An explosion in the number of ETFs that invest according to environmental, social and governance principles is fuelling concern among regulators that fund managers are “greenwashing”: using misleading environmental claims to entice well-meaning customers.
Exchange traded funds that use ESG metrics to inform investment decisions have developed into a key driver of new business for asset managers as more investors seek strategies that can deliver returns from doing good.
As a result, the number of ETFs carrying an ESG label more than doubled in the past two years, reaching almost 1,300 at the end of 2022, according to ETFGI, a London-based consultancy.
But all these ESG ETFs differ in their approach, ranging from “dark green” funds — designed to be compatible with the Paris Agreement goal of limiting global warming to 1.5C — to index trackers that retain significant exposures to fossil fuel companies, and to a wide variety of “thematics” that target specific ESG priorities.
“The speed of product proliferation means that investors have to do their homework with real care to ensure that they choose an ESG ETF that matches their needs and expectations,” says Deborah Fuhr, the founder of ETFGI.
ESG ETFs held global assets worth $394bn at the end of last year after registering net investor inflows of $74.7bn during 2022 — a drop of 54.5 per cent on the $164.3bn gathered over the previous 12 months, according to ETFGI.
That decline in new business for ESG ETFs last year was significantly larger than the wider 33.7 per cent drop recorded in the ETF industry’s overall net inflows.
This suggests that an increasingly fractious debate over ESG standards — along with mounting attacks by US Republican politicians — has started to damp investor demand. Republican governors from at least 19 US states have pledged to resist ESG investing, over antitrust, consumer protection and discrimination concerns.
Fund managers, on the other hand, complain that incomplete disclosures by companies, particularly regarding environmental data, combined with shifting regulatory requirements, have created real difficulties for product designers.
Problems are also evident in Europe, home to ESG ETFs holding $253bn-worth of assets. Possible accusations of greenwashing have prompted asset managers, including BlackRock, Amundi and UBS, to remove ETFs from the EU’s strictest ESG category, known as “Article 9”, which covers funds that hold sustainable investments or which target reductions in carbon emissions.
Amin Rajan, chief executive of the investment consultancy Create Research, says the reclassification of multiple Article 9 funds “shows that greenwashing was occurring but it remains difficult to say if this was deliberate or unintentional”.
However, the downgrading of almost all ETFs tracking Paris-Aligned Benchmark (PAB) and Climate Transition Benchmark (CTB) indices prompted the European Commission to issue a clarification this month. Fund managers will be permitted to carry out their own assessments for sustainable investments and they must also disclose their methodology, according to the Commission.
Raza Naeem, a partner at the law firm Linklaters, says the new guidance would be “welcomed by the [fund] industry, although some will likely think this has come too late”.
Hortense Bioy, global director of sustainability research at the data provider Morningstar, believes managers in Europe will want to be seen as sustainability-focused, so there will now be commercial pressures on them to reclassify their funds as Article 9.
“Some asset managers will be relieved that the Commission has decided against imposing minimum standards, as the onus remains on product providers to determine the level of sustainable investments in each of their funds based on their own methodologies,” she says. “Some other managers would prefer to have seen minimum requirements, as that would have levelled the playing field and been easier for end-investors.
“Investors will now have to do more due diligence to understand the methodologies used. Investors may also be confused by the flip-flopping that we are likely to see over fund classification.”
Even more changes could follow. Europe’s top three financial regulators this month proposed additional changes to disclosure and reporting requirements that would require investment products labelled as “sustainable” to carry more information about decarbonisation targets and how they will be achieved.
UK regulators appear anxious to avoid the problems that have bedevilled the development of the ESG market in Europe. The Financial Conduct Authority is consulting on the introduction of a new set of consumer-friendly labels for sustainable investments. It has proposed restrictions on investment managers using terms such as “green” and “ESG” in fund marketing documents.
In March, the FCA also issued a blunt warning to index providers that they were fuelling greenwashing after identifying “widespread failings” in ESG-related disclosures. It has said ESG ratings providers should be formally regulated, too.
“We are witnessing the birth pangs of a new form of investing which involves big value judgments,” says Rajan. “The definition of a ‘good company’ varies greatly between different countries and cultures. ESG data disclosures and reporting will improve due to pressure from investors, regulators and company directors who have a fiduciary duty to shareholders.”