It's a common misconception that an ETF's liquidity is best gauged by its average daily volume.
The reality is more complex, because the secondary market liquidity found on a stock exchange is only one source of an ETF's liquidity. It is important to consider that an ETF has an additional source of liquidity, that which is derived from its underlying portfolio of securities.
Source : Vanguard
Exchange liquidity
The most readily observable source of an ETF's liquidity is the on-screen trading activity of buyers and sellers in the secondary market. Average daily trading volume (ADV) is a measure of this activity, but it is only one part of an ETF's total liquidity profile.
Not all of an ETF's liquidity in the secondary market is easy to see. If you're a typical investor, your "on-screen" view is often limited to the information made available through public financial websites. This means you'll have access to the best available bid and ask for an ETF, but you won't be able to see all the quotes in an ETF's order book. These quotes are another source of ETF liquidity because they represent additional prices at which ETF units can be bought or sold.
An ETF's liquidity can be hidden in other ways too. In Canada, ETFs trade across many different marketplaces, including on, but not limited to Toronto Stock Exchange (TSX). Many data sources reflect only the trading activity that has occurred on TSX, and do not capture trading activity that has occurred on another venue. When possible, we encourage investors to make sure they have a consolidated market view, to get a more accurate picture of an ETF's liquidity and to assess the best available bid and ask in the market.
Liquidity from underlying securities
The key to ETF liquidity lies in an ETF's open-ended structure. Unlike single stocks, which have a fixed supply of shares, new ETF units can be created and existing units redeemed based on investor demand. This unique process allows ETFs to access the liquidity of their underlying securities. The result is that investors can often trade ETFs in amounts that far exceed an ETF's ADV, without significant impact to the ETF's market price.