How to understand a correction in the ESG fund market


For years, financial professionals have made inflated ESG claims that have fueled market booms with little in the way of oversight. That era of frenzy around environmental, social and governance investment is now coming to an end with increasingly consistent waves of regulation. In the US, where ESG has also been drawn into partisan politics, the effects are evident in the decline in ESG-labeled assets; has fallen by more than half in the past two years. New regulations in Europe have forced the world’s largest asset managers to remove the coveted ESG labels from more than $140 billion in total client funds in the latter part of 2022. And there’s more to come.

1. What is the state of affairs for ESG in the US?

The US Securities and Exchange Commission has become more aggressive about greenwashing, fining money managers who fail to comply with their own ESG marketing requirements using existing anti-fraud rules. Last year, it proposed new restrictions aimed at ensuring ESG funds accurately describe their investments amid growing concerns about a lack of standards. For example, funds labeled ESG must invest at least 80% of their assets in a way that is consistent with that strategy. But the proposals faced political pushback from Republicans, whose influence is likely to grow after the party took control of the House of Representatives this year. In any case, a more critical look is already being cast on ESG funds. The U.S. SIF, the nation’s main sustainable investment association, said such assets would total about $8.4 trillion in 2022, up from $17.1 trillion two years ago. The massive difference, it says, is largely due to changes in methodology. Facilities were required to provide more “granular information” on ECG-related problems. The U.S. SIF said its counterparts in other regions are conducting similar reviews and that they will likely lead to revisions of ratings around the world.

2. What is the landscape like in Europe?

It is ahead of the US and still developing. Investment managers targeting clients based in the European Union must comply with the bloc’s sustainable finance disclosure regulation, the world’s most ambitious anti-greenwashing handbook, which comes into effect in March 2021. sustainable investments and what it took to meet Article 9 to attract investors with the strictest category and a gold star awarded to ESG. The EU has since clarified the regulation to reserve funds that have 100% sustainable investments, excluding hedging and liquidity needs. A review by Morningstar Inc. last year found that Article 9 funds have about 470 billion euros ($506 billion) in assets under management, but less than 5% of funds meet that benchmark. That suggests more Article 9 fund downgrades will follow the $140 billion recorded at the end of 2022.

That would be the EU’s less stringent category known as Article 8, which represents around €4 trillion in customer assets. Unlike Article 9 funds, they do not necessarily make the improvement of environmental or social conditions a goal commensurate with financial returns. But their status is also unclear. In November, the European Securities and Markets Authority proposed that any Article 8 fund with ESG-related terms in its name must demonstrate that at least 80% of its assets actually pursue ESG objectives. And if a fund includes words related to sustainability in its name, it must be able to record a sustainable investment objective of no less than 40% in its portfolio. Morningstar believes only 18% of Article 8 funds will meet that benchmark. ESMA said it plans to publish final guidelines on the labeling of Article 8 funds by the third quarter of the year.

4. Why all the problems with SFDR?

A major source of confusion is the lack of a standard definition of terms such as sustainable investing. Investor groups and asset managers have begun to publicly voice their dismay. The main EU regulators (ESMA, the European Banking Authority and the European Insurance and Occupational Pensions Authority) have asked the European Commission, which developed the SFDR, to provide clearer general guidance to financial markets. The commission said it was looking into the matter, and possibly more. In early December, EU Financial Markets and Services Commissioner Mairead McGuinness told lawmakers the bloc was planning a consultation this year and said a review of the full range of ESG measures may be needed. It’s not clear how far the commission is willing to go, however.

6. What are ESG advocates saying?

Paul Clements-Hunt, who led the United Nations team that created the ESG label in 2004, spent much of the past year criticizing the “marketing frenzy” that had fueled it and predicted a “shake-up” would rid the market of charlatans. It’s a refrain that grew louder after Russia’s invasion of Ukraine, which drew attention to the billions of ESG dollars allocated to Russian assets, many of them state-owned. Some ESG investors even owned Russian government bonds.

7. What are the effects of political battles in the United States?

Conservative Republicans, including Florida Gov. Ron DeSantis and former Vice President Mike Pence, have turned ESG into a symbol of everything they say is wrong with left-wing politics. More than a dozen Republican state attorneys general are cracking down on ESG financial practices, while Republicans in Congress plan to increase their oversight of what they derisively call “woke capitalism.” Meanwhile, President Joe Biden’s sweeping climate package, the Inflation Reduction Act, has been hailed as a game-changer that will direct hundreds of billions of dollars to GHG-related activities such as cleaner energy and electric cars. Much of that spending will come in the same Republican-led states. And the US Department of Labor clarified last year that private sector pension plans can consider ESG factors when choosing investments.

8. What do investors think about chaos?

Better Finance, Europe’s main association for retail investors, has pushed for more transparency, such as mandatory client notifications when asset managers reclassify their funds. Institutional investors have also expressed concern that ESG fund designations are fraught with inconsistencies that need to be addressed. The ECG is clearly going through some sort of cleaning. But despite all the criticism, investors haven’t started pulling cash out of the funds, according to data compiled by Bloomberg. That sentiment suggests the rubric is here to stay. A survey by PwC last year found that 89% of large investors said they had already rejected, or would consider rejecting, an asset manager because of shortcomings in their ESG strategy. The same survey found that 86% were similarly dismissive of those whose corporate ESG efforts had been inadequate. And a Bloomberg survey of terminal users found that more than 60% expect ESG to be a standard part of doing business or increasingly important. About a third of respondents, however, said they thought the EKG was just a fad.

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