ESG Fund Downgrades Spark EU Investor Group Complaint

Europe’s main association for retail investors says members are largely being left in the dark as they try to figure out how a mass wave of ESG fund reclassifications will affect their savings.

Some of the world’s biggest asset managers spent the past several weeks removing the European Union’s top environmental, social and governance investing designation from funds, in response to stricter guidance from the EU Commission. Though some firms have notified clients, the industry’s approach has lacks consistency and transparency, according to Better Finance, which represents roughly 4 million financial services users across more than two dozen countries.

In all, well over $125 billion of funds have been hit by downgrades, as the lines of Europe’s ESG market are fundamentally redrawn. Industry bosses say confusing EU ESG investing rules are to blame. But retail clients are also starting to point the finger at investment firms for appearing to keep the flow of information at a minimum.

“As it stands, the process of informing investors of changes is limited to companies posting a very basic explanation or motivation as to why they’re downgrading their funds, for example by pointing to the regulatory changes and requirements,” said Arnaud Houdmont, chief communications officer at Better Finance. “But investors are rarely informed of key differences between such funds and need further clarity.”

When a fund is reclassified, asset managers should be required “to explain their reasoning and methodology for downgrading,” Houdmont said. Better Finance, created in 2009 in the wake of the financial crisis, is sending its recommendations to the EU Commission, urging the bloc’s executive arm to address its concerns.

Since the Sustainable Finance Disclosure Regulation was enforced in March 2021, the EU Commission has clarified that so-called Article 9 funds, the bloc’s top ESG designation, must be reserved for 100% sustainable investments, save for hedging and liquidity needs. It’s a requirement that asset managers only started acting on in earnest in the latter part of this year, as they face a Jan. 1 deadline to provide quantitative proof of their ESG claims to meet so-called Regulatory Technical Standards.

The billions of dollars worth of Article 9 funds that have been downgraded have almost all become Article 8 products, which is a less stringent ESG designation within SFDR. It’s also a considerably bigger fund category, covering roughly $4 trillion in client assets, according to data compiled by Bloomberg.

Europe’s markets watchdog, ESMA, has proposed minimum thresholds that Morningstar Inc. estimates would mean only 18% of Article 8 funds could rightly call themselves sustainable. That has retail investors wondering what they’re left with, as funds that once carried the EU’s highest ESG tag suddenly get lumped in with a category whose ESG status is questionable.

“On the one hand, the market doesn’t have a uniform interpretation, which risks being to the detriment of retail investors’ understanding of the financial products they’re investing in,” Houdmont said. “On the other, there is little support to enable retail investors to properly distinguish between these two categories of financial products.”

Mikhaelle Schiappacasse, a partner at law firm Dechert who advises asset managers, said it’s important to remember that many of the downgraded funds haven’t changed strategy, just their SFDR designation.

“The question becomes when you’re downgrading, do you have investor consent issues,” she said. “Most people can be fairly comfortable in that scenario that this wasn’t a situation of misrepresentation. It was a situation of lack of clarity around the rules, which were clarified and managers adjusted to it accordingly.”

Ultimately, “investors were always getting what they were told they were getting,” Schiappacasse said.

Still, the EU Commission has taken note of the level of confusion among asset managers and their clients, and has promised to launch a consultation into SFDR early next year.

Mairead McGuinness, the EU’s financial markets and services commissioner, said earlier this month that some asset managers appear to have taken too “liberal” an approach when assigning ESG designations to financial products. But she also promised a consultation on SFDR early next year.

“We may need to take a much broader look at this regulation,” she told lawmakers on Dec. 6. And if efforts to address shortcomings in SFDR fail, then the EU may need to embark on a fundamental rewrite of the regulation, McGuinness said.

In a position paper dated Dec. 20, Better Finance noted that EU Law “rightly requires information provided to individual investors to be clear.”

“As such, retail investors expect definitions and classifications of funds to be understandable,” it said. For now, though, they’re being “left alone in interpreting whether or not there are intended, of even unintended, greenwashing practices, with limited guidance and support.”

Frances Schwartzkopff reports for Bloomberg News.

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