How Asset Managers Are Driving ESG Investing

In response to investor demand, asset managers are increasingly using environmental, social, and governance factors as part of their security selection. However, because funds use widely varying nomenclature to describe their aims and approaches, investors still face some challenges in determining what a sustainable fund does. Policymakers can provide some help to make the landscape clearer but should avoid erecting barriers to new, innovative approaches to ESG investing.

We take a look at where this effort stands today and what is still needed from regulators.

Asset Managers Have Embraced ESG Investing, but Lack of Common Nomenclature is Problematic for Investors There are now 311 sustainable open-end and exchange-traded funds in the United States (more than triple the amount from only a decade ago), along with more than 2,500 in Europe, as asset managers respond to investors' demand for investments that align with their sustainability preferences and values, according to Morningstar data.

However, the term “sustainable funds” can describe a wide variety of strategies. Our sustainable funds framework includes three subgroups of funds:

• ESG Focus funds, which use ESG criteria as a key part of their security selection and portfolio construction process.
• Impact/Thematic funds, which seek to make a measurable impact with investments on specific thematic areas like climate change, gender diversity, and community development.
• Sustainable Sector funds, which are nondiversified funds investing in mostly environmental-services industries and renewable energy.

In addition to funds committed to sustainability, many otherwise conventional funds now include some consideration of ESG issues within their investment process. These funds, known as ESG Consideration funds, invest across a variety of asset classes and implement their goals in numerous ways. They are also becoming increasingly common as more asset managers incorporate ESG factors in their analysis: In two years, the number of ESG Consideration funds in the U.S. grew more than tenfold, from fewer than 50 at the end of 2017 to over 500 as of December 2019. In Europe, integrating ESG factors at the research, securities selection, and/or portfolio level has become the norm.

However, because of the newness of the area, the ESG information that mutual fund asset managers disclose about their holdings can be inconsistent. Third parties use their own approaches to analyze a fund’s holdings and estimate the degree to which a fund is sustainable or meets various ESG measures, and this approach may not align with the definition the asset manager uses to define an ESG holding or how their strategy reflects an ESG approach. This sustainability data is valuable for investors, and asset managers should present sustainability information in a way that helps lay investors understand a fund’s sustainability objectives.

To some extent, this is a problem caused by inconsistent disclosures from issuers. For example, companies inconsistently disclose their direct and indirect carbon emissions, as well as the carbon emissions in the value chain, so asset managers often end up double-counting carbon emissions.

To understand why, consider an asset manager that discloses the carbon footprint for a portfolio with equities issued by Company A, which reveals both the carbon it produces (scope 1 emissions) and the carbon that its energy suppliers produce (scope 2 emissions). Company A is also part of the supply chain for Company B, which also discloses the emissions of Company A as part of its supply chain (scope 3 emissions). The asset manager has now double-counted the emissions of Company A. In an ideal world, every issuer would disclose its scope 1 and scope 2 emissions, eliminating the need to worry about double-counting, but since disclosure practices vary, double-counting persists at the portfolio level. This is a major issue because it can overestimate exposure to carbon risks.

Regulators Can Help Build Confidence in ESG Investing by Clarifying the Approaches of Sustainable Funds Regulators could boost confidence in the sustainable funds universe by tightening requirements for how funds address ESG factors in their prospectuses--at least in jurisdictions that have not yet done so. These prospectuses should provide clear, consistent descriptions on funds' approaches to considering or incorporating ESG factors in their analysis and through their stewardship activities.

Regulators need to provide flexibility, however, and we do not believe that investors would benefit from efforts to tie fund names to a specific percentage of “green” holdings or other highly prescriptive approaches. Regulators also need to be sure that fund-level disclosures match issuer-level disclosures.

For example, the growth of ESG Consideration funds presents the challenge that simply adding a line to a prospectus that “ESG is considered” does not convey the extent to which the manager acts on ESG factors. In fact, nearly 60% of these ESG Consideration funds in the U.S. fail to earn a High Morningstar Sustainability Rating. Investors need clear and consistent disclosures that make it easy to understand what a portfolio manager is doing when it considers ESG factors and also that these considerations do not necessarily mean a fund is more sustainable.

Similarly, investors need more disclosure on the extent to which funds integrate different ESG factors. Investors interested in amplifying the effect of their investments also need consistent disclosures that explain how a fund does so and how it evaluates success. For example, in a recent analysis, Morningstar found that funds that market themselves as climate funds often have exposure to companies deriving revenue from fossil fuels. Such exposure may be appropriate given a fund's strategy, but it is important that investors understand what they are getting from their investment.

Given these needs and the current state of disclosures, we believe that regulators could require that funds with “Sustainability” or “ESG” in their names:

• be able to demonstrate "intentionality," or that their process has been carefully designed to consider a variety of ESG indicators to arrive at a sustainable investment mix, and
• evaluate all aspects of ESG, both qualitatively and quantitatively. For example, in Hong Kong, the Securities and Futures Commission requires green or ESG funds to substantiate that they invest primarily in sustainable securities.

However, we do not think that eco-labels or other regulatorily defined sustainable naming conventions will ultimately help investors choose a fund that matches their sustainability goals.

Policymakers' Next Steps for Evaluating the State of ESG Investing When it comes to streamlining ESG investing for investors, European policymakers are the furthest down the road. As soon as March 2021, asset managers will be required to add more substantive information to their websites and prospectuses. In 2022, they will also be subject to additional quantitative measures in annual reports that attest to their success in achieving their ESG aims. The twin challenges for the policymakers are ensuring that disclosures are useful to investors and that asset managers have access to the underlying data that they need from issuers.

In a new research paper, "EU Sustainability Disclosures," Morningstar's Policy team fully explores these requirements, timings, and challenges.

In the U.S., the SEC has issued a Request for Information, or RFI, that will assess whether ESG fund names should have 80% of their portfolio in “ESG securities.” With regard to these “ESG funds,” we do not see a widespread problem of misleading names. We also think the 80% rule is generally inappropriate for ESG funds, as ESG funds tend to follow strategies rather than investing in particular asset types.

Rather, the SEC should follow other countries’ leads and explore a principles-based approach to ESG fund names that examines intentionality and whether ESG funds evaluate all aspects of ESG, both qualitatively and quantitatively.