As an increasing number of fund managers start to integrate ESG criteria into their portfolio management process, the potential to disappoint investors and fail to live up to their expectations increases.
Investors who are buying a fund with a sustainable or ESG-related investment objective may think that these funds have a strong focus on all relevant criteria. But obviously this is not always the case, as all fund managers have different views on how to integrate non-financial criteria into their selection process. Some only focus on single aspects such as carbon emissions, while others focus more on social criteria or the overall governance for the selection of eligible securities for their portfolio. In addition to this, some portfolio managers may only take ESG criteria as a second measure into consideration when evaluating securities. For example, the securities in the portfolio can have quite bad ESG scores when they meet the main selection criteria. All of these funds had been marketed as sustainable funds in the past.
To align the fund industry with the EU Taxonomy and to avoid the so-called “greenwashing” in fund objectives and the respective marketing materials, the EU Commission has introduced the Sustainable Finance Disclosure Regulation (SFDR) as part of the EU’s action plan to finance sustainable growth. SFDR came into force on March 10, 2021. On the one hand, this regulation gives a high-level definition of what constitutes a sustainable investment. It says a sustainable investment is an investment in an economic activity that contributes to an environmental or social objective. On the other hand, it groups funds in three different clusters. These clusters are based on the declaration of the level of alignment to the EU Taxonomy. For example, the fund management company must disclose if and to which extend a product takes sustainability risks into consideration.
In brief, funds classified under article 6 of the regulation are not required to show alignment with the EU Taxonomy and, therefore, may not use terms such as “ESG” or “sustainability” in their fund names and/or the respective fund prospectus or marketing materials. Funds classified under article 8 of the regulation need to take sustainability risks into account and have to disclose the environmental and/or social criteria which are used in the selection process. Hence article 8 is about the extent to which environmental and social factors are considered for the assessment and selection of securities and the overall portfolio construction. Article 9 marks the next level, since only products that focus completely on sustainable investments as the specific objective of the fund are considered as compliant to article 9. It is noteworthy that funds classified under articles 8 and 9 have additional liabilities regarding disclosures and other regulatory requirements, which are not further described here.
As a result of this regulation, we see that some funds have already removed the acronym ESG from their fund names, as well as all references to ESG and sustainability from their marketing materials. This shows that new SFDR disclosure actually helps to guide investors to products that suit their needs. Nevertheless, the regulation has some shortcomings, as there are still standards missing (mainly on environmental topics), which leads to the fact that a number of funds which consider themselves as sustainable have now opted for an article 6 declaration. This is because they are not sure if their current processes are strict enough to comply with the article 8 requirements once all standards have been met. On the other hand, there are also funds which interpret the standards as rather low and, therefore, may declare themselves as article 8 funds in the current uncertain environment. This is because they want to profit from the trend toward sustainable investments and will have to move back to article 6 designations once the dust around the definition and standards has settled. That said, one needs to bear in mind that the upcoming definitions and standards will mainly cover environmental topics. This means that funds with a focus on social issues might not become sustainable at all under the upcoming standards.
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