Analysing an ESG fund solely by considering the portfolio holdings, without taking into account the investment strategy and who actually manages it, is misleading and ambiguous.
In addition to analysing the portfolio, it is important to consider the asset manager, the investment team and the strategy separately, which results in a more reliable and holistic sustainability rating. Investors and advisors need assistance in identifying truly sustainable investments across all asset classes, in order to help avoid the issue of greenwashing.
Understanding the dynamics in the ESG investing world can be complex, not least due to the lack of uniformity in terms of definitions of what a sustainable product is.
Back to basics
If we define ESG investment funds as those that fall into the categories of Article 8 (ie promoting ESG characteristics) or Article 9 (with sustainable objectives) of the new SFDR regulation, they amount to over €3trn of assets, equivalent to one-third of the value of all European funds.
According to recent market estimates, ESG funds could reach half of the total assets in the market in just 12 months.
These are impressive figures which certainly no one last year would have thought could be achievable in Europe.
To our minds, the Article 8 categorisation in itself is not sufficient to define a fund as ESG and it is still imperative to carry out detailed analysis on the investment in question.
Keep in mind, for example, that the category of Article 8 funds mentioned above includes strategies with very different characteristics, ranging from generalist funds that simply exclude critical sectors from an ESG perspective or companies involved in controversial behaviour, to thematic funds with a sustainability-oriented mission.
It is not a trivial exercise to navigate your way in an enormous universe of funds labelled ESG by asset managers, and in one that is constantly evolving.
Moreover, even at the level of the underlying companies in the portfolio, very different ESG ratings are often assigned by the various providers, thus increasing confusion for investors.
The question investors are increasingly asking is: who actually performs the in-depth ESG analysis of funds?
Not so simple
It is therefore a very complex exercise to measure the sustainability of a fund across the board, given the currently very wide universe of funds and ETFs, while also considering the requirements arising from the new European regulation (SFDR): the identification and disclosure of sustainability risks required by the regulation makes it vital to go beyond simply the average rating of holdings in the portfolio.
Both investors’ questions and regulation itself aims to promote an assessment based on multiple metrics and factors: the asset manager’s approach to sustainability, its ESG policies, the assessment of ESG risk, the level of transparency of disclosures, how sustainability principles are incorporated into the investment process and how these may influence financial performance.
Also, it is important to monitor and incorporate controversies as key steps in trying to reduce the reputational risk of investing in a fund which may invest in issuers/companies associated with controversial activities and/or behaviours.
Today we are in a situation where investing in funds that do not have the minimum ESG considerations will be increasingly complex, both because of regulatory impositions as well as investor demand and manager supply.
However, let us not forget that the transition of wealth to the millennials and younger generations, who have sustainability as an essential principle in many of their choices, is a historic process of transformation.
For these investors, solid ratings based on deep ESG analysis will be a must.
If asset managers do not, will not or cannot step up to this challenge, we could see the wheat separated from the chaff in the coming years.
Neill Blanks is research director at MainStreet Partners
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