My understanding is that Vanguard uses derivatives to both be fully invested and have a cash reserve. When you sell your shares, you get paid from the cash reserve. When you send the mutual fund money, that cash goes into their cash account.
I would guess Vanguard buys a "call" option on the underlying index. When there's more cash than stock exposure, Vanguard buys a call with some of the cash position, which is a leveraged way of becoming 100% invested again. This is not leverage to make more money - it's leverage exactly proportional to the fund's cash position. It keeps the fund fully invested.
Over time, sometimes stocks are cheaper than options. So Vanguard probably waits for those opportunities, and then shrinks it's cash position by purchasing underlying securities. That ensures incoming funds remain fully invested, and that it doesn't spend too much of it's assets on options.
Note the ETF and creation units are a little different - demand pushes the price up, which causes third parties to want to make a profit on the excess demand. They essentially sell blocks of stock to the ETF, because the block of stock is cheaper than the ETF. And then the ETF accepts a creation unit block of stock. One complexity is that Vanguard has some way of mixing ETF and mutual funds that involves a patent. So the situation might differ in some details at Vanguard.
