The growth in ESG compliant funds appears to be inexorable. However, as we’ve mentioned before1, ESG labelling continues to be problematic for two main reasons. Firstly, due to the inconsistent definition and application of ESG principles. Secondly, as a result of a reliance on third-party collected data which in itself doesn’t go far enough in redirecting capital in public markets to where it’s most urgently needed to solve the environmental and social problems we face as a society. It’s important investors are aware of the limitations of fund labels, in ESG or indeed sustainability. Hopefully, the introduction of the EU’s new Sustainable Financial Disclosure Regulation (SFDR) will improve investors’ confidence that their invested capital is really working towards their desired non-financial goals alongside their financial ones.
There’s a significant commercial opportunity in ESG and the fund management industry is responding. Recently, Bloomberg estimated that within 5 years ESG funds will make up one third of the projected $140.5 trillion global total by 2025; and that ESG assets are on track to reach $53 trillion – up from $37.8 trillion – by year-end2. As part of this expansion drive, many existing funds have been re-labelled. In the UK in 2020, there were 505 sustainable funds launched, 250 were simply repurposed existing funds that had previously not marketed themselves as having any sustainable credentials3. With such growth, and the re-tooling of investment teams required to incorporate ESG analysis, there is a danger of variations in quality. Our experience with our fund due diligence has revealed a noticeable divergence of quality within these launches. Since inception, we’ve done extensive due diligence on more than 150 varying funds across all asset classes (all of which market themselves as either ESG or impact) and only around 40 have been approved having passed through our proprietary rigorous twin-lens approach which analyses for impact and investment.
Unsurprisingly, passive funds have been a large driver of growth of the ESG market in Europe and by the end of 2020 accounted for 22.5 percent of funds by number4. While requiring even less fund manager oversight and a greater reliance on third-party data, which may have been subject to lower levels of scrutiny, passive funds generally have no expectation of engagement with management teams over non-financial issues. This is not a new concern, but it serves as a reminder that ESG alone is unlikely to create a culture of engagement with management teams to effect positive change. We are conscious of the relative ineffectiveness of ESG compliance compared to more action orientated funds which are prioritising a higher standard of responsibility and sustainability in their engagement. The recent example of the activism of Engine No.1 LLC in Exxon5 is a case in point. Exxon wasn’t being influenced by the criticism coming from the responsible investment community and omission from ESG indices. Instead, the active engagement of the Engine No.1 LLC hedge fund has potentially delivered significant change, with three “climate friendly” board members appointed and a demonstrable change of tack now more possible at one of the world’s largest carbon emitters.
The introduction of the SFDR in March this year should offer some welcome regulatory support to the categorisation of fund strategies, which are being asked to self-certify compliance with Articles 6, 8 or 9, the latter two corresponding to “light green” and “dark green” respectively. Article 9 funds for example should have sustainability or reduction of carbon emissions as the fund’s stated objective. While all of the equity funds that appear on Tribe’s approved list that require certification for distribution into the EU are classified Article 9, we have seen significant compromises in the marketplace, especially in passives. We’ve seen ETF launches which have top-sliced the ESG scores of a larger index certifying as Article 9, despite one of these funds holding at least two airlines at launch, for example, which is not a sector we believe to be positively impactful or gearing up for transition in the way we would expect. More clarity and possibly higher standards will be applied during the Level 2 implementation, which comes into effect on 1 January 2022, where asset managers will be required to back up their categorisation decisions with hard data and performance metrics.
Time will tell if increased regulation will lead to improvements. In the meantime, the noise around non-financial objectives is unlikely to reduce and investors will need to be extra vigilant to ensure that they understand the limitations of fund labelling. For now, the best protection for investors is to keep a close eye on what fund managers are actually investing in, rather than how they are describing their strategy.