How to Understand the Correction in the ESG Fund Market


For years, financial professionals made exaggerated ESG claims that fed a market boom with little in the way of oversight. That era of exuberance around environmental, social and governance investing is now coming to an end with increasingly consequential waves of regulations. In the US, where ESG has also become embroiled in partisan politics, the fallout is evident in the shrinking pool of assets carrying an ESG label: down by more than half over the past two years. In Europe, new regulations led the world’s biggest asset managers to strip coveted ESG tags from more than $140 billion in aggregate client funds in the latter part of 2022. And there’s more to come.

1. What’s the situation for ESG in the US? 

The US Securities and Exchange Commission has gotten more aggressive with greenwashing, penalizing money managers that don’t live up to their own ESG marketing claims using existing rules against fraud. Last year it proposed new restrictions aimed at ensuring ESG funds accurately describe their investments, amid mounting concern about a lack of standards. For example, funds labeled ESG would have to invest at least 80% of their assets in a way that lines up with that strategy. But the proposals have faced political pushback from Republicans, whose influence is likely to grow after the party took control of the House of Representatives this year. In any case, a more critical eye is already being cast on ESG funds. The US SIF Foundation, the country’s main sustainable-investing association, reported such assets totaled about $8.4 trillion in 2022, compared with $17.1 trillion two years ago. The massive difference, it said, was largely due to changes in methodology; Institutions were required to submit more “granular information” about their incorporation of ESG issues. US SIF said its counterparts in other regions are conducting similar reviews, and that these will likely result in estimates being revised down across the globe.

2. What’s the landscape in Europe?

It’s ahead of the US and still evolving. Investment managers targeting clients based in the European Union have to comply with the bloc’s Sustainable Finance Disclosure Regulation, the world’s most ambitious anti-greenwashing handbook, which went into effect in March 2021. But confusion soon reigned over issues as basic as how to define a sustainable investment and what it took to qualify for Article 9 — the strictest category and the gold star for attracting ESG-minded investors. The EU has since clarified the regulation to reserve the top designation for funds that hold 100% sustainable investments, save for hedging and liquidity needs. A review by Morningstar Inc. last year showed that Article 9 funds have about €470 billion ($506 billion) of assets under management, but less than 5% of funds met that bar. That implies that a lot more Article 9 fund downgrades will follow the $140 billion registered as of late 2022.

That would be the EU’s less-stringent category, known as Article 8, which represents about €4 trillion in client assets. Unlike Article 9 funds, these don’t have to make improving the environment or social conditions a goal on par with financial returns. But their status is also unclear. In November, the European Securities and Markets Authority proposed that any Article 8 fund with ESG-related terms in its name would need to show that at least 80% of the assets it holds actually pursue ESG goals. And if the fund puts sustainability-related words in its name, it would have to to be able to document a sustainable investment target of no less than 40% in its portfolio. Morningstar reckons that only 18% of Article 8 funds would meet that bar. The ESMA has said that it plans to issue final guidelines on labeling Article 8 funds by the third quarter of the year.

4. Why all the problems with SFDR?

A major source of confusion is the lack of a standard definition for terms such as sustainable investment. Investor groups and asset managers have started to publicly vent their frustrations. The EU’s main regulators (ESMA, the European Banking Authority and the European Insurance and Occupational Pensions Authority) have asked the European Commission, which drafted SFDR, to provide clearer overall guidance to financial markets. The commission has said it’s looking into the matter — and possibly more. In early December, the EU’s financial markets and services commissioner, Mairead McGuinness, told lawmakers the bloc was planning a consultation this year and said an overhaul of the entire framework for ESG funds may be needed. It’s not yet clear how far the commission is willing to go, however. 

6. What do the ESG advocates say?

Paul Clements-Hunt, who led the United Nations team that created the ESG label in 2004, spent much of last year criticizing the “marketing mania” that it had generated and predicted a “shakeout” would purge the market of charlatans. It’s a refrain that grew louder after Russia’s invasion of Ukraine, which drew attention to billions in ESG dollars devoted to Russian assets, many of them state-owned. Some ESG investors even held Russian government bonds.

7. What effect are the political battles in the US having?

Conservative Republicans including Florida Governor Ron DeSantis and former Vice President Mike Pence have turned ESG into an emblem of everything they say is wrong with left-wing politics. More than a dozen Republican state attorneys general are fighting ESG financial practices, while Republicans in Congress plan to increase their scrutiny of what they derisively call “woke capitalism.” At the same time, President Joe Biden’s sweeping climate package — the Inflation Reduction Act — has been hailed as a game-changer that will steer hundreds of billions of dollars into ESG-related activities such as cleaner energy and electric vehicles. Much of that spending will be in those same, Republican-led states. And the US Department of Labor last year made clear that private-sector retirement plans can consider ESG factors when choosing investments.

8. What do investors make of the chaos?

Europe’s main association for retail investors, Better Finance, has pushed for more transparency, such as mandatory client notifications, when asset managers reclassify their funds. Institutional investors have also expressed concerns that ESG fund designations are riddled with inconsistencies that need to be addressed. ESG is clearly going through something of a purge. But for all the criticism, investors haven’t started pulling cash out of funds, according to data compiled by Bloomberg. That sentiment suggests the rubric is here to stay. A survey last year by PwC showed that 89% of large investors said they’ve already rejected — or would consider rejecting — an asset manager due to shortcomings in their ESG strategies. The same survey showed 86% would be similarly dismissive of those whose corporate ESG efforts were inadequate. And a survey of Bloomberg terminal users found that more than 60% expect ESG to be a standard part of, or increasingly critical to, running a business. Roughly a third of the respondents, however, said they think ESG is just a fad.

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