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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?

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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.

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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.)

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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.

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  • Thanks, but the ETF is a stock of its own. SO if nobody wants to buy the ETF, why will it shoot up just because the underlying shot up? It is a bit unintuitive since the way i understand, there needs to be a demand for the ETF itself for its price to increase.
    – Victor123
    Jan 24, 2014 at 16:02
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    You will have to understand the ETF creation/redemption mechanism to understand this. Try to read this article here indexuniverse.com/etf-education-center/…
    – zsljulius
    Jan 24, 2014 at 16:08
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    The "nobody wants to buy" is the part that you're missing since the arbitrage opportunity is what various firms will take advantage and move the trading price of the ETF and thus there will be those seeking to exploit these differences if possible.
    – JB King
    Jan 24, 2014 at 17:38
  • @zsljulius that article was great! I now want to know more details about these authorized participants (AP)
    – Robert Houghton
    Jan 20, 2020 at 4:10
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An ETF consists of two componenets : stocks and 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

This does not take into consideration tracking error && tracking difference , fund expense ratio which may affect the returns of the ETF also

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    You do know the value of the stocks in the ETF can have a different value than the trading price of the ETF yes?
    – JB King
    Jan 24, 2014 at 17:56
  • @JBKing The difference is due to the weightage given for each stock and the tracking error
    – Computernerd
    Jan 24, 2014 at 18:02
  • So then the fund company sets the price that the ETF trades? That seems more than a little nutty to me. sg.ishares.com/understand_etfs/basics/liquidity.htm covers a creation/redemption mechanism that is supposed to keep the share price near the Net Asset Value of the fund as ETFs aren't quite like open-end funds in this regard to my understanding.
    – JB King
    Jan 24, 2014 at 18:06
  • No the fund company does not set the price that the ETF trades. It normally tracks the underlying which is normally the share price of the stock , any difference is caused by tracking error
    – Computernerd
    Jan 24, 2014 at 18:08
  • While an ETF may accumulate tracking error relative to its index, it's also possible for a buyer and seller to exchange shares of the ETF on an exchange at a price that implies a market cap which is different than the sum of all the ETF assets (regardless of any index). That is the situation being analyzed here.
    – user296
    Jan 27, 2014 at 0:57

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