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Imagine S&P goes -5% and so, technically, should VOO. But VOO is a stock itself - subject to supply and demand. The market could just happen to demand many VOOs and push its price up.

Why doesn't this happen?

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https://en.wikipedia.org/wiki/Exchange-traded_fund

financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks (such as 50,000 shares), called creation units. Purchases and redemptions of the creation units generally are in kind, with the institutional investor contributing or receiving a basket of securities of the same type and proportion held by the ETF
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The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares.
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If there is strong investor demand for an ETF, its share price will temporarily rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market. The additional supply of ETF shares reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an ETF: its shares trade at a discount from net asset value.

What this is saying is that if you own the same basket of stocks as the ETF is made up of, then you can turn in those stocks to the fund, and get shares of the fund in return. So if the S&P goes down 5% but the ETF doesn't, then you can buy the stock for 5% less, create ETF shares from them, and then sell those ETF shares at the full price, netting a ~5% profit. This process will then create more supply of ETF, which drives the price down.

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  • Wow, that makes sense, thank you. I should've studied wikipedia in the first place :)
    – Vadim Tikanov
    Apr 19, 2019 at 20:49
  • Why wouldn't the AP (or any institution) just buy the under priced underlying shares and then sell ETF shares on the open market, driving the ETF’s price back toward fair value and earning the risk-free arb profit? Why involve the creation/redemption process?
    – Bob Baerker
    Apr 19, 2019 at 21:36
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    @BobBaerker Anyone, if he notices a difference between the ETF and the underlying shares, can purchase the ETF, recognizing the bargain, and wait for the situation to rectify itself. But the creation/redemption mechanism ensures that the price will right itself. Without that, you would just be trusting all the other investors to value the ETF the same as the real shares.
    – Ben Miller
    Apr 20, 2019 at 13:13
  • Yes, anyone noticing a difference between the ETF and underlying shares can purchase the ETF and wait for the situation to rectify itself but that would put them at market risk (the ETF drops). But per the question, you have it reversed. The ETF is overvalued as compared to the components so the arbitrage is to buy the undervalued shares and sell the ETF. My question isn't about the potential arb but why not just do it directly in the market? Also, why would the ETF want to redeem creation units for the sake of the AP? What's in it for them? Is it done just to maintain price parity?
    – Bob Baerker
    Apr 20, 2019 at 14:33
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    @BobBaerker You could ask this as your own question. I'd say your arb is not risk-free if there is not a direct way to get the holdings into or out of the ETF. Your scenario applies to closed-end funds, which routinely trade at significant premiums or discounts. ETFs set up AP creation/redemption to obtain a very liquid, tax-efficient, and low-tracking-error fund and thereby to attract investor capital.
    – nanoman
    Apr 21, 2019 at 7:35

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