A $6 Trillion ESG Headache Is Bleeding Into Fund Flows

2023-10-26 01:26

The world’s biggest ESG fund category is also by far its most opaque, and that’s starting to bug

A $6 Trillion ESG Headache Is Bleeding Into Fund Flows

The world’s biggest ESG fund category is also by far its most opaque, and that’s starting to bug investors.

Asset managers are sitting on roughly $6 trillion of funds registered as Article 8, which is a European Union classification requiring that environmental, social and good governance goals be “promoted.” But according to fresh data from Morningstar Inc., roughly a third of such funds “target no sustainable investments.”

Article 8 has become the main destination for fund managers keen to market their products as ESG, without the hassle of having to live up to strict requirements. Last quarter alone, managers upgraded about $64 billion worth of funds to Article 8, according to Bloomberg Intelligence.

Tracking SFDR Upgrades and Downgrades

“More than 90% of the most recent moves were upgrades, mostly to Article 8, despite increased regulatory scrutiny,” BI analysts led by Adeline Diab said in a report on Wednesday.

Investors are increasingly skeptical. More than $20 billion was pulled from Article 8 funds last quarter, bringing six-month withdrawals to over $40 billion, according to Morningstar. Its analysis also found that portfolios suffering the biggest outflows were those with the weakest sustainability credentials.

The development has left the world’s largest ESG fund market in an awkward place, as a vision built on years of ambitious rule-making starts to unravel. The Sustainable Finance Disclosure Regulation, which is global in scope, is now the subject of a major review that the EU’s commissioner for financial markets and services, Mairead McGuinness, has said will seek to establish whether it’s in fact “fit for purpose.”

For now, a key concern is how much greenwashing there is inside SFDR’s vast Article 8 designation.

Investors will continue to fear that Article 8 funds “possess an element of greenwashing until clear definitions and metrics are put into place,” said Mariyan Nikolov, research and policy officer at the European Federation of Investors and Financial Services, which represents the bloc’s retail investors.

The European Securities and Markets Authority wants to impose new minimum investment requirements on funds putting “ESG” and “sustainable” in their names. If it goes ahead as planned, about 80% of Article 8 funds wouldn’t be able to call themselves sustainable, the watchdog’s advisory body, the Securities and Markets Stakeholder Group, said earlier this year.

There are signs that ESG fund managers have started taking more steps to guard against allegations of greenwashing. Analysts at Jefferies estimate that about 50% of Article 8 funds now have some form of fossil-fuel exclusion policy, compared with just 20% 12 months ago.

Meanwhile, SFDR’s highest ESG disclosure category — known as Article 9 — has yet to suffer any quarterly outflows. That’s as fund managers are required to meet 100% sustainable investing targets, with some allowances for hedging and liquidity. At the same time, an SFDR fund class that makes no ESG claims — Article 6 — has also seen healthy inflows.

The data from Morningstar and Bloomberg Intelligence indicate that what investors really want — whether they care about ESG or not — is transparency.

Assets Under Management; SFDR Share

It’s unclear what the future of SFDR holds. A Morningstar Sustainalytics survey found that 50% of market respondents want the framework replaced by a clear labeling regime. Almost 40% only want to keep Articles 8 and 9 if new minimum standards are introduced. And just 7% want to keep the current system as it is.

The European Commission is collecting responses to its consultation on SFDR through mid-December. Morningstar says investors should brace for what may be “significant amendments” to the world’s biggest ESG investing regime.

But the industry shouldn’t assume that whatever comes next will be better, according to Stephan Kippe, head of ESG research at Commerzbank AG.

And ultimately, investment managers may “resist changes,” he said in a recent LinkedIn post. Especially after investing huge sums of money trying to comply with the existing framework, he said.