What are Exchange Traded Funds (ETFs)?

An ETF is a fund that is listed and traded on a stock exchange, which can be bought or sold directly during normal trading hours, similar to a stock. ETFs differ as they consist of a basket of securities which may hold stocks, bonds, or other assets such as commodities. The asset mix of an ETF generally aims to track the performance of an index or provide exposure to an asset class.

Benefits of ETFs



Investors get access to both core ETFs that track broad indices such as the S&P 500 and more focused ETFs that track market sectors and industries.



ETFs provide intraday liquidity through buying and selling during the trading hours of the stock exchange.



ETFs offer potentially lower risk than individual securities.


Portfolio Transparency

Investors have access to the price of an ETF and the portfolio composition at any time during regular market trading hours.



Generally management fees for ETFs are lower than many other investment solutions. This means more of your money is working for you over the long term.


Tax Efficient

ETFs provide the potential for relatively lower capital gains tax liabilities than other investment products.

How They Work?


ETFs can be bought and sold at any point throughout the trading day through your advisor or trading platform.


Market Tracking


The purpose of an indexed ETF is to track as closely as possible the return of a specific market benchmark or index. Deviation from the benchmark return, known as a tracking error, can occur for several reasons:


  • Fund Trading Costs. However, since the underwriters deliver, or take possession of, the underlying securities during subscriptions and redemptions, ETFs lessen the need for the Fund Manager to trade securities on the exchange. Therefore, trading and commission costs are kept to a minimum.
  • 'Cash drag' (the result of an un-invested portion of a portfolio's net assets). ETFs will seek to minimize cash drag by reinvesting the proceeds or providing income distributions to investors.

Understanding Liquidity


The liquidity of an individual security is directly related to the traded volume of that security, the same correlation however does not apply to ETFs.


Instead, the liquidity of an ETF is best measured by the underlying securities which it holds. If the individual securities that compose the ETF have a high traded volume, and are therefore very liquid, then the ETF that holds them will have the same degree of liquidity. Similarly, if the underlying securities of the ETF have a low traded volume, or are illiquid, the ETF will have a low degree of liquidity as well. BMO ETFs have been constructed to have liquid portfolios by establishing traded volume requirements for each security held within the portfolios.

An ETF’s underlying liquidity can be seen by observing the difference between the buying price and the selling price, or the “bid-ask spread.” A tighter bid-ask spread on an ETF generally indicates that the underlying securities also have tight bid-ask spreads and are therefore also more liquid.


In this way, even an ETF with low traded volume is liquid if its bid-ask spread is tight. Again, if the securities that make up the ETF are liquid, so is the ETF itself.

How does the ETF liquidity 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

Market makers are responsible for posting bid and ask offers on the exchange. This enhances liquidity and allows a buyer or seller to transact with minimal trading costs. Market Makers continually post units at a price which reflects the spread of the underlying portfolio.

Third level of liquidity – Unit creation based on underlying securities

Market makers 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. When a large buy order occurs, the market maker will buy the basket of securities and initiate a creation order with the ETF provider.


When evaluating ETFs, the underlying liquidity is what matters. 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.

Graph displays interaction between the buyer and seller through an Exchange to an ETF Provider.

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