Scams targeting ETF investors

The rise of crypto ETFs

In the beginning of 2024, the world’s first spot Bitcoin Exchange-Traded Funds (ETFs) saw the light of day. Just a day after the U.S. regulators approved applications, Bitcoin ETFs started trading. 

The emergence of Bitcoin spot ETFs was widely welcomed within the crypto and investor community because ETFs are used to simplify investment strategies, especially when it comes down to assets that are not typically easy to own or trade such as cryptocurrencies or gold. 

ETFs remove the need to own and hold an asset; investors can purchase ETFs instead of purchasing and storing an asset. They work as investment funds whose value changes depending on the underlying asset. 

If you want to know more about the emergence of Bitcoin spot ETFs in January 2024, we suggest reading this article: 'Bitcoin spot ETFs are here. How do I buy Bitcoin ETFs?'.

Bitcoin ETFs were just the beginning; on the famous Bitcoin Pizza Day in May 2024, the U.S. Securities and Exchange Commission (SEC) approved the creation of Ethereum ETFs, and 8 of them were given the green light to start trading. 

The emergence of Ethereum ETFs is considered to have the potential to impact investors and increase options for accessing crypto assets through more familiar channels. 

To learn more about Ethereum ETFs, why not read this article: ‘Ethereum ETFs are here: Insights into the SEC’s approval’. 

Are crypto ETFs safer than holding cryptocurrencies?

The introduction of cryptocurrency ETFs meant for many investors that there is a more secure way to start their crypto journey. That’s kind of true- ETFs provide protection that direct crypto investments lack. 

It is generally safer to invest in cryptocurrencies through ETFs than holding crypto assets directly because you don’t have to deal with crypto wallets and storing private key information, as well as being aware of scams associated sometimes with crypto exchanges. 

Whenever the prices of Bitcoin or Ethereum fluctuate, investors want to get into the crypto space, but many traditional investors are reluctant to examine the concept of crypto storage and cryptocurrency exchanges. Crypto ETFs enable investors to gain exposure to the crypto space without the need to directly purchase and store the assets. 

However, it is still important to keep it real- cryptocurrencies are volatile assets and that volatility can be seen in the ETF’s value analysis as well. 

Keep in mind that the content in this article is not and shall not be construed as financial or investment advice. This information is meant to be informative and for educational purposes only. Before making any investment decisions make sure that you are well educated and consult an investment professional.

Are ETFs less risky than stocks?

All investors face two types of risk: specific risks and systemic risks. A specific risk is associated with a particular situation or company. For example, you probably know about BP's Deepwater oil, Wisecard's fraud scandal or Volkswagen's emissions scandal. Thereby, this risk is associated with the wrongdoing of a certain company in which you have invested.

It is highlighted all the time how all risks can be reduced by diversifying your portfolio. A diversified portfolio limits the impact of one company's wrongdoing or overall poor performance on the market since other assets can perform better and offset financial losses.

This is a good thing about investing in ETFs- since they enable investors to invest in a diversified manner, they eliminate the specific risks.

On the other hand, systemic risks have an impact on the entire market as they arise from external factors such as macroeconomic or regulatory events. A diversified portfolio cannot eliminate truly systematic risks because they affect all investments equally.

Why was the SEC concerned with potential investment scams?

The Securities and Exchange Commission (SEC) as the financial industry regulatory authority that approved the mentioned crypto ETFs issued the Better Markets Letter to comment on a proposed rule change by the NYSE Arca Inc seeking to list and trade shares of a spot Bitcoin exchange-traded product (ETP). 

In the letter it has been stated that the crypto industry’s track record is clear when it comes to consumers, investors and financial stability as it has allegedly suffered $2 trillion in losses as well as multiple enforcement actions and criminal prosecutions which gave it a bad name. 

The Commission mentioned that it has rejected many attempts by national securities exchanges to list and trade shares in spot Bitcoin-based ETPs, adding that the Exchange Act is direct in stating that any proposed changes to national securities exchange rules must be created to prevent fraudulent and manipulative acts and practices as well as protect investors. 

It has been added that spot Bitcoin markets are highly concentrated and have a history of artificially inflated trading volumes due to certain scams and wash trading, along with relying on a select group of individuals and entities to maintain Bitcoin’s network. 

The crypto community's comment

Before Ethereum ETFs were officially approved, back in March 2024, the SEC issued a request for public comments on Nasdaq’s pending application for a rule change to allow the trading of iShares Ethereum Trust to reflect the price of Ether.  

The SEC stated that the Exchange raised similar arguments to support the listing and trading of the shares as those made in proposals to list and trade spot Bitcoin ETPs and asked whether there are any features related to Ether and its ecosystem that raise unique concerns regarding Ether’s vulnerability to fraud or manipulative practices. 

Consensys Software Inc., a U.S.-based company, responded with a public comment letter explaining that Ethereum’s Proof-of-Stake (PoS) mechanism encompasses built-in anti-fraud and anti-manipulation mechanisms that are resistant to tampering. 

The company has singled out certain features such as faster block finality and a distributed and randomised validation process that prevents broad stakeholder control, highlighting that the Byzantine fault tolerance (BFT) concept adds up to the total cost of attack.

It has been further answered that security is enhanced by slashing penalties and Ethereum’s decentralised community. They have urged the Commission to consider Ethereum’s advanced safeguards. 

Traditional ETFs and investment fraud

In August 2023, the SEC charged Samuel Masucci and entities he founded and controlled with adversely affecting the ETF they managed as well as misleading the ETF’s trustees to obtain $20 million in rescue financing to avoid a potential bankruptcy. 

It has been discovered that back in 2019, in exchange for $20 million in financing and related services, Masucci agreed to keep the ETF’s securities-lending business at the broker-dealer that provided a broad influx of financing despite offers with better terms from other securities lenders that could have benefited investors more, as well as failing to disclose a joint arrangement between his and his company, the fund, and the broker-dealer to independent trustees. 

The main point is that investment advisers cannot mislead clients or leverage their assets for their benefit. They have agreed to a cease-and-desist order to pay a penalty.

The many faces of investment fraud

This is an example of how things can go south with investment frauds; in the past decade, frauds have become more widespread and sophisticated. While common investment scams are based on fraudsters tricking people into giving away their money for shady investments, investment fraud on higher levels can be much more sophisticated and harder to detect.

For example, common investment scams include affinity fraud, pyramid schemes, and Ponzi schemes, along with real estate investment scams with people promoting an allegedly world-class property development as a great investment deal.

All legitimate investments have in common is the fact that their issuers and the individuals who sell them operate within the rules of securities law. For example, the Securities and Exchange Commission (SEC) in the United States regulates investments to protect investors such as requiring the issuing companies to properly register. 

Exchange-Traded Products (ETPs) include Exchange-Traded Funds (ETFs), Exchange-Traded Notes (ETNs), and several other similar product types that represent investment vehicles that are listed on an exchange and can be bought and sold. 

There is no single definition of ETPs; an ETP is considered a security listed on an exchange that seeks to provide exposure to the performance of a benchmark such as the price of gold or an index, such as the S&P 500.  

ETFs are the most common type of ETP and refer to pooled investment opportunities that include baskets of, for example, stocks, bonds, and other assets based on the fund’s specific objectives. 

Therefore, most ETPs are structured as ETFs as well as registered with and regulated by the financial industry regulatory authority such as the SEC. In the United States, they are regulated as investment companies under the Investment Company Act of 1940. 

When it comes to the crypto space, in the beginning of 2024, the SEC issued a statement concerning a fake post regarding the approval of a Bitcoin ETF as well as that their X account has been compromised. The fake post drove Bitcoin's price to go up immediately.

Investment frauds have many faces, but the main point is that it harms investors in multiple ways. Investment fraudsters don’t just steal money from investors but discourage new investors from participating in the market in the first place. 

Risks associated with ETFs

Even though most ETFs are registered investment companies with shares that represent an interest in a portfolio of securities and other assets that track an underlying index or benchmarks, not all of them turn out to be like that.  

Some funds, especially those that invest in certain commodities, can be unregistered. 

All investors should be aware that investing in an ETF comes with higher risks besides the occurrence of investment fraud. Common ETF investment strategies encompass swaps, short sales, futures contracts, and other derivatives, and all of these can sometimes expose the fund and the investors to more risk. 

For example, non-traditional ETFs such as leveraged and inverse ETFs reset each day, meaning that their performance can quickly part with the performance of the underlying benchmark or index. 

The ETF investment vehicle is the new hot thing and occasionally you can read about a new fund that could outperform the market with a lower degree of risk. Although many good ETFs are on the market, investors should always do their due diligence and remain updated. Investor education is crucial- study the market to understand the underlying trading strategies.

What is inverse and leveraged ETF fraud?

Not every investment opportunity is a good one, especially if you don't have enough knowledge of the relevant market and how certain types of ETFs work. Let's lay down another example of investment fraud to explain the importance of knowledge.

Inverse and leveraged ETFs represent sub-categories of ETFs that have the purpose of expanding the returns of a certain index. Therefore, an inverse fund aims to generate a performance that is the opposite of the underlying index while a leveraged ETF uses borrowed money to track its index and possibly double or triple the performance. 

It must be noted that most leveraged and inverse ETFs reset daily- in other words, they are created to achieve their stated goal only on the day of purchase. 

Such funds are usually attractive to a wide range of investors due to their objectives to amplify performance, but they are not a good choice for users who want to hold their ETFs for more than one day.  

Additionally, many securities regulators have warned investors that inverse and leveraged funds that reset daily are not appropriate for retail investors who want to hold assets longer than one trading session. For example, the U.S. FINRA issued the Regulatory Notice 09-31 to remind investors of obligations relating to leveraged and inverse trading funds. 

You probably wonder what all this information has to do with investment fraud. Think of a situation where a, for example, financial advisor, recommends clients to buy an inverse or leveraged ETF for more than one day or doesn’t explain the associated risks- this also presents an example of investment fraud or at least negligence. 

It is the same with crypto assets; to recognise crypto scams and stay away from fraudsters, you must be well-educated and informed. We can help you with that- check out available courses at our Learn Crypto Academy.

Can an ETF really run away with your money?

Let's do some myth-busting now; even though these investment scams are real and can happen, they are highly sophisticated, and ETFs are not that unsafe.

For example, a common fear spreading among new or potential investors is that they’ll lose all their investment if the fund provider or another party goes bankrupt. Remember that ETFs are registered with the financial regulator, and there are usually built-in regulatory measures to protect individual investors from suffering in the occurrence of a fund going bankrupt. 

As other traditional investment funds, ETFs need to place their underlying investments with a custodian who cannot be the fund manager. If an ETF goes bankrupt, the investments shouldn’t be truly gone because they should be kept with the guardian. 

This separation is evident, for example, in the EU regulatory framework governing financial services. 

You probably wonder what happens if the custodian goes bankrupt? Most jurisdictions have thought of this situation and built in safeguards to protect guardians from bankruptcy or at least make sure that investors’ assets are secure.  

Let’s lay down another example from the EU regulatory framework- in Europe, the asset protection framework set out a requirement that custodians keep client assets separate from their own clients. For example, if the custodian goes into bankruptcy, holdings of an EFT are treated as client assets and are not accessible to the custodian’s creditors. If the guardian loses the assets, they are held liable in many jurisdictions.  

And what about delisting? It can happen that an ETF closes. However, funds become profitable only when they reach a certain scale. So, if an ETF closes, the funds are sold, and investors get back the value of their investments. 

How to avoid an investment scam?

We have discussed the topic of avoiding scams in the crypto space multiple times in the past. For example, take a look at this article to learn more about common scams: 'The most common crypto scams & how to avoid them'.

However, in this article, we talked about more sophisticated investment scams that can hurt ETF investors, either directly or indirectly. To avoid investment scams related to ETFs, there are a few things you have to keep in mind.

ETFs are not mutual funds, but they don’t sell individual shares directly to, or redeem their shares directly from, retail investors. The ETF’s market price fluctuates during a trading day because of multiple factors, including the prices of the underlying assets and demand on the relevant market. 

Long story short, before investing in any kind of ETF, remember to read its summary prospectus as well as full prospectus to get your hands on important information such as principal investment strategies, investment objectives, associated risks, costs, and historical performance metrics.  

The main point is- don't invest in something that you don’t understand. Investing in ETFs requires knowledge and due diligence, and if you cannot understand the investment opportunity, it is better to go back to basics and learn a bit more.