ETFs and Legal Risks: How Class Action Lawsuits Impact Fund Performance and Investor Returns

In the past year, Exchange-Traded Funds (ETFs) have become increasingly entangled in the web of securities litigation. While ETFs are often marketed as low-cost, diversified, and transparent investment vehicles, recent high-profile lawsuits and regulatory actions reveal a darker side: legal risks that can ripple through fund performance and investor returns. This article examines the growing trend of ETF-related class action lawsuits, their implications for fund managers, and actionable strategies for investors to mitigate risk.

The Vanguard Case: A Cautionary Tale

The most notable example in 2024–2025 is the lawsuit against The Vanguard Group, Inc. over its 2020 decision to lower the investment minimum for institutional target date funds from $100 million to $5 million. This move triggered a mass exodus of investors from higher-cost retail target date funds, forcing those funds to liquidate assets to meet redemptions. The resulting capital gains were absorbed by remaining retail investors, creating significant tax liabilities for those holding the funds in taxable accounts. One investor reportedly faced a tax bill exceeding $150,000.

The class action lawsuit, which alleged breach of fiduciary duty and failure to disclose tax consequences, culminated in a $40 million proposed settlement. However, the court denied the settlement in May 2025, ruling it superfluous due to a parallel $106 million SEC enforcement action. This case underscores how legal missteps by fund managers can directly impact investor returns, particularly in taxable accounts, and highlights the interplay between regulatory and civil litigation.

Broader Trends in ETF-Related Litigation

The Vanguard case is not an isolated incident. According to the 2025 Global Class Action Annual Report by Broadridge Financial Solutions, global securities class action settlements reached over $5.2 billion in 2024, with 136 settlements across 20 countries. Ten cases exceeded $100 million, and over 300 new cases were filed involving publicly traded securities. While ETFs are not explicitly singled out in these statistics, the rise in AI, ESG, and cybersecurity-related lawsuits suggests that ETFs—especially those tied to emerging technologies or ESG strategies—are increasingly under scrutiny.

For example, ETFs marketing themselves as ESG-compliant may face litigation if their holdings fail to align with stated environmental or social criteria. Similarly, AI-driven ETFs that rely on algorithmic trading or index construction could face claims of insufficient disclosure about risks or performance factors. These trends indicate that legal risks are no longer confined to traditional asset classes but are expanding to cover the complexities of modern investment products.

Legal Risks and Fund Performance

Class action lawsuits can directly affect ETF performance in several ways:
1. Capital Gains and Liquidity Pressures: As seen in the Vanguard case, forced redemptions and asset liquidations can generate capital gains, eroding returns for remaining investors.
2. Reputational Damage: A lawsuit can deter new inflows, particularly in passive ETFs where investor trust in index methodology is critical.
3. Compliance Costs: Legal settlements and regulatory fines increase fund expenses, which are passed on to investors via higher management fees.
4. Regulatory Scrutiny: Post-litigation oversight may lead to stricter disclosure requirements, complicating fund operations and increasing costs.

Investment Advice: Navigating the Legal Landscape

For investors, the key takeaway is to conduct thorough due diligence on ETFs, particularly those with complex strategies or niche exposures. Here are three actionable steps:
1. Review Legal Disclosures: Scrutinize prospectuses for details on governance, risk management, and potential conflicts of interest. ETFs with opaque fee structures or ambiguous ESG criteria are red flags.
2. Diversify Holdings: Avoid overexposure to ETFs in sectors prone to litigation (e.g., AI, cryptocurrency, ESG). Diversification reduces the impact of any single legal issue on your portfolio.
3. Monitor Regulatory Developments: Stay informed about SEC enforcement trends and court rulings. For instance, the SEC's 2025 focus on ESG disclosure requirements could reshape the landscape for ESG ETFs.

The Road Ahead

As ETFs continue to innovate—expanding into private credit, digital assets, and active management—the legal risks will only grow. Fund managers must prioritize transparency and proactive compliance, while investors must remain vigilant. The Vanguard case serves as a stark reminder: even the most reputable names are not immune to the financial and reputational fallout of class action lawsuits.

In this evolving landscape, the intersection of legal and financial risk demands a strategic approach. By understanding the potential pitfalls and leveraging data-driven insights, investors can protect their returns and navigate the complexities of modern ETF investing.

Final Note: The ETF industry's growth is a double-edged sword. While it democratizes access to diverse markets, it also amplifies the consequences of legal missteps. For investors, the lesson is clear: diligence, diversification, and a watchful eye on the legal horizon are essential to safeguarding long-term returns.