It’s been six months since the European Union set phase one of its Sustainable Finance Disclosure Rules (SFDR) in motion, requiring fund groups to divulge information about their investments’ environmental, social and governance (ESG) risks as well as impact on society and the planet for the first time.
The ambitious piece of regulation is designed to provide fund selectors and investors with greater clarity about where their money is going by highlighting funds that “promote environmental or societal characteristics,” Article 8, and those that have “a sustainable objective,” Article 9. Funds that do neither are classed as Article 6.
At the 20-day mark Morningstar found after examining half the 5,695 Luxembourg-domiciled funds, 21% had been classified as Article 8 or 9, or 25% of total European fund assets. Four months later, when it had examined around 82% of funds in the market, Article 8 and 9 funds made up nearly a quarter of the market.
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In terms of assets, funds falling under the EU’s new ESG taxonomy account for a third of the fund market, or €3trn (£2.58trn), and Morningstar estimates that could hit 50% in the next 12 months as products are launched and existing strategies are upgraded.
Legal & General Investment Management and Allianz Global Investors told Portfolio Adviser that around half of their European-domiciled Ucits funds have been classified as Article 8 or 9 funds to date.
JP Morgan Asset Management and Fidelity International also had over half of their European ranges in the Article 8 or light green category but no funds in the stricter Article 9 or dark green category.
Alliance Bernstein said 90% of its European fund range had been moved into the Article 8 category or around $90.3bn. Dark green Article 9 funds represented just $4bn assets or 4% of funds.
Schroders said in its H1 results it was looking to have most of its assets in its main continental fund range managed within either Article 8 or 9 funds under the EU’s SFDR later this year.
A slippery slope
Compared with Article 9, Morningstar says Article 8 appears to be a “catch-all category”, home to a wide variety of asset classes with very different approaches to ESG.
Of the top 20 largest Article 8 funds, only one – Vontobel mtx Sustainable Emerging Markets Leaders – had any ESG or related terms in its name “that would indicate they are actively marketed by their asset managers as ESG or sustainable”, the research house notes.
Many asset managers justify their funds’ Article 8 badges on the basis ESG factors are “integrated” into the investment process. But this is often poorly defined and buried beneath hundreds of pages of legal fund documentation.
As ESG factors are not baked into the investment objective this means funds can still buy and hold securities regardless of their environmental or social impact, which may catch certain investors off-guard.
Clarity on what this ESG integration process involves is critical. DWS is currently under investigation by German and US regulators after its former head of global sustainability Desiree Fixler claimed it overstated how much it used sustainable investment criteria to manage assets.
Joshua Kendall, head of responsible investment at Insight Investment, says fund groups’ variety of interpretations will not necessarily result in so-called greenwashing.
However, he adds: “Article 8 status is weakened by the proliferation of strategies that can be aligned with it, some of which bolt elements of ESG onto their approach rather than having ESG risk analysis as a core part of the methodology.”
How are fund managers interpreting the Article 8 classification?
AllianceBernstein’s €21.1bn American Income Fund and the €17.5bn Global High Yield, the largest active Article 8 funds currently, claim to integrate ESG factors “into all aspects of the investment-making process” and “extensive engagement” with corporate issuers and governments.
A spokesperson says AllianceBernstein’s framework for applying and retaining Article 8 classification is “in line with many of our peers” and based on a minimum proportion of net assets that promote environmental and social characteristics while seeking to achieve their investment objective.
“As we refine our SFDR framework for Article 8 funds, additional environmental, social and governance-related thresholds may be imposed, pending regulatory approval,” they add.
The €12.6bn Pictet Global Megatrend Selection Fund applies an exclusionary approach by not directly investing in issuers that are deemed “incompatible” with Pictet Asset Management’s approach to responsible investment and “may engage” with companies to promote positive ESG practices, according to its factsheet.
A look at Pictet’s Responsible Investment Policy shows it treats “ESG integrated” strategies, which can buy and hold securities of issuers with “high sustainability risks and/or principal adverse impacts”, as Article 6 funds.
The Article 8 moniker is reserved for strategies that have stricter exclusion policies, including those with a positive tilt – a bias toward companies with low sustainability risks – and a best-in-class approach – seeking out issuers with low sustainability risks and avoiding those that pose a high ESG risk.
The Allianz China A-Shares Fund, another multi-billion-euro active Article 8 strategy, puts the emphasis on engagement “specifically with heavy carbon emitters in order to promote climate consciousness”, its factsheet states.
It is overweight materials and industrials relative to the benchmark and includes petrochemical maker Wanhua Chemical among its top holdings, which has a severe ESG risk, according to Sustainalytics.
“As we don’t have impact goals or measurements – we use our ESG criteria and have determined China A fits under Article 8,” a spokesperson says.
JP Morgan Asset Management and Fidelity International told Portfolio Adviser for a fund to be classified as Article 8 it must hold at least 50% of net assets in companies with good environmental or social characteristics. The €11bn JP Morgan Emerging Markets Fund and Fidelity’s €9.2bn Global Dividend Fund both have a five-globe sustainability rating from Morningstar, while the €12.9bn Fidelity Global Tech Fund has four globes.
When exclusion is not enough
While active managers tend to employ exclusions on top of other approaches like ESG integration or engagement, Morningstar notes many index funds rely on exclusions only. Critics question whether such exclusions go far enough to justify the SFDR labels.
The L&G UK Equity Ucits ETF is touted as an Article 8 fund on the basis it tracks the Solactive Core UK Large & Mid Cap Index, which excludes coal miners, companies that make controversial weapons such as cluster weapons or antipersonnel mines, or those that have breached at least one of the UN Global Compact (UNGC) principles for three consecutive years.
But its top 10 holdings are identical to the L&G funds tracking the FTSE 100 that do not have the Article 8 badge and include ‘sinful’ stocks such as British American Tobacco, miner Rio Tinto and oil giants BP and Royal Dutch Shell.
SCM Direct co-founder Alan Miller feels it’s a stretch to say it promotes ESG characteristics.
“We are not aware of a single UK plc with 30% or more of their revenues from coal mining, a single UK plc controversial weapon company or a single UK plc that has breached the UNGC principles three years running, so its exclusions are in practice meaningless.”
It’s a similar story with other passive products applying basic exclusions. The iShares MSCI Europe ESG-Screened ETF also weeds out UNGC violators, as well as thermal coal companies, tobacco firms and controversial weapons and nuclear weapons makers.
However, these types of businesses represent a small fraction of the MSCI Europe Index. Tobacco companies account for 0.89%, while civilian firearms make up 0.44%, nuclear weapons 0.65%, thermal coal 0.42% and UNGC breachers 2.1%.
“All stakeholders need to act with integrity, honesty and transparency in terms of ESG offerings to consumers looking to do good as well as receive good returns,” explains Miller.
“Unfortunately, it appears that companies have no ethics or integrity and are essentially ‘gaming’ the system by making very marginal tweaks to existing products and investments to allow them to classify funds as being Article 8 funds, when in practise they have at best marginal differences to a non-Article 8 fund.”
An LGIM spokesperson says funds are classified as Article 8 if the promotion of environmental or societal characteristics is “a binding element” of the investment selection process.
They add that across the industry index managers have marked funds that are deemed ‘exclusions-only’ as SFDR 8. “This is often as a result of consultation processes organised by various index providers with their asset management clients.”
Article 8 will seem like a lower threshold a year from now
With so many different interpretations of SFDR classifications, particularly Article 8, is this helping investors to make more informed choices?
According to EQ Investors senior sustainability specialist Louisiana Salge, in terms of improving transparency the regulation has been successful so far.
“The aim of the regulation package is not just to classify funds. In fact, they aim to classify funds as a means to then request different types of disclosures about their ESG policies, processes and outcomes,” Salge says.
“This should improve the information available to the fund selector. It also aims to force all fund managers to think about how their process relates to ESG outcomes, and to formalise thinking.
“There is naturally going to be more nuance in sustainable investment approaches than three categories, so searching by classification would and should have never been enough information to judge the suitability of a strategy to a portfolio objective or client preference,” she adds.
Troy head of responsible investment and senior fund manager Hugo Ure says as ESG advances through the industry and becomes ‘mainstream’ Article 8 “is going to seem like a lower threshold in a year’s time than it does today”.
The FCA is currently toying with the idea of requiring fund groups to disclose their climate change risks in line with the Task Force for Climate-related Financial Disclosures. Asset managers who implemented this and applied it to their funds would meet many of the Article 8 requirements, Ure notes.
Should the UK adopt its own SFDR?
As it stands, the UK does not have any standardised ESG disclosure regime, a situation Miller believes must be urgently rectified given the “exponential growth in ESG and greenwashing”.
“There needs to be much stricter classifications rather than marginal tilts that in practice make very little difference whatsoever to a product’s fundamental ESG credentials,” he says.
“The UK regulator talks about greenwashing but until it names and shames companies and products that it feels mislead the public, the industry will continue to unashamedly allow funds to be marketed as ESG funds with nominal ESG credentials since the current rules allow almost anything.”
Kendall adds that ideally a UK ESG disclosure regime would be aligned with the existing EU framework and “reflect the complexities of asset management”.
He says: “Oversimplifying sustainability factors across asset classes, particularly in a diverse asset class like fixed income, is a potential problem that must be avoided.”