Sanction Risks in ETFs and Funds: Why Compliance Has to Look Deeper

Our daily lives are full of risks. That used car you bought might have looked pristine on the outside, but a closer inspection reveals hidden damage. In the worst case, it’s a technical write-off – and the money you invested is down the drain. Economist George Akerlof described the problem behind these so-called lemons back in 1970: if the seller knows more about the quality of a product than the buyer, information asymmetries arise. These, in return, lead to adverse selection, where bad products crowd out good ones.

The same principle applies in the financial world: in ETFs and mutual funds, sanction risks can be hidden, even if the issuer or provider is considered trustworthy. Because of the worsening geopolitical situation, the dynamics of sanctions in the capital market are also increasing – as is the challenge of complying with them. Securities that were permitted yesterday could be subject to sanctions today, and thus excluded from trading.

A look at Russia and China shows how broad the spectrum of current sanctions has become. Companies and countries with links to forced labor or military sectors are increasingly coming under the eye of western regulatory authorities. Particularly relevant are the US sanctions against companies under the Chinese Military Industrial Complex (CMIC), which impose a full prohibition on Americans investing in this area. Then there are the human rights sanctions regimes of the EU and the UK. This plethora of instances increasingly leads to sanction risks arising indirectly within indices as well.

Since January 2022, the number of sanctioned securities has risen by roughly 700%. The most recent cases highlight the speed of these developments. At the end of September 2025, the US Bureau of Industry and Security (BIS) announced that it was aligning its Export Administration Regulations with the 50% rule of the U.S. Department of the Treasury.

Accordingly, the Affiliates Rule, as it is known, extends export restrictions to foreign subsidiaries that are 50% or more owned by companies that are on the blacklist or are red flagged. This step would have fundamentally reassessed shareholding structures, but has since been postponed by one year.

Although the regulation primarily relates to import and export and does not target securities directly, it can still become relevant for investors: If a company’s classification changes, fund providers and investors have to quickly check whether or not they are indirectly exposed to a risk.

On October 22, 2025, the American-based Office of Foreign Assets Control (OFAC) also imposed sanctions on the Russian oil giants Rosneft and Lukoil. Within just a few hours, 91 ETFs – with a total volume of 280 billion US dollars – had to recalculate their portfolios and inform investors. 

The monitoring of ETFs and mutual funds is especially challenging for compliance teams and market participants. Unlike individual securities, these products consist of broad “baskets” including several hundred to several thousand securities, depending on the index, theme, or strategy involved.

With traditional investment funds that can sometimes have multi-layered ownership structures, the situation is often even more opaque. The Know Your Customer (KYC) process ensures that a fund provider is authorized, but it does not provide certainty regarding the actual composition of its products. This lack of transparency leads to dangerous blind spots. If a company is hit with sanctions, it results in a chain reaction: Index providers have to make adjustments, and subsequently ETF and funds providers have to update their baskets and valuations. In practice, this happens under extreme time pressure, within 24 to 48 hours.

The question of how many sanctioned securities an ETF or fund may contain before it becomes prohibited depends heavily on the respective legal system. The EU and UK  take an essentially zero-tolerance approach in line with EU Regulation 833/2014 and UK Regulation 16.

At the same time, both sets of regulations contain exceptions and transitional time stipulations, for example for positions acquired prior to the sanctions taking effect, or for certain sector-specific sanctions. The regulations also distinguish between direct holdings – securities that a fund holds directly, for example – and indirect holdings. Indirect holdings can arise through multi-level structures or intermediary entities, which in practice leads to room for interpretation.

In the USA, the established 50% rule of the US Treasury Department applies to Russian investments, while there is a complete investment ban for CMIC securities. Here, too, a number of nuances play a role, including deadline regulations, the treatment of currently held positions, and differences in the type of holding.

The current sanction situation also leads to attempts to exploit regulatory loopholes. A recent example is the merger between the Chinese technology companies Hygon and Sugon. Sugon is on the CMIC list, and thereby off limits for US investors, while Hygon is “only” on the BIS Entity list. Unlike the CMIC list and the (currently postponed) Affiliates Rule, this export control list doesn’t fundamentally prohibit investments. A merger could result in a situation whereby investors in Hygon become indirectly and illegally invested in Sugon.  

A similar issue arises with so-called shell companies. Through intermediate special-purpose entities domiciled offshore, economic connections are often obscured or presented in fragmented form in order to remain below threshold values or to conceal indirect holdings. Such structures may appear compliant on the surface, but economically they meet the criteria of being a prohibited engagement.

Together, these examples demonstrate how important it is to closely examine multi-tiered holdings and beneficial ownership relationships, since corporate circumvention strategies could prove disastrous for issuers and investors.  

Sanction monitoring in the case of ETFs and funds is challenging from an operational perspective. Compliance teams not only have to keep an eye on the constantly changing sanction landscape, but also have to dive deep into the structure of every product. They have to…

• …check whether or not an ETF or fund contains sanctioned securities.
• …determine the weighting of each component.
• …take into account sector-specific and time-limited sanctions.
• …monitor relevant jurisdictions concurrently.

These duties are time-intensive and susceptible to error, especially while updating regulatory lists on a daily basis. These can trigger a complete revaluation within a trading day. 

Where sanctions are not complied with, economic consequences may follow. Sanctioned components often decline sharply in value since their liquidity takes a hit. That can significantly impair the profitability of a fund – even if the positions involved constitute only a small portion of the portfolio. Those who recognize sanction risks too late leave themselves open not only to poor returns but significant fines, reputational damage, and frozen investments as well. 

In the course of the Russia sanctions starting in 2022, several funds were closed to trading. Investors were no longer able to divest their positions since the securities were illiquid or blocked for regulatory reasons. This resulted in cases in which the overall volume of all assets under management (AUM) shrank by several billion.

According to Fenergo, the developer of software to combat financial crime, global fines relating to sanctions have quadrupled since 2024. And in the USA, recent OFAC proceedings have resulted in fines in the hundreds of millions of dollars.

Responsibility for compliance with sanction requirements extends across the entire value chain – from issuers, to brokers, through to fund managers, and compliance teams.

In the case of ETFs, the obligation rests primarily with issuers. They have to ensure that their products do not include any securities that are sanctioned in either their own jurisdiction, or in the jurisdiction of the investor. This means that not only do they have to know the composition of their baskets, they also have to take into account the regulatory differences between markets.

Brokers and other intermediaries who trade or invest in ETFs also have obligations to fulfil. They have to review the holdings within the products to ensure that they do not invest in funds that contain sanctioned securities above the prescribed threshold. Things get particularly tricky when investing beyond one’s borders: An investor in the US who invests in a Hong Kong ETF has to be aware of possible CMIC risks – even if the fund is permitted within their own legal jurisdiction.

The same principle applies for mututal funds, but with additional challenges. Fund managers and custodians not only have to monitor the direct holdings, but also the structures of umbrella funds and sub-funds. The lack of transparency across multiple levels makes it necessary for these actors to use what are known as look-through mechanisms to uncover any hidden risks.

The workload behind sanction monitoring is considerable. Estimates put the annual cost of a compliance team of roughly 100 employees at between 12 and 29 million US dollars. Smaller financial institutions, in particular, often don’t have these kinds of resources, which underscores the relevance of automated monitoring solutions.

Artificial intelligence (AI) can harmonize name variations, different spellings, and multilingual datasets in real time, and thus reduce error rates. This makes AI models a crucial lever, especially in the case of global fund structures and thousands of individual components. With the growing influence of alternative investment forms such as cryptocurrencies, the importance of such systems has increased as well.

The granular database administered by the Sanctioned Securities Monitoring Service of SIX displays not only individual risks, but also structural examples in the market. An analysis of the global EFT landscape highlights where sanctioned components occur especially frequently, and which regions are most affected:

• Roughly seven percent of all analyzed ETFs worldwide contain sanctioned securities.
• Most of these ETFs originate in Asia, Ireland, and the USA.
• China and Russia are among the countries from which a particularly high number of sanctioned components originate.

These trends show that sanction risks are not limited to individual markets, but can arise globally across different ETF structures. For market participants, it is becoming increasingly crucial to have transparency regarding domicile, origin of the components, and regulatory requirements.