ESG funds use environmental, social and governance criteria to screen out or select investments. These have been given a push under the EU’s recent Sustainable Finance Disclosure Regulation. During the interview, Voss explained the difference between funds that fall under SFDR article 8 and article 9, and what that could mean for investors.
Aaron Grunwald: Are there enough ‘qualified’ investment opportunities in the market for the ESG fund segment to continue to grow?
Denise Voss: I think it’s important to say that there probably will always be funds that are not sustainable.... I understand your point about ‘will there be enough funds for the demand?’ which I think was your question. But I think that given the regulatory push that’s been going on now--even before the EU Green Deal, we had the Sustainable Finance Action Plan--where we are with regulatory--in Europe, of course--as well as investor demand, I don’t think assets managers really have a choice, to be honest. If they want to get shelf space, they will have to.
The challenge is that this is a journey. And it’s a journey for asset managers, too. Some asset managers are further along the journey than others. So some have perhaps more work to do to get there than others who’ve been actually incorporating ESG into their investment analysis and decision making process for a long time, for instance. In any case, the industry’s pretty much full on focusing on getting this done. And there’s still a lot more to do.
So, you know, we had that first big deadline of March 10th 2021. But that was really just the first step. It’s true that there were some who expected to see more so-called article eight and article nine SFDR funds. It seems [based on media and research reports and Voss’s own conversations with industry executives] that some asset managers were a bit conservative, which I can understand.... don’t forget, SFDR is a self-disclosure regulation. So a lot of [asset managers initially opted to classify a majority of their funds as] article six, which are not taking sustainability into account. But since then, they have been working night and day to, I don’t really want to use the word ‘upgrade’, but in some respects, ‘upgrade’ the article six funds into article eight funds.
When you say ‘upgrade’, you don’t necessarily mean from a portfolio point of view? Do you mean in terms of data disclosure?
I mean more things like, in the prospectus for an article eight fund, you need to say, we will do these things and these things we will not. We no longer will have the language of ‘it’s at the discretion of the portfolio manager’, we say we will do these things. That’s what some of the upgrading is, basically putting these binding aspects in the prospectuses which weren’t necessarily there. Some of that is about applying an exclusion list in a binding way, or perhaps looking at the portfolio and saying, ‘we’re only going to invest in companies that have a greenhouse gas emissions rate of less than this and the rest we’re going to screen out of our our investment universe.’
You know, these things take time, because you also have to work with the portfolio management team, the risk managers, even maybe the operations team.... I don’t [know about] every asset manager, but a lot of, if not most, asset managers are in that process now. [Upgrade] is not a great word, because it sounds like they were poor before. It’s [rather about] bringing up more funds to the article eight and article nine SFDR category.
I guess my other question is, for the portfolio managers or deal teams, are there enough good investments that will pass muster?
I guess what my answer to that is, we have to remember that we’re talking about article eight funds, which are about the investment process. So it’s about incorporating E, S and G factors. So greenhouse gas emissions, number of women on boards, [taking those] factors into your investment analysis and decision making process. So it’s about the process, if you know what I mean, it’s not about the companies, necessarily. Generally people will, in their process, look at financials, the usual, cash flow and stuff like that. And now, of course, the ESG integration is about adding non-financial factors like environmental, social and governance stuff, and kind of taking a holistic view of a company. So a more well rounded view. And yes, in that process, there probably will be companies that are kicked out of the universe, if you will, of what they’re going to invest in. That’s article eight.
Then article nine tends to be focusing on positive impact.... so that’s building a process that will [for example] help recycle batteries and electric cars, and its business model is this and this only, so that’s really seeking a positive impact in terms of adapting and mitigating the climate crisis.
That’s very different from when you have an investment process, article eight, where you incorporate non-financial--so environmental, social, and governance--factors as well as financial into your investment analysis. Asset managers have always tried to reduce their investment pool universe down to something they could look at, and try to figure out what they will invest in. Now they’re just doing it with non-financial factors. So long, long answer, it shouldn’t really reduce the number of companies that the article eight funds invest in, because they’re just taking a more well rounded look at those companies, if you will. Whereas it’s true that for the article nine funds, it’s challenging, because there’s maybe not that many companies [making a] positive impact, although there’s more and more every day.
Do you think that your everyday investor understands the difference between article eight and article nine?
No. No. No, a lot of education [is needed]. No, and that’s going to be the job in many ways of the bankers, the insurance companies, the financial advisors, that will be having to ask [under the EU’s Markets In Financial Instruments Directive, which has been updated in line with the SFDR]. Mifid [regulated] advisors--so those banks, insurance companies and financial advisors--will have to ask clients what their sustainability preferences are. So those advisors are going to have to be able to explain, basically, what you can have, what is your preference, and they’re going to have to ask the question in a way their clients will understand. And then that will be the point at which there’s an opportunity for them to say, well, you know, you have [these] funds. It’s not going to be easy.
I’m not sure the media has explained the difference very well.
What I usually say and actually Sachin [Vankalas, the late Luxflag general manager] is the one who described this to me in the past.... if you could just remember one thing, [article eight] ESG investing is about the process, incorporating these non-financial ESG factors as well as financial factors into the investment analysis and decision-making process, even though I know that’s a statement that people are like, ‘What are you talking about?’ And then article nine is really about positive impact. It’s about a product. It’s not about a process, it’s about a product. Now, article nine funds also use the same process, I’m sure. But they really are focusing on companies that are doing this positive impact.
So maybe that’s the other challenge with people understanding, that the word ‘impact’ is the word we use all the time in our daily lives. Sometimes asset managers--in the past, hopefully, they don’t do that now--used to say, ‘here’s the impact of our ESG integration process’. Don’t say that!
Asset managers need to be super clear in their communications to their investors. I do think that SFDR is a big help, I have to say, because at least it’s a category. And at least you can kind of latch on to something and then ask the question, ‘what is this thing?’ We find that with our labels, it’s actually quite useful. Luxflag has five labels and people are constantly saying, ‘what are all these labels about anyway’. We have a nice infographic where we’ve actually put the four impact labels under article nine, and the ESG label under article eight, so that’s helpful for us. But even if it’s not easy, and lots of work is needed, it’s a step in the right direction.
You mentioned your labels. Will Luxflag be changing the process for evaluating and granting the labels based on the SFDR required disclosures?
Yep, we already updated our criteria. We effectively said for the ESG label, it needs to be SFDR article eight disclosure and then for the other labels, article nine. So again, that’s why that’s been useful for us too.
What else are you seeing?
I’m sure you’ve seen that PwC study that says that by 2025--it’s not really very far away--that [57% of] investments will be sustainable. There will always be unsustainable investments, I’m sure. Because don’t forget, we’re talking about Europe, other parts of the world are also getting on the bandwagon. But [the Q3] Morningstar global sustainable fund flows review [shows that] Europe represents 77% of the global investment into sustainable funds, the US 11%, Asia the rest.... It shows that over the last eight years, it’s growing everywhere. It’s just because of SFDR and [the EU] taxonomy, Europe is just leaps ahead at the moment.
That is kind of a worry, though, in a way. I mean, 77% means there’s a lot of catching up to do outside Europe.
But don’t forget, [Morningstar was tracking] flows into European funds [and] don’t forget European funds, like Luxembourg Ucits, are held by investors in over 75 countries. So it’s not just Europeans investing in European funds, Ucits being that kind of global brand, everywhere except for the US practically. Now, to be honest, I would imagine a good chunk of that is European money. But it can’t just be European money, because it’s an international product.