In June of this year, the Securities and Exchange Commission published proposed rules for Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices. At more than three hundred pages, the proposed rules take a deep dive into how registered funds subject to the Investment Company Act of 1940 and registered investment advisors (RIA) subject to the Investment Advisers Act of 1940, disclose and market their use of environmental, social, and governance (ESG) factors in their investment process. The topic has become one of the most pervasive and acrimonious issues in investment management.
Climate Politics
These days, the politics of climate change and social inequality in the U.S. seem to saturate all aspects of the legislative and regulatory agenda. As the current Securities and Exchange Commission (SEC or Commission) engages on ESG, it seems as if the Commission it is trying to make up for lost ground on climate change and ESG-related matters.
However, depending on your politics, the views of the investment industry’s responsibility for and involvement with ESG range from being essential to being a blatant violation of fiduciary duty. While the political divide is clear, how a regulator navigates the partisan divide is another story.
For now, the current SEC aims to formally address a growing problem with ESG investments, i.e., the mis-selling of investment products labeled “green” or ESG-centered. We define “greenwashing” as disclosures or advertising materials that intentionally or inadvertently mislead investors about the ESG approaches used in an investment product, the ESG characteristics of an investment product, or the degree of influence that an investment product has on ESG issues.
Anti-Greenwashing Proposal
The Commission proposes an extensive set of new disclosure requirements for funds and advisers that call for significantly increased ESG-related disclosures in fund prospectuses and annual reports and Form ADV Parts 1 and 2 for advisers. The objective is an important one for CFA Institute — more consistent and comparable details concerning if and how funds and advisers consider ESG factors in the investment decision making process in an effort to eliminate false and misleading ESG claims.
The Commission’s efforts to improve the quality and consistency of ESG-related disclosures is strongly needed to address unchecked mis-selling of ESG products and services in the marketplace. Some investment firms are aggressively marketing ESG products and their “green” prowess to meet growing demand from an entire generation of investors seeking exposure to ESG-focused strategies. Put simply, these firms need to substantiate their ESG claims and provide specific disclosures that validate the ESG strategy they are selling.
Typical Greenwashing Ploys
Of particular concern are fund names that refer to ESG, sustainable investing, responsible investing, socially responsible investing, and similar ESG terms that are not aligned with the actual investment strategy being used. Likewise, there are many funds holding themselves out, promoting, selling, and marketing their fund product or adviser services as ESG-focused. They are capitalizing on large and growing investor demand for these products, as evidenced by the dramatic rise in assets managed according to several types of ESG approaches. Because ESG-related terms are not standardized and lack widely recognized meanings, such terms and related ESG sales hype can have several different interpretations and provide little or no clarity or specific information to investors when choosing a fund. This inconsistency in terminology and lack of transparency makes it far too easy for an adviser to tout its “climate saving” credentials.
The SEC Proposals
The Commission proposed amendments to rules and disclosure forms to promote consistent, comparable, and reliable information for investors concerning funds’ and advisers’ incorporation of ESG factors.
The more important rules and amendments include:
- Adding new, more detailed disclosure requirements regarding ESG strategies in fund prospectuses, annual reports, and adviser brochures.
- Differentiating between funds that merely integrate ESG from those that market or feature an ESG focused strategy.
- Requiring, for ESG-Focused Funds, a standard ESG Strategy Overview Table with various categories of ESG funds – to allow consistent and easy comparison of ESG funds.
- Requiring environmentally focused funds to disclose additional details about the portfolio’s carbon footprint.
- Requiring “Impact” funds that seek to achieve an ESG impact, such as reducing carbon emissions by portfolio investment, to disclose progress in achieving this impact.
The Commission also proposed amendments to its Investment Company Names rule. While these proposed rules would apply to all registered funds, the rules include:
- Requiring a fund to define the terms in its name and the key criteria the fund uses to select the investments implied by its name.
- Prohibiting a fund from including ESG terminology in its name if ESG factors do not play a central role in the fund’s strategy.
The Challenge – Regulating the ESG Bad Actors
Notwithstanding the good intentions, there are key areas where these proposals wander off course. The motivation is strong: holding firms and advisers that are improperly stamping ESG on products to meet investor demand to account for their actions. But the approach is over-inclusive – the disclosures proposal will likely capture any fund or manager that only considers ESG factors as part of their investment strategy.
Based on our experience, most active managers employing a fundamental analysis approach to investment selection have, for many years, factored environmental, social, and corporate governance risks into their work. It has become a matter of routine investment practice. These funds/advisers are not holding themselves out as offering an ESG product or using a fund name to fool investors into thinking they now have an ESG strategy. The integration of ESG factors is simply part of thorough financial analysis that factors in an ever-changing list of financial and fundamental risks, including ESG. These funds and advisers are rightly concerned about being caught up in new SEC regulations that force extensive ESG disclosure regimes, as if they had shifted to a new strategy. We have recommended that the SEC limit its target for new ESG disclosure to funds and advisers who actively market, promote, or otherwise hold themselves out as offering an ESG product or strategy.
Calibrate Fund and Adviser Coverage Under the new ESG Disclosure Proposals
As the SEC describes it in the disclosures proposal Fact Sheet – “While ESG strategies have existed for decades, investor interest in these strategies has rapidly increased in recent years, with significant inflows of capital to ESG-related investment products and advisory services. Asset managers have responded to increased demand by creating and marketing ESG products.” That is the right focus — those creating and marketing ESG products.
To be clear, a large number of investment firms operating in the U.S. markets have been marketing ESG-branded products, making unsubstantiated claims ranging from an investment outperformance strategy to the ability to influence and change corporate social behaviors, to being able to help slow climate change through its ESG strategy.
To its credit, the Commission has rightly identified ESG greenwashing as the most flagrant example of mis-selling financial products and services in many years. The challenge here is to ensure that the calibration is correct on which funds and advisers represent a real greenwashing threat. If the Commission succeeds, our capital markets, investors, and the entire ESG industry will be in a far better place.
Paul Andrews is Managing Director for Research, Advocacy, & Standards for CFA Institute. Paul is also a current member of the CFA Institute Systemic Risk Council. Previously he was Secretary General of the International Organization of Securities Commissions (IOSCO), Vice President and Managing Director, International Affairs, of FINRA and Senior Managing Director, Business Operations – Europe, at Nasdaq Europe.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.