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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)

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    How does your buying shares of SPY from someone else (not SPY directly) cause a rise in the value of shares in SPY? You are able to buy a share of SPY because someone else is willing to sell his/her share at the price you are bidding, or you are willing to pay the price the seller is asking. If the asking price goes up, you may be unwilling to buy at that price. – Dilip Sarwate Feb 6 '15 at 21:50
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Mutual funds don't do what ETFs do because, according to how the fund was built in their contract, they can't. That is not how they are built and the people that invested in them expect them to act in a certain way.

That is ok, though. Many people still invest in mutual funds partially because of their history but there are some advantages to mutual funds over etfs. Mainly mutual funds must mark-to-market at the end of day while etf values can drift from the asset value especially in crisis. As long enough people invest in mutual funds the funds make enough money on their fees they don't need to change. Maybe mutual funds will go extinct as etfs do have significant advantages, but it likely won't happen soon.

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