How to spot and avoid illiquid ETFs

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.

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.