If there is an ETF that is made up of 5 stocks and let us say one day, one of these stocks shoot up by 10%, will the underlying ETF also shoot up, even if there was no additional buying activity for the ETF itself?
The ETF supply management policy is arcane. ETFs are not allowed to directly arbitrage their holdings against the market. Other firms must handle redemptions & deposits. This makes ETFs slightly costlier than the assets held.
For ETFs with liquid holdings, its price will rarely vary relative to the holdings, slippage of the ETF's holdings management notwithstanding. This is because the firms responsible for depositing & redeeming will arbitrage their equivalent holdings of the ETF assets' prices with the ETF price.
For ETFs with illiquid holdings, such as emerging markets, the ETF can vary between trades of the holdings. This will present sometimes large variations between the last price of the ETF vs the last prices of its holdings.
If an ETF is shunned, its supply of holdings will simply drop and vice versa.
The creation mechanism for ETF's ensures that the value of the underlying stocks do not diverge significantly from the Fund's value. Authorized participants have a strong incentive to arbitrage any pricing differences and create/redeem blocks of stock/etf until the prices are back inline.
Contrary to what was stated in a previous answer, this mechanism lowers the cost of management of ETF's when compared to mutual funds that must access the market on a regular basis when any investors enter/exit the fund. The ETF only needs to create/redeem in a wholesale basis, this allows them to operate with management fees that are much lower than those of a mutual fund.
Expenses Due to the passive nature of indexed strategies, the internal expenses of most ETFs are considerably lower than those of many mutual funds. Of the more than 900 available ETFs listed on Morningstar in 2010, those with the lowest expense ratios charged about .10%, while those with the highest expenses ran about 1.25%. By comparison, the lowest fund fees range from .01% to more than 10% per year for other funds. (For more on mutual fund feeds, read Stop Paying High Fees.)
Since the market is in general rather efficient, the price of the ETF will most of the time reflects the prices of the underlying securities. However, there are times when ETF price deviates from its fundamental value. This is called trading at a premium/discount. This creates arbitrage opportunity, which is actually being studied in finance literature.
An ETF consists of two componenets :
weightage of each stock.
Assuming the ETF tracks the average of the 5 stock prices you bought and equal weightage was given to each stock , an increase in 20% in any one of the five stocks will cause the price of the ETF to increase by 4% also