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As I understand:

index ETF attempts to track value of some specific index. It may be done by either really buying index (physical ETF) or by creating some arcane financial instrument that is supposed to result in identical returns/losses (synthetic ETF).

ETF fees are collected by systematically reducing amount of assets corresponding to single ETF share.

ETF market makers are obligate to sell/buy ETF shares with some specified maximal spread.

Is there anything (standard contract, regulatory oversight) that ensures

  • index ETF tracks indented index (if fund manager spend all money on Premium Pokemon Trading Cards someone must cover resulting losses)
  • fees are not higher that specified in prospectus (again, is there any institution that would be obligated to cover losses?)
  • There is no large permanent tracking error. I am aware that in some situation massive short-term tracking error may appear, there are known cases of stop-losses triggered what resulted in massive losses. But is there protection against something like that happening for longer term? For example - is it at least theoretically possible to end with ETF shares that for weeks cannot be sold for 95% of NAV (market maker runs away and is refusing to trade, or market maker suddenly increases allowed spread between bid/ask price)?

As I understand actions that would lead to the mentioned problems may or may not be illegal and maybe someone would be punished for it but losses incurred by investors would be their own problems.

  • @Brick - this answers only third part of my question, the first two seems to not be covered by this answer (I assume that "underlying securities" is "assets owned by ETF fund", not "assets that are supposed to be tracked by ETF"). – Mateusz Konieczny May 13 '16 at 5:40
  • The first two parts of your question don't make sense as far as I can tell. The first one asks if there can fraud (yet, but it's a crime), and the question about fees seems at odds with how an ETF works. – user32479 May 13 '16 at 15:22
  • @Brick "The first two parts of your question don't make sense as far as I can tell." Why? There are well known cases of respectable business/institution turning out to be fraudulent swindlers. Also, it is not like financial managers taking risks that were supposed to be avoided is something that never happened. I admit that I never heard about fund invensting into Pokemon collectibles but it was just example of something outrageous and not wanted by people who bought ETF shares. – Mateusz Konieczny May 16 '16 at 8:51
  • The first two parts - as I read them - don't reflect how an ETF is run at all. So far from it that it's hard to understand what could be meant by them. I get that you want to be sure you're not swindled, and that's totally reasonable. At the same time, if you ask a question like "how am I sure there's no dairy in my printer paper?" because you're lactose intolerant it becomes difficult to put an answer to that even if the question is sincerely asked simply because the question appears to start with a false premise. – user32479 May 16 '16 at 15:49
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index ETF tracks indented index (if fund manager spend all money on Premium Pokemon Trading Cards someone must cover resulting losses)

Most Index ETF are passively managed. ie a computer algorithm would do automatic trades. The role of fund manager is limited. There are controls adopted by the institution that generally do allow such wide deviations, it would quickly be flagged and reported. Most financial institutions have keyman fraud insurance.

fees are not higher that specified in prospectus

Most countries have regulation where fees need to be reported and cannot exceed the guideline specified.

at least theoretically possible to end with ETF shares that for weeks cannot be sold

Yes some ETF's can be illiquid at difficult to sell. Hence its important to invest in ETF that are very liquid.

  • "computer algorithm would do automatic trades", "role of fund manager is limited" note that it does not eliminate possibility of mistake, stupidity or fraud. – Mateusz Konieczny May 13 '16 at 5:50
  • @MateuszKonieczny Yes it does not eliminate mistake, even computer programs can behave crazy and it does happen, banks / networks / atm / cards go down. There are case where amount and price get interchanged while placing orders, resulting in losses. That is more generic and the losses are absorbed by financial institution from profits / reserves. Fraud as indicated most organization have keyman fraud insurance cover to cater to such eventuality. Also note there is quite a bit of monitoring in place internally by organization as well as regulators. – Dheer May 13 '16 at 6:16
  • thanks for info about keyman insurance, I was unaware about this concept. But one thing that is missing - is there some equivalent of deposit insurance, with entity above company selling product guaranteeing that money will not be lost (with some limitation) due to collapse of company offering financial product? – Mateusz Konieczny May 13 '16 at 8:19
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    Not to my knowledge in most countries. It is assumed [wrongly?] that people who invest in Stocks are financially well of and literate and understand the risks. Plus the structure of how Mutual Funds companies are formed to an extent ensure safety. For example in EFT, the underlying shares held with depositories are pledged to Exchange. So even if the company collapses, the assets are locked with depositories and exchange and record keeping ensure actual individual owners. – Dheer May 13 '16 at 8:27

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