Sustainability in investment – what are responsible funds?

Being ‘Paris-aligned’ sounds more like a style problem than an investment issue – and it is fair to say that there is plenty of confusion surrounding the sustainability labelling of investor portfolios. Investors who want to make their money matter are often faced with a bewildering array of choices, and it can be complex to ensure their investments are in harmony with their values.

Inevitably, there are different ideas about the parameters of sustainability. The nuclear industry is a signal case in point. For some, especially the French government, it is a vital aspect in the decarbonisation transition, but for others, it is an environmental threat that has no place in a ‘responsible’ portfolio. Sustainability or ESG (Environmental, Social and Governance) labelling must accommodate these divergent views and try to organise them into meaningful categories.

That’s what Europe’s regulators and legislators have sought to do with the European Union’s Sustainable Finance Disclosure Regulation (SFDR). Three core parts of the legislation – articles 6, 8 and 9 – have been embraced as de facto classifications or labels, even though this was not the intention of the authors of the regulation. This conundrum has prompted a debate among EU regulators and policymakers as to whether the SFDR should be rewritten to incorporate an explicit labelling regime to replace the informal use of article 8 and article 9 tags to designate sustainable funds. As of July 2024, however, almost all funds domiciled in Europe continued to be subject to article 6 of the legislation, and some of them also by one of the other two articles’ requirements.

What are SFDR funds covered by article 6, 8 and 9?

So-called article 9 funds, which the SFDR stipulates must proclaim a sustainable objective, can be said to be “the greenest” category, says Alessandra Simonelli, Head of Sustainable Development at Banque Internationale à Luxembourg. “These funds are designed to achieve certain objectives – on decarbonisation, for example, or social inclusion.” The regulation stipulates that an article 9 fund must “have sustainable investment as its core criteria. It must meet stringent criteria to demonstrate that its investments contribute to environmental or social objectives”.

Fund managers are required to be transparent about the goals they adopt and how their products achieve them. While designations under article 8 is a bare minimum for any fund that proclaims to be engaged in sustainability, designation under article 9 of the SFDR have come to be seen as the gold standard for sustainability investing as they go beyond just proclaiming to integrate ESG, but they actually have, measure and report on how they respected their Sustainable Objective. The issue is that there have been teething problems around the availability of information, and the relative difficulty of measuring different impacts.

The legislation says that products that promote environmental or social characteristics or a combination of them, tagged as SFDR article 8 funds, must explain how environmental, social effect and governance factors are used in their decision-making, Simonelli says. Various types of funds can exist, including ones whose strategy combines environmental and social factors, focus on certain themes or, in some cases, on certain sectors (example: funds that only invest on activity sectors seen as less harmful for the environment, etc).

Article 8 funds with a combined environmental and social factors strategy may not always be the perfect choice for an investor   seeking specific exclusions, or particularly concerned about one specific issue, such as environmental protection; they are often a generalist option for investors who would prefer their money to be used in ways that benefit the natural world or human society, or take environmental or social factors into account in their investment decisions. Thematic article 8 funds may enable investors to align their investments with more specific personal values and interests by targeting particular themes, sectors or activities.

It’s worth noting that funds that meet the criteria of SFDR article 8 do not necessarily exclude problematic or controversial sectors such as the oil and gas industry or tobacco and cigarettes. Some funds with sustainability features take a best-in-class approach, targeting the strongest companies in each sector, which could be a problem for investors who do not expect funds that have aspirations to sustainability to invest in fossil fuel producers or tobacco companies.

Not black or white, but shades of green

Article 6 of the SFDR applies to almost all funds, including those with investment strategies that make no particular claims to sustainability. While funds covered solely by article 6 do not promote environmental or social characteristics, they must still consider and disclose how they are taking sustainability risks into account. This ensures that all investment products covered by the SFDR are accountable for potential sustainability-related impacts on their performance, providing a baseline level of sustainability integration across the financial market.

Clients often ask, ‘Is it green or not?’ when we talk about sustainability in investment, but it’s not black and white – we talk about shades of green.

Says Alessandra Simonelli: “Clients often ask, ‘Is it green or not?’ when we talk about sustainability in investment, but it’s not black and white. We talk about shades of green – it’s about the investment strategies that are applied, and how far the fund manager goes in applying those strategies.”

For a number of its products, BIL holds LuxFLAG ESG labels, part of a range covering seven product categories: environment, climate finance, microfinance, green bond, ESG, ESG insurance product and ESG discretionary mandate. LuxFLAG is an independent non-profit Luxembourg agency that seeks to provide a trustworthy label for financial products on which consumers can rely. While there are rival labelling systems elsewhere, it has built a strong international following.

An example: The BIL approach

BIL applies two main strategies. The first is a negative screen, which means that certain controversial sectors may be excluded from portfolios, such as polluting industries, weapons manufacturing and trading. Exclusions may also cover corporate behaviour such as companies with a poor record on human rights or on adherence to employment law.

The second strategy involves integrating ESG scores. Each company receives a score based on its sustainability record; portfolios include high-scoring companies and exclude low-scoring ones. To obtain a high ESG score, a company must perform well on ESG matters, while upholding a high degree of transparency in reporting material ESG data publicly. This means that an activity contributing to one ESG factor is not enough for a high score: the company must also avoid a poor performance on other ESG factors. For example, a renewable energy company that treated its employees poorly or did not exert effective supervision of executive decision-making would not receive a high score.

Alessandra Simonelli recognises that engaging with companies to drive change in specific areas, such as their decarbonisation strategy, can be an effective tool for large investment management groups, but it requires a lot of voting power. The LuxFLAG label requirements incorporate various clear rules, which are shared with portfolio companies. She says: “They know what is acceptable and what is not. If they want us to invest, they have to apply those rules.”

Most investors have relatively few specific demands, but many want to make sure their money is being put to productive use in areas that will benefit the climate and broader environment.

What do clients want?

Most investors have relatively few specific demands, but many want to make sure their money is being put to productive use in areas that will benefit the climate and broader environment. While few clients will ask explicitly for a product that is aligned to the goals set out in the Paris Agreement, the climate deal agreed at the 2015 UN Climate Change Conference (COP21), a fund that helps rather than hinders progress in curbing climate change will have broad appeal.

Any investment recommendations must be balanced against risk and performance considerations. If investors also want to exclude specific companies or sectors, this needs to be made explicit and incorporated into their investment strategy. Excluding certain sectors can have an impact on the investment parameters as well, for instance on portfolio companies’ payment of dividends.

There can also be times when having a sustainability tilt to a portfolio entails missing out on performance gains, such as the spike in commodities prices precipitated by the outbreak of conflict in Ukraine. Sustainable funds that do not own shares in fossil fuel companies – most of them – experienced a temporary relative under-performance. Although these fluctuations subsequently subsided, such developments may be alarming for investors who aren’t expecting them.

Says Alessandra Simonelli: “Sustainability-related investing tends to focus on long-term value creation rather than short-term gains. Companies that prioritise ESG factors are often better positioned to adapt to changing market conditions and society’s expectations, which can lead to sustained growth and profitability.”

The labelling of sustainability funds tends to be imperfect and complicated, and they are not a quick route to understanding fully the sustainability parameters of a particular fund. However, such labels do have value and can offer assurance to investors looking for ways to achieve beneficial results with their money, by ensuring that a fund’s strategy adheres to strict sustainability standards and criteria and has been verified by an external agency.