Is transparency the answer to sustainability uncertainty?
- Labelling funds as sustainable can be challenging due to a lack of regulatory clarity
- Actively managed exchange traded funds disclose their holdings and are one way of creating greater transparency in investing
- There is no silver bullet to tackle greenwashing, but giving investors information is vital
Most asset managers across Europe in recent months have had to re-evaluate how they classify their sustainable funds and strategies.
At heart, these moves stem from an ongoing absence of regulatory clarity and stability over what does, and does not, constitute a sustainable investment. As guidance has changed, asset managers have erred on the side of caution, preferring to reclassify their funds’ sustainability designations than risk being caught on the wrong side of evolving regulation.
The result has been that increasing numbers of Article 9 funds - those with the highest sustainability classification under the EU’s Sustainable Finance Disclosure Regulation (SFDR) - have been reclassified to the broader Article 8 designation.
More changes may yet emerge. Greater regulatory clarity would be helpful, but it seems, given the current complexity and scope for interpretative confusion, any future guidance is unlikely to be the final word.
Time for a different approach?
The core problem with sustainable investment, in terms of disclosure frameworks and labelling systems, is definitional. Most managers employ their own scoring systems and assess the sustainability of a company – through its products, services and operations – idiosyncratically or via specialised data vendors. It is therefore challenging for groups to decide exactly how to label funds without clear direction as to what is considered sustainable under the rules.
That may yet change.
But, in the meantime, we should ask if the industry could do more to help achieve the aims of SFDR - to increase transparency and build a consistent environmental, social and governance (ESG) framework for investors - by other means.
One way could be for asset managers offering sustainable strategies to seek to be far more transparent. That could mean, at the portfolio level, managers disclosing all holdings in the funds they regard as sustainable. Prospective (and existing) investors could easily discover, at the click of a mouse, what stocks a fund holds, and decide whether or not they want to be exposed to those companies.
Of course, some may not agree that all a portfolio's holdings fit their personal definitions of sustainability. They would, however, know exactly what they would be buying. This may not completely irradicate greenwashing in the narrow sense (some asset managers could still attempt to make inflated claims), but it would make it far easier to detect, as investors would enjoy more complete portfolio information than they often do today. Greenwashing would, over time, wither away.
Needless to say, this approach would be challenging for the asset management industry, both technically and in terms of mindset, to adopt at scale. But is it not impossible going forward to see such a future utilising existing infrastructure? For instance, some investment structures, like exchange traded funds (ETFs), already provide a format that could form the basis of an evolved category of highly transparent, sustainable funds.
ETFs typically disclose complete holding information every day the markets are open. As almost all are passively managed vehicles that track an index, this transparency is, to some degree, superfluous: the underlying holdings of major indices are already public knowledge.
This transparency is far more valuable when it comes to active ETFs – active strategies offered in an ETF wrapper. For some asset managers, offering active strategies in this format can be unappealing as it would mean disclosing their intellectual property - their stock selections and allocation tilts. But transparency, for those managers willing to publicly share their positioning convictions, could be a fundamental way to address greenwashing.
At face value, it neatly solves a simple problem. Sustainably-minded investors are typically attracted to a fund because its objectives and approach appeal to their values. Disenchantment can occur when it fails to meet their expectations. Asset managers can avert this problem by simply being more transparent about what they hold and why. For instance, if an Article 8-level fund holds transitioning stocks - those some investors might not, at first glance, expect to see in a sustainable fund - asset managers can be open about the fact they are held, and clear about why they consider them appropriate for inclusion.
This is key. Asset managers are responsible for conducting the research and analysis that drives investment decisions. They also engage with investee companies to influence their behaviour, a key tenet of responsible investing. Their judgement and conviction are accordingly central, but some investors know less than they could about why some sustainable funds will hold certain types of stocks.
By being more open about their investment choices and aims, asset managers can help investors select the sustainable funds that are right for them, and minimise reliance on a classification or rule interpretation that might be subject to change.
An active approach
When it comes to creating genuinely sustainable funds, the investment approach, whatever the fund format, must be active. Attempting to construct an Article 9-equivalent fund by simply excluding some sectors in an index is far from desirable when every investment held has to be truly sustainable.
That is why passive strategies, which are typically found in the ETF format, make little sense in this space. Some may point to smart beta as an exception, but these are custom-built strategies created through active decisions. The advantage of ETFs in this sense lies purely in their structural transparency.
Of course, it is unrealistic to expect the industry to convert every sustainable strategy into an active ETF - and nor need they. Costs and logistical challenges aside, many will simply not want to move away from the mutual fund model. But going forward the more successful asset managers in the sustainable space are likely be the most transparent ones, because they will be held - publicly - to the highest standard. They will always conform to the spirit of regulation, even if the letter of it is subject to change.
Ultimately, we do not want to end up in a situation where asset managers become so concerned about contravening evolving rules that they simply classify all funds Article 8 or the non-sustainable Article 6 classification. In the end, we all need capital to be channelled to sustainable businesses. In this respect, regulation could yet fulfil an important role.
But if some asset managers are willing to argue the case for sustainability in the assets they choose to hold in a fund - and are prepared to accept the scrutiny that transparency brings - it would help move the sustainability market forward while creating clear and discernible distinctions between products. Inevitably, this will evolve as investors decide for themselves how to allocate capital according to their values. But this will be an organic, progressive process.
There is no silver bullet to tackle greenwashing. But surely arming end-investors with better information - and helping them to make their own judgements - should be an important facet of a sustainable market that will play a vital role in tackling the existential threats facing us all.
This article first appeared on the Pensions & Investments website on 24 February 2023.