Inside ETF liquidity: A market maker’s guide to better execution
Understanding how ETF liquidity works can help investors and Advisors execute trades more efficiently, avoid common pitfalls and deliver better outcomes for clients. Below, we debunk myths on true liquidity and share best practices — from spreads and execution timing to block trades and price deviations.
1. What actually determines an ETF’s liquidity?
Contrary to popular belief, it’s not the number of shares you see on screen.
For ETFs, real liquidity comes from its underlying basket—the stocks, bonds, or commodities inside the ETF. If the underlying securities are highly liquid, the ETF is typically highly liquid too, even if its on‑screen volume looks small.
Advisor takeaway:
On‑screen volume is not the ETF’s true liquidity. The underlying market drives execution quality. In order to evaluate an ETF’s liquidity, Advisors should look at the bid-ask spread of an ETF as a first step, before they look at trading volume.
2. So if an ETF trades only a few thousand shares a day, is it illiquid?
No. That’s one of the biggest misconceptions.
Low trading volume only tells you how frequently investors trade it — not how liquid it is.
If the underlying securities trade millions or billions per day, market makers can easily create or redeem ETF units to facilitate any size trade.
Think of the ETF like a doorway to the underlying market:
The doorway might look narrow (low volume), but the room behind it (underlying liquidity) could be huge.
3. What’s the role of a market maker?
We’re responsible for:
- Providing continuous two‑sided quotes (bid/ask).
- Making sure spreads are fair relative to the underlying securities.
- Stepping in to facilitate larger trades.
- Creating or redeeming ETF units when supply/demand shifts.
Our job is to make liquid markets for ETFs and keep them trading smoothly, regardless of who’s buying or selling.
4. Why do ETF spreads widen sometimes?
Spreads move mainly because the underlying market moves.
Common reasons spreads widen:
- Opening minutes of the trading day.
- Volatility spikes (macro events, economic data flow, central bank announcements).
- Underlying markets closed (e.g., ETFs holding international stocks, or U.S. equity ETFs when their market is closed for a holiday and the Canadian market is open).
It’s rarely because “the ETF is broken” — it’s just reflecting what’s happening underneath.
5. When is the best time of day to trade ETFs?
Generally:
- Avoid trading in the first 10 – 15 minutes after the market open.
- This allows enough time for the underlying securities in the fund to start trading.
- Avoid trading in the last 10 minutes before the market close.
- Underlying portfolio movement can be volatile at the end of the day.
- Instead, trade during middle-of-the-day hours when underlying markets are fully open and spreads are tightest.
- When the underlying market is closed, the underwriter will have to model the price, and will therefore set a slightly wider spread to reflect their increased risk on the trade.
If the ETF holds North American stocks, trade during full Canada and U.S. market hours.
If an ETF holds international stocks, since many European markets generally close around 11:00am (ET), best practice is to trade before then. It should be expected that bid-ask spreads will widen out once European markets close.
6. Should Advisors use market or limit orders?
Always use limit orders. Market orders expose you to whatever price the next trade happens to hit — especially risky in thin markets or volatile times.
A limit order doesn’t mean you won’t get filled. It just means you control the price.
That said, if the Advisor is looking for an immediate fill on the buy, best to enter at the ask. If they are prepared to wait until their price is hit, they can enter a limit order priced at the mid-point of the bid-ask spread.
7. How should Advisors trade larger blocks?
For large trades, reach out ahead of time.
The BMO ETF PM desk (1−877−741−7263) has direct lines to market makers. Working together, we will aim to achieve:
- Providing insight on underlying liquidity and market conditions.
- Coordinating creation/redemption.
- Helping to source blocks.
- Providing guidance on execution strategy and limit pricing.
- Reduction in spread.
Typical threshold for reaching out: $1 million+, though even smaller orders may benefit from a quick check‑in.
8. What causes the ETF price to deviate from NAV?
The ETF often doesn’t “deviate” (or in other words, trade at a large discount or premium to its NAV) — it’s actually showing the fair value of the underlying securities.
In Canada, ETF NAVs are calculated once per day, at market close. ETF prices, on the other hand, update every second.
If the ETF holds U.S., European or Asian securities, and those markets are closed, the ETF’s traded price will reflect new information (futures, ADRs, macro data) that the stale NAV cannot.
A good example of this is when the international corporate bond market froze up during March 2020, and many underlying issues did not trade. During that time, ETFs continued to trade, and actually provided price discovery to the stale priced asset class. ETFs remained liquid at a time of market stress.
To learn about this in more detail, please consult: Trading and the True Liquidity of an ETF.
Advisor quick‑start checklist
Do:
✔ Use limit orders
✔ Trade mid‑day while underlying markets are open
✔ Explain to clients that ETF liquidity = underlying liquidity
✔ Call the PM desk for large trades (see below)*
Avoid:
✘ Trading right at the open or close
✘ Using market orders
✘ Judging liquidity by ETF volume
✘ Reading too much into momentary price movements
ETF trading may appear straightforward, but understanding the mechanics behind liquidity can make a meaningful difference in execution quality. By focusing on the liquidity of the underlying securities, using disciplined trading practices such as limit orders and timing trades when underlying markets are active, Advisors can significantly improve trade outcomes. Just as importantly, leveraging the expertise of the BMO ETF PM desk for larger trades can provide valuable insight and coordination.
*BMO GAM ETF PM desk hotline: 1−877−741−7263
Additional resources:
Trading and the True Liquidity of an ETF
Largest and Most Liquid ETFs Tool | BMO Global Asset Management
Disclaimer:
For Advisor use only.
This article is for information purposes only. The information contained herein is not, and should not be construed as investment, tax or legal advice to any party. Particular investments and/or trading strategies should be evaluated and professional advice should be obtained with respect to any circumstance.
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