This is what I understand on how ETS work vis-a-vis mutual funds: If I buy an ETF (SPY), then the ETF trust fund does not take my money and go out and buy the underlying stocks. I buy one share of SPY from someone else who already has that share. But if I continue to do this over and over again, it puts buying pressure on the ETF, thereby raising its price and throwing it off balance from the underlying (which has not moved because of this activity).
Now, to correct this difference, the ETF arbitrageur(who are these guys anyway, are they big firms like Goldman) will short some shares of ETF, use the money to purchase the underlying basket of stocks, which will raise the price of underlying stocks, so that now SPY and the underlying mirror each other in price.
Then , the arbitrageur will use these stocks to create new shares of the ETF and cover their short position.
This constant buying and selling by the arbitrageurs reduces the fund manager to do the re-balancing, thereby saving on transaction fees, hence ETFs have low transaction fees.
Mutual funds on the other hand, do not have this arbitrage mechanism, so the fund manager is responsible for this continuous buying/selling/re-balancing, hence the hefty transaction fees.
Now the question is: why don't the mutual funds do what the ETF fund does? What exactly is it gaining by taking on the work of the arbitrageur (i.e constant re-balancing)