Fund managers brace for ESG correction with $4 trillion at stake

ASSET managers are trying to digest new regulatory proposals that have the potential to upend Europe’s biggest ESG fund category.

A plan by Europe’s markets watchdog, ESMA, to set quantifiable ESG and sustainable investing standards is forcing portfolio managers to rethink how they design and market an ESG fund class known as Article 8. Morningstar Inc. estimates that only 18 percent of Article 8 funds, which hold about $4 trillion of assets, currently meet the watchdog’s proposed threshold for sustainable investments.

There’s “a chill of realism,” blowing through the investment industry as managers digest the risks of getting environmental, social and governance designations wrong, said Matt Townsend, a partner at Allen & Overy in London. “This is starting to drive much greater caution in how products are being classified.”

It’s the latest in a wave of regulatory updates causing upheaval and triggering a sense of “mass frustration” among fund managers struggling to keep up, according to analysts at Jefferies International Ltd. There’s already been a cycle of downgrades from the EU’S top ESG class—article 9—to Article 8, after the EU clarified its rules. Downgrading Article 8 funds, however, means forfeiting the right to market a product as ESG or sustainable.

“From a fund’s perspective, reclassifying an Article 8 fund” to the EU’S non-esg product category, known as Article 6, “has a number of knock-on effects,” townsend said.“it’s not straightforward.”

Martin Mager, investment funds partner at Linklaters LLP, said asset managers can’t afford to downgrade from Article 8 if they want to keep ESG clients. “Managers realize they need it in order to do their marketing,” he said.

But European regulators have made clear they’re determined to set much stricter standards around what fund managers can call ESG and sustainable. As part of that process, they’re continually updating the EU’S anti-greenwash rulebook, the Sustainable Finance Disclosure Regulation, which was first implemented in March 2021.

Under SFDR, Article 9 funds must have an ESG goal as their objective. Article 8 products need to “promote” ESG “characteristics.” It’s a broad requirement that’s led to confusion and even greenwashing allegations.

ESMA is now proposing that a fund with Esg-related words in its name have at least 80 percent of its holdings in investments that actually meet the strategy description. Funds with sustainable-related words in their name face an additional requirement to have at least 40 percent of assets that meet SFRD’S definition of a sustainable asset.

ESMA Chairverena Ross said on November 18 that the watchdog’s goal is to “ensure that investors are protected against unsubstantiated or exaggerated sustainability claims.” ESMA wants to give national supervisors and asset managers “clear and measurable criteria to assess names of funds, including ESG or sustainability-related terms,” she said.