The True Liquidity of ETFs

BMO EXCHANGE TRADED FUNDS

T
he traded volume of an ETF has little effect on its on both the bid and ask side, at a price which reflects the
liquidity. While the liquidity of an individual security is spread of the underlying securities.
directly related to the traded volume of that security,
the same correlation does not apply to ETFs.
The Liquidity of the BMO Aggregate Bond
Instead, the liquidity of an ETF is best measured by the
Index ETF (ZAG)
underlying securities which it holds. If the individual
securities that compose the ETF have a high traded volume, The following chart illustrates the depth of liquidity
and are therefore very liquid, then the ETF that holds them of ZAG. A large $80 million trade was placed on ZAG
will have the same degree of liquidity. Similarly, if the effectively increasing the ETF’s size by 50%. Despite
underlying securities of the ETF have a low traded volume, the large trade size, there was no impact on the
or are illiquid, the ETF will have a low degree of liquidity trade’s execution price.
as well. BMO ETFs have been constructed to have liquid Large Trade on ZAG
LARGE TRADE ON ZAG
portfolios by establishing traded volume requirements for
16.00
each security held within the portfolios. 6, 000,000

15.95
An ETF’s underlying liquidity can be seen by observing the 5, 000,000

15.90
difference between the buying price and the selling price, 4, 000,000
15.85
or the “bid-ask spread.” A tighter bid-ask spread on an ETF
generally indicates that the underlying securities also have 15.80 3, 000,000

tight bid-ask spreads and are therefore also more liquid. 15.75
2, 000,000
In this way, even an ETF with low traded volume is liquid 15.70

if its bid-ask spread is tight. Again, if the securities that 15.65

1, 000,000

make up the ETF are liquid, so is the ETF itself. 15.60

30 31 4 5 0 3 0 9 9 0 9 8 9 9
9: 9: :0 :0 :3 :0 :2 :5 :0 :1 :3 :5 :5 :5
10 10 10 11 11 11 12 12 12 14 14 15

How does the ETF liquidity Shares Price Bid Nav Ask Nav

mechanism work?
First level of liquidity – On the exchange
The interaction between buyers and sellers creates the
first level of liquidity for an ETF. This natural liquidity
is established when a sell order from an existing unit
holder is matched with a buy order from a purchaser on
the exchange. Popular and established ETFs with high
transaction volumes can develop even greater liquidity
than their underlying holdings.
Second level of liquidity – Market maker activity
Third level of liquidity – Unit creation based
on underlying securities
Because ETFs are open-end structures, the market maker
can correct supply imbalances by creating or redeeming
units. This is essential as the market maker can offset an
increase in demand by creating more units. On the other
hand, when the demand for the units decreases, the
market maker redeems units to tighten supply.

Market makers are responsible for posting bid and ask When a large buy order occurs, the market maker will buy
offers on the exchange. This enhances liquidity and allows the basket of securities and initiate a creation order with
a buyer or seller to transact with minimal trading costs. the ETF provider. The cost to the investor would be the
For BMO ETFs, the market maker continuously posts units fair value of the units based on the midpoint of the spread,
BMO EXCHANGE TRADED FUNDS 2

the market maker’s costs of building the basket, and
the investor’s single trade commission rate with their
broker. The market maker’s costs are based on how
much each security trade impacts its traded volume.
With very liquid underlying securities, this cost is
minimal. The cost increases as the liquidity of the
underlying securities decreases.
By comparison, if the investor instead purchased each
underlying security within the ETF, they would be faced
with commission costs on each individual trade, plus the
trading costs incurred with each transaction.
When evaluating ETFs, the underlying liquidity is what
matters. Consider the BMO S&P/TSX Equal Weight
Global Gold Index ETF (ZGD) and BMO S&P 500 Index ETF
(ZUE). Liquidity of the ETFs were driven by the volume
of the underlying which regularly trade at much higher
volumes. This is where the ETFs true liquidity resides.
Trading volume was light, but the ETFs easily absorbed
large transactions with minimal impact. Despite the low
volume on the new ETFs, the bid-ask spread remained
very tight.

True Liquidity of an ETF:

Daily Average Volume ($)

BMO S&P/TSX Equal Weight BMO S&P 500 Index ETF (ZUE)
Global Gold Index ETF (ZGD) $736,000
$58,000 ETF ETF
.............................................................................................................................................

S&P/TSX Equal Weight S&P 500 Universe

Global Gold Universe $117 Billion
$1 Billion
Underlying Underlying

The true liquidity of an ETF is best measured by the liquidity of its underlying securities and allows
for significant trade orders without having an impact on the price of the ETF itself.

06/14-1401
Visit bmo.com/etfs or contact Client Services at 1-800-361-1392.

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ZCN, ZUE, ZSP and ZSP.U (the “ETF”) The index or indices are products of S&P Dow Jones Indices LLC and have been licensed for use by
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LLC, S&P, TSX or their respective affiliates, and S&P Dow Jones Indices LLC, S&P, TSX and their respective affiliates make no representation
regarding the advisability or investing in such ETFs.
This communication is intended for informational purposes only and is not, and should not be construed as, investment and/or tax advice
to any individual. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals
should seek the advice of professionals, as appropriate, regarding any particular investment.
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before investing. Exchange traded funds are not guaranteed, their values change
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