts or Canadian Depositary Receipts, accessibility and liquidity can be further reduced.
Bond ETFs require a bit more nuance. Government bonds issued in Canada or the United States are generally among the most liquid fixed-income instruments in the world. There is a large institutional market supporting them; however, all bonds trade over the counter rather than on centralized exchanges. That means pricing is dealer-based and less transparent than equities.
As you move into corporate bonds, liquidity becomes more fragmented. Investment-grade corporate bonds rated BBB and above tend to be more liquid than junk bonds. Once you move into specialized credit products such as collateralized loan obligations, or CLOs, liquidity can thin out significantly.
This approach requires more effort, but it gives you the clearest answer. If the underlying securities trade easily in large volumes, the ETF built on top of them is likely to be liquid as well.
The potential hazards of owning an illiquid ETF
If you determine that an ETF is less liquid, how does that actually affect you? In most cases, the impact shows up in the bid-ask spread.
The bid price is the highest price a buyer is currently willing to pay for the ETF. The ask price is the lowest price a seller is willing to accept. The difference between those two numbers is called the spread. It can be expressed in absolute dollar terms or as a percentage of the ETF’s price.
The spread matters because it represents an implicit transaction cost. It is separate from the MER. When you buy an ETF, you typically transact at or near the ask price. When you sell, you transact at or near the bid. That gap between the two is a cost you absorb, just like a commission.
For long-term investors who rarely trade, the impact may be small. For shorter-term traders, or those moving in and out of positions, a wider spread can materially drag on returns. Narrower spreads are generally better, and they tend to occur in more liquid ETFs.
The best ETFs in Canada
Returning to our earlier example, consider XIU versus ZIU. On February 17, nine minutes before market close, XIU had a bid price of $48.38 and an ask price of $48.39. That is a one-cent spread. Relative to the price, that works out to roughly 0.02%.
ZIU, despite trading only a few thousand shares that day compared to XIU’s millions, showed a bid of $73.68 and an ask of $73.72. That four-cent spread equates to roughly 0.05%.
Both spreads are tight. Even though daily trading volume differed dramatically, the actual cost to enter or exit either ETF was minimal. The reason is simple. Both hold the same basket of highly liquid Canadian blue-chip stocks. Authorized participants can easily create or redeem units, keeping spreads narrow.
Now compare that with a more specialized ETF such as the CIICBC UBS S&P China 500 Index ETF (CHNA.B), which also trades on the TSX. This fund holds 500 Chinese companies, including mainland A-shares that are more difficult to access directly for foreigners.
At the same time of day, CHNA.B showed a bid of $29.21 and an ask of $29.31. That 10-cent spread translates to roughly 0.34%. That is meaningfully wider than the spreads observed for the TSX 60 ETFs.
The difference reflects the underlying holdings. Mainland-listed A-shares and certain offshore listings do not trade with the same depth or transparency as large-cap Canadian equities. As a result, the creation and redemption process is more complex, and market makers demand a wider cushion.
The key takeaway is that volume alone does not determine liquidity risk. The spread is what directly affects your returns. If spreads are consistently wide, especially during normal market conditions, that is a signal to proceed carefully and add it to your total cost of owning said ETF.
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Read more about investing with ETFs:
- Why Vanguard’s ETF aimed at retirees is currently cautious in its asset allocation
- How often should you rebalance?
- The MoneySense ETF Screener
- Can you hedge against a market crash with ETFs?
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