Generating value from sustainable regulatory labels

Key points

• As the number of sustainable funds balloons, choosing the right investments can be complicated due to a lack of transparency and clarity in the industry
• Regulators are intensifying their scrutiny of greenwashing, and the labelling of sustainable investments is a step in the right direction
• But investors should only be using these labels as a rough guide until there’s more consistency between them
• And while there may be a dizzying array of terminology to decipher, if you know how to interpret the labels you can also use them for cross-fund comparisons, and to challenge fund managers’ investment processes

Incoming financial regulation aims to increase capital invested sustainably and prevent potential greenwashing. However, fund labelling is at early-stage of development and can be confusing. We look at how investors might use labels, even in current stage, to help make better investment calls and boost portfolio performance.

Sustainable investing may be becoming mainstream; however, investors can’t rely solely on regulatory labels when deciding how to allocate their funds. Indeed, concerns of greenwashing by fund managers marketing their sustainability credentials still abound.

Current regulatory regimes are in their infancy and their approaches to labelling sustainable investments are still developing. Interpretations by different jurisdictions and fund managers mean that there is little consistency when funds are classified.

Additionally, where regimes exist, like in the EU’s Sustainable Finance Disclosure Regulation (SFDR), funds have been changing their initial classifications. For example, Morningstar identified 1,800 European funds that were reclassified from March 2021 to Feb 2022; and 713 funds that were re-classified during the second quarter of this year¹.

As a result, investors should use regulatory labels to inform, but not determine, their investment selection. 

Previously, we’ve explained how investors can Unpick the jargon of sustainable investing. In this article, we outline three ways that investors might profit from regulatory labels without being overly reliant on them.

Labels can provide investors a rough and ready guide 

Investors should read regulatory labels as a rough guide to how sustainability is incorporated into the fund.

Think of them like the frequented spots when taking a holiday fishing trip.  Motoring to locations known for a variety of fish that depend on the locality and season, the skipper will make it clear that you’re fishing for example for grouper or snapper, but not tuna. Of course, you never know what you might reel in, and there’s no guarantee that you’ll catch any fish.

In the EU context, fund managers of Article 8 funds are expected to incorporate, and promote, environmental or social characteristics. Managers have various methods to achieve this. However, it’s clear that they go further than Article 6 funds which do not necessarily integrate any kind of sustainability into their investment process².

It also differentiates them from Article 9 funds, which have an explicit objective to invest exclusively in sustainable investments. These are investments into organisations whose goods and services (their “economic activity”) contribute to environmental objectives, social objectives, or both³.

While Article 8 and 9 labelled funds account for about 35% of funds (see chart), they hold just over 50% of all EU funds by asset value (as of 30 June).

In the end, regulatory labels can indicate what type of fish an investor might expect to catch in a given location when told by their adviser or the fund manager its classification, so to speak.

Using required disclosures to make better fund comparisons

Historically, fund managers did not have to publish or explain how they invested sustainably, making it difficult to compare funds.

Now, managers must disclose various aspects of their sustainability policies, processes, and outcomes to merit a regulatory label. Investors can use these disclosures to more effectively compare funds’ approaches and portfolios.

For example, under Article 8, fund managers apply a wide range of approaches to promote environmental or social characteristics. One manager could screen for holdings based on ESG ratings. Another might target the portfolio to have a higher/lower score on sustainability-related metrics, like carbon intensity. Or a manager could exclude companies that violate UN Global Compact criteria. Another may combine several of these approaches.

EU regulation now requires detail on selected fund characteristics, how these are attained, and indicators and measurements to demonstrate the process. Although data availability does remain an issue, investors can use this enforced transparency to evaluate funds more easily.

Clarifying and challenging fund managers’ investment process

Thus far, fund managers have self-determined their fund’s regulatory classification.

This means making a conscious decision, as well as internal approvals within their organisation. Some managers and firms have been cautious, others ambitious. Ultimately, though, the final decision needs to be defensible against future regulatory scrutiny.

Investors can use these self-selected categories to ask about the investment holdings and the investment process. Again, to the EU context, considering an Article 8 fund, an investor could ask:

• Can you explain the decision to classify as an Article 8 fund?
• Which approach(es) are you taking to incorporate environmental or social characteristics?
• Why these? And why not any others?
• How are you assuring your fund maintains alignment with your selected sustainability criteria?
• How does your classification compare with other funds within your organisation, or competitors with similar/different classifications in the same asset class or thematic sector?
• What would cause you to change the classification (to become an Article 6 or 9 fund)? 
• What evidence are you providing to substantiate the classification?

Moving from labels on the outside, to intentions from the inside

Around the world, financial regulators are establishing frameworks to classify funds. Beyond the EU, the UK, US, Singapore, and others are soon to launch their own systems. Their aim is to encourage greater investment to address social and environmental challenges while also reducing greenwashing.

This is laudable in principle. In practice, the frameworks and their application are embryonic. So investors can’t be sure of labels. However, they can still be useful if you know how to read, and look beneath, them.

More importantly, this reinforces our view that investors should not permit regulatory labels to determine their sustainability ambitions. Instead, begin deciding what you want from your portfolio, then use the frameworks to help with selection and portfolio construction. This inside-out approach focuses attention on where it should be – on your intentions, both financial and sustainable, to maximise the value of your investments to you and the wider world.

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