Can you have too much of a good thing? For regulators looking at the recent proliferation of funds sold with an environmental, social and governance stamp, the answer may be “yes”. Fund managers who cannot substantiate ESG branding had better beware.
According to data provider Morningstar, the number of “sustainable” — that is, ESG-focused — open-ended and exchange traded funds in the US increased last year by 30 per cent, to 392.
They attracted a record $51.1bn of net inflows, more than twice the amount in 2019, with investors drawn not just by ethical and environmental concerns but also by the prospect of good returns. Over the three years to the end of 2020, 75 per cent of ESG funds ranked in the top half of their fund category for performance, Morningstar says.
Reluctant to miss out on this bonanza, managers of some long-established funds have repurposed them for the ESG era, adopting new investment strategies and ESG-signalling names. Morningstar says 69 have done so since 2013 — 25 in 2020 alone, of which the two biggest were Invesco Floating Rate, now Invesco Floating Rate ESG, and USAA World Growth, now USAA Sustainable World.
“I am sure that some folks, because ESG and responsible investing are sometimes hard to define . . . have taken advantage of the marketing opportunities that having an ESG or sustainability label would have afforded them,” says Meredith Jones, a partner and global head of ESG at professional services firm Aon.
This surge in ESG branding has attracted the attention of the Securities and Exchange Commission, the US financial regulator, which has indicated that it will not tolerate “greenwashing” — the practice of embellishing or misrepresenting an investment product’s ESG characteristics.
Addressing his organisation’s asset management advisory committee in July, SEC chair Gary Gensler said: “we’ve seen a growing number of funds marketing themselves as ‘green’, ‘sustainable’, ‘low-carbon’ and so on” — and noted that “there’s not a standardised meaning of these sustainability-related terms”.
He said SEC staff were considering asking managers to disclose the criteria they use in making such claims, as well as reviewing the policy on fund naming conventions. “If a fund’s name suggests a certain investment focus, investors expect investment in that area,” Gensler stated.
Regulators elsewhere are tightening up ESG disclosure standards. In Europe, the Sustainable Finance Disclosure Regulation, effective since March, requires asset managers to use a uniform set of reporting standards in disclosing the impact their portfolios have on people and the planet.
The growing regulatory and reputational risk in sustainable finance was illustrated in August, when DWS, Deutsche Bank’s asset management arm, became embroiled in a row about its ESG claims. Following allegations by Desiree Fixler, DWS’s former head of sustainability, that it had misrepresented the rigour of its ESG processes, both the SEC and BaFin, the German financial regulator, launched investigations into the firm.
DWS says it rejects Fixler’s allegations, and insists that it has “always been clear” in its ESG reporting.
The furore erupted weeks after not just Gensler’s remarks, but also a DWS announcement that nine of its ETFs would be renamed to include the ESG tag.
DWS’s travails have sent shockwaves through the ESG sector. As managers try to predict precisely how the SEC will approach their investment products, compliance experts advise detailed risk disclosures and caution in making sustainability-related claims.
“ESG isn’t really new any more, but in the broader picture it is a new area in terms of compliance and enforcement,” says Jason Ewasko, chief compliance officer at Cipperman Compliance Services.
“I would recommend caution for any firms that are looking to slap ESG on to a strategy or a model or a portfolio,” he adds. “It’s clear to anybody who’s half awake that the SEC is scrutinising this.”
The regulator’s initial steps may include requiring firms that use ESG-related fund names to justify them through detailed reporting and standardised disclosures of the risks inherent in such products.
“We anticipate, with the current administration, that there will be more guidance,” says Anthony Eames, director of responsible investment strategy at Calvert Research Management. “I think managers are going to have to be able to prove that, if ESG is integrated, how it is integrated.”
Managers also expect regulators to be mindful of the policies emerging among their overseas counterparts.
“One of the questions that the SEC has right now for asset managers [is] how we see things in a global context,” says Jens Peers, CEO and chief investment officer at asset manager Mirova US.
“The industry wants to avoid having different rules in different parts of the world,” he adds. “At this stage, I see no evidence of regulators co-ordinating policies, but I’m sure they keep a close eye on developments in other countries.”