In my last post I wrote about seven principles for ESG investing. I developed these principles in collaboration with Desiree Fixler. Ms. Fixler was the group sustainability officer at the large German asset management firm DWS. She was fired after six months on the job when she raised concerns internally about the firm’s marketing practices around ESG investing products. The goal in this piece was to suggest some simple principles to help any asset manager who is constructing and selling ESG investment products. Since DWS is now being investigated by BaFin (the German securities regulator) and the Securities Exchange Commission (SEC) and Department of Justice in the U.S., the DWS situation has been a “teaching moment” for asset management firms all over the world.
A key point Ms. Fixler and I made is that since there is so little regulation regarding ESG investment products, it is important that asset managers manufacturing and selling them be clear about what this term means to them. That said, regulators are starting to address this issue. In the U.S., on April 9, 2021, The Division of Examinations at the SEC published a Risk Alert on ESG Investing which states that the SEC will be evaluating portfolio management, performance advertising and marketing, and compliance programs. AMF, the French equivalent to the SEC, has also issued guidance in its July 27, 2020 position/recommendation paper “INFORMATION TO BE PROVIDED BY COLLECTIVE INVESTMENT SCHEMES INCORPORATING NON-FINANCIAL APPROACHES.” So has BaFin, “BaFin Consultation on Guideline for Sustainable Investment Funds,” on August 2, 2021. In June of 2021 the International Organization of Securities Commissions (IOSCO) published a Consultation Report “Recommendations on Sustainability-Related Practices, Policies, Procedures and Disclosure in Asset Management.” Also worth noting is the EU’s “Sustainable Finance Disclosure Regulation” and its guidelines for what can be deemed as Article 8 and Article 9 funds.
I found the July 19, 2021 letter, “Authorised ESG & Sustainable Investment Funds: improving quality and clarity,” by the U.K.’s Financial Conduct Authority (FCA), the U.K. equivalent of the U.S. SEC, sent to the chairs of asset management firms, to be especially thoughtful. This letter was informed by extensive fact-finding work, as well as a research project on how consumers react to funds’ sustainability claims and make investment decisions. One finding of the research was that objective labels matter. Another was that consumers cannot easily identify exaggerated or misleading claims.
The letter begins by noting how strong investor interest is driving the tremendous growth in ESG products, by whatever name. The FCA notes that there “is now a wide spectrum of ESG and sustainable investment funds, reflecting different objectives, investment strategies and characteristics.” It expresses its support for the product innovation taking place, but also notes some significant challenges “such as improving ESG-related data and metrics.” It also expresses its concern about “the number of poor-quality fund applications we have seen and the impact this may have on consumers” and clearly states that “This must improve.” Towards that end the letter lists three principles that asset managers should follow. The overarching principle is Consistency: “A fund’s ESG/sustainability focus should be reflected in its design, delivery and disclosure. A fund’s focus on ESG/sustainability should be reflected consistently in its name, stated objectives, its documented investment policy and strategy and its holdings.”
I thought it would be a useful exercise to compare the preliminary list of seven principles suggested by Ms. Fixler and me to the three principles from one of the world’s leading securities regulators. I found a substantial degree of commonality, but also two notable exceptions. The FCA’s principles rightly incorporate the importance of stewardship, something Ms. Fixler and I neglected. Conversely, she and I note the importance of governance, and this is largely lacking in the FCA’s principles, but more on this below.
Principle 1. The Design Of Responsible Or Sustainable Investment Funds And Disclosures Of Key Design Elements In Fund Documentation.
There are four key considerations in this principle: fund name, investment objectives and policy, investment strategy, and stewardship approach. This principle addresses our Principle No. 1: Have Clear Criteria For What Is Meant By An ESG Product.
The fund name should not be misleading and should accurately reflect the investment objectives and strategy of the fund which should be clearly communicated. The description of the investment strategy should include such key elements as:
· The investible universe, including investment limits and thresholds
· Any screening criteria (positive or negative) that it applies
· Specific E, S, and G characteristics/themes or ‘real world’ (nonfinancial) impacts that it pursues
· The application of benchmarks/indices, including any tilts to mainstream benchmarks, and expected/typical tracking error relative to the benchmark
· The stewardship approach to the fund
The attention to stewardship is one of the great strengths of the FCA’s approach. This involves the exercise of voting rights consistent with the name and investment strategy of the fund. If stewardship is part of the fund strategy and objectives, this should be clearly explained. For example, a fund might be based on selecting companies that are underperforming on some dimension of sustainability but through engagement this can be improved with a concomitant improvement in financial performance. If engagement is not a part of the fund’s objectives, this should be explicitly noted.
Principle 2. The Delivery Of ESG Investment Funds And Ongoing Monitoring Of Holdings.
The key considerations for this principle are resources to support delivery; data, research, and analytical tools; and holdings. This principle addresses our Principles No. 2 (Choose Your ESG Data Vendors Carefully), No. 3 (Develop A Rigorous Process For How You Aggregate These Data), and No. 4 (Have An Integrated Process For Constructing ESG Products).
Resources to support delivery include investment professionals with the appropriate skills and experience, ESG/sustainability research and data, analytical tools, and technology support. Since ESG integration is a relatively new phenomenon, many investment professionals are still coming up the learning curve on how to effectively do this.
In terms of the second consideration, Ms. Fixler and I noted that there are a number of challenges in developing and using ESG data, whether done internally or purchased from third parties. The FCA notes the importance of having the appropriate resources to oversee ESG data and its use and that the asset manager “should also consider due diligence on any data, research and analytical resources it relies upon (including when third-party ESG ratings, data and research providers are used) to be confident that it can validate the ESG/sustainability claims it makes.” Model validation and data governance are essential. Any gaps and limitations in data and analytical tools should be recognized and addressed in terms of meeting the fund’s objectives.
In terms of holdings, the asset manager needs to ensure that any reasonable investor examining the stocks being held in the fund properly reflect the fund’s name and the ESG claims for what is trying to accomplish, in addition to financial returns. If some of the holdings look to be inconsistent with the strategy, this should be explained. The fund manager should also make disclosures about how its stewardship activities support fund objectives, such as contributing to the climate transition or diversity, as well as any ‘real world’ metrics that are relevant.
Principle 3. Pre-Contractual And Ongoing Periodic Disclosures On Responsible Or Sustainable Investment Funds Should Be Easily Available To Consumers and Contain Information That Helps Them Make Investment Decisions.
The key considerations for this principle are easy availability, pre-contractual disclosures, and ongoing performance reporting. This principle addresses our Principle No. 5: Ensure That You Are Authentically Walking Your Talk.
Easy availability means that consumers have ready access to relevant ESG/sustainability-related information. This includes third-party data and analytical tools. Without violating any intellectual property considerations, the fund manager should provide “interpretative information, describing relevant methodologies used and highlighting any material data considerations/limitations.”
Pre-contractual disclosures regarding the fund’s ESG/sustainability focus should be clear, fair, and not misleading, and readily available in regulatory documents and marketing materials. “The information should be presented in an accessible way that is clear, succinct and comprehensible, and that forms a sufficient basis to support consumers in making investment decisions.”
Ongoing performance reporting includes key performance indicators (KPIs), non-financial (real-world) outcomes, and stewardship. When a fund has certain ESG/sustainability objectives that can be quantified, progress on these KPIs should be reported on a periodic basis. For example, a fund that invests in “green” companies, such as a ratio of revenues to carbon emissions, it should periodically report on this KPI, and against expectations if these are included in the fund prospectus. Non-financial or ‘real-world’ outcomes are often described in the language of “impact.” When these impacts can be quantified, the fund should report on them, explaining what standards and frameworks it is using to do so. When these impact objectives cannot be quantified, narrative information should be provided such as through examples of actions taken by companies in the fund portfolio.
Stewardship factors into this principle as well. If stewardship is a core element of the fund strategy, the asset manager “should articulate clearly, on an ongoing basis, how the execution of its stewardship strategy has supported the achievement of its stated objectives.”
What is largely missing from the FCA’s three principles are our Principle No. 6 (Identify And Manage Conflicts) and Principle No. 7 (Ensure Proper Governance At All Levels Of the Organization). These are very important issues, for the reasons I explain in my previous post.
That said, the FCA doesn’t regard their letter as their final word on this important topic. Towards that end, their 2021/2022 Business Plan has some priorities that can easily build out from the guidance in their letter. This business plan will also support the commitments made in the July 1, 2021, Mansion House Speech by Chancellor Rishi Sunak. Included in this work are sustainability reporting requirements, ESG/sustainability fund labeling, and oversight of ESG data vendors.
What I think would be ideal is that IOSCO build on the work of the FCA, AMF, BaFin, the SEC and other securities regulators, as well as its own paper cited above. It could develop a baseline of principles for ESG investing that cover those of the FCA and the ones suggested by Ms. Fixler and me, with whatever additions it deems appropriate. Given that IOSCO “develops, implements and promotes adherence to internationally recognized standards for securities regulation,” it has a key role to play in ensuring that global securities regulation keeps pace with developments in the ESG market. Work has already started through the IOSCO Sustainable Finance Task Force and should continue beyond COP26.
Obviously, each country has its own set of securities laws to which these global baselines will have to be adapted. But ESG investing is a global phenomenon and institutional and retail investors want to be able to invest globally. Having some clear global guidelines regarding ESG investing would help to ensure the authenticity of this investing. It is crucial that ESG products, and the surrounding financial ecosystem, develop with integrity, and that investors can trust that ESG products are designed in a way that is clear, fair, and not misleading. Failure to do so will just provide more grist to the mills of the critics. This will ultimately compromise efforts to develop authentic sustainable investing products that deliver the appropriate risk-adjusted returns and contribute to the “real-world” outcomes they claim to be addressing.