The SEC’s Proposal Is a Good First Step for ESG Disclosures

The SEC has proposed a significant change to the way mutual funds and advisors describe their use of environmental, social, and governance factors in their investing. In this article, we will focus on funds, because if these new proposals are adopted in anything resembling their draft form, investors will have a lot more information to evaluate sustainable funds.

The SEC’s goals are laudable. The commission seeks to “promote consistent, comparable, and reliable information for investors” on how funds incorporate ESG information into their investment process. We at Morningstar share those goals, although we prefer to think about disclosure using the three C’s: consistent, comparable, and comprehensive. (We support reliable disclosures, but if the disclosures are consistent and comparable, they should be reliable.)

This proposal is just that: a proposal. We expect the SEC to make significant changes as it evaluates the hefty stack of comments it received in response to the first draft. Nonetheless, we also expect a final rule that will substantially increase the disclosures funds will have to provide. This will in turn create more questions from investors and create some opportunities for advisors to help investors align their investments with their values.

I will discuss what we at Morningstar like about the proposal, what we think could be improved, and what advisors should keep in mind in advance of a final rule.

It’s Time to Require Structured Fund Disclosures

We agree with the SEC in principle that there are many different ESG or sustainable-fund strategies available to investors and that without more structure, it’s hard for investors to understand what a fund actually does to incorporate ESG information. This is not the fault of the fund companies—it’s the regulator’s job to help structure these disclosures and reduce confusion.

We support requiring funds to disclose ESG information in a consistent, comparable, and comprehensive fashion. Further, we agree with the SEC’s overall goals: Funds should report data in a structured format and be subject to certain minimum standards and formats standardized across funds.

That said, we also hope fund companies will go above the proposal’s minimum and disclose additional metrics when they are relevant.

A More Nuanced Approach Is Needed

The SEC’s proposed framework allows for only three categories of sustainable funds: ESG integration, ESG-focused, and impact. It can be very hard for investors to draw clear lines between these strategies, and many sustainable funds consider more than one approach.

We would prefer a system that allows for a more nuanced approach to how funds disclose where they fall within the range of ESG strategies. The Morningstar Sustainable-Investing Framework gives investors six approaches that sit on a spectrum, from avoiding negative outcomes to advancing positive ones:

1. Apply Exclusions. These funds exclude issuers based on certain products and services, industries, or corporate behaviors.

2. Limit ESG Risk. These funds use information such as ESG ratings to assess a company’s material ESG risks as part of an overall assessment of risk.

3. Seek ESG Opportunities. These funds use ESG information to identify companies that are sustainability leaders with established competitive advantages or companies that are improving their ESG practices to build competitive advantages. This approach includes what is sometimes called “ESG best in class” or “positive screening” based on ESG ratings.

4. Practice Active Ownership. These funds, as shareholders in public companies, seek positive ESG outcomes via active ownership. This includes engaging directly with companies on ESG issues, proposing ESG-related shareholder resolutions, supporting ESG issues through proxy voting, participating in ESG-related investor coalitions, or advocating for public policy measures that address sustainability concerns.

5. Target Sustainability Themes. These funds identify investments that stand to benefit from the long-term trend toward greater sustainability. Such themes may be environmentally related, such as renewable energy, clean technology, and clean water. They can also be social themes, such as gender equity, managing population growth, and health and well-being.

6. Assess Impact. These funds integrate impact assessments into security selection and portfolio construction. Fixed-income managers, for example, may focus on bonds that finance projects to benefit people and planet. Equity managers may consider whether a firm’s products and services support the United Nations Sustainable Development Goals, which many investors and companies use as an impact framework. At the portfolio level, a fund may assess the overall impact of its portfolio holdings in relation to a goal or benchmark.

Using this framework, we can see that the SEC disclosure proposal misses several types of ESG funds. Only the Apply Exclusions and Assess Impact approaches are captured by the proposal.

Eliminate the ESG-Integration Category

In the proposal, the SEC describes ESG-integration funds as any fund that uses ESG information in its investing process. The problem with this is that ESG investing is becoming so mainstream that this disclosure requirement would apply to too many funds to be helpful to investors. It would also impose an unnecessary burden of disclosure on funds.

Beginning in 2016, the first time the term “ESG” was used in a fund prospectus, Morningstar began tracking the number of mentions. By 2019, nearly 600 funds (not counting ESG-focused and impact funds) mentioned ESG in their prospectuses. We subsequently stopped tracking this data because these so-called ESG-integration funds became too numerous for the metric to be useful to investors.

Given that such a large number of these funds are using ESG in some manner to inform their investment decisions, even if only on occasion, it is not beneficial to require all of them to detail their approach—especially when it might not be central to their strategies. It may even be harmful. The added disclosure burden could discourage asset managers from continuing to incorporate ESG, and it could mislead investors into thinking that many mutual funds are ESG funds in some manner when in fact they are not.

To avoid these risks, we recommend that the commission eliminate the ESG-integration category.

More ESG Disclosures

Regardless of how the SEC adjusts the proposals, we expect investors will soon have more access to comparable and consistent information about how investment managers incorporate ESG. We also expect that this will mean advisors have to be prepared to explain funds’ ESG strategies and, in some cases, help investors better align their beliefs and values with ESG strategies. We think the SEC can improve the clarity of the disclosures, but we support the commission’s overall goals of making it easier for investors to compare strategies, and the proposal is a good first step.

This article was first published in the Q4 2022 issue of Morningstar magazine.