ESG Portfolios: An Analysis of SFDR Article 8 and 9 Compliant Funds - 2.5 years after (2024)

Executive summary

• ESG investing in the long run is growing in importance with Europe being the main driver.
• The main provisions of the Sustainable Finance Disclosure Regulation (SFDR) have been live in the European Union for 2.5 years. It introduced, inter alia, framework for ESG investing with classification of investment products between one of three categories: Article 6 (not promoting sustainable aspects) and Article 8 and Article 9.
• Article 8 funds (light green) are a very wide and heterogeneous group, encompassing various strategies and different levels of sustainability alignment. Since the inception of SFDR, Article 8 funds are gradually becoming the most important UCITS fund group in the EU with 52.9% of total fund assets under management as of June 2023 ME.
• Article 9 funds (dark green) are a more hom*ogenous group, with less instruments and investment strategies, more theme and sustainability focused (as intended). The number of those funds was gradually increasing since the inception of SFDR until the drop in the last quarter of 2022 - this was caused by a wave of reclassification of Article 9 funds back to Article 8 funds, mainly as a result of supervisory expectation that financial products that have sustainable investment as an objective should only make sustainable investments. However, within the universe, not all of the investments are fully sustainable as one might expect.
• Article 6 funds (conventional) flows are highly correlated with Article 8 funds flows - it might indicate that investors are looking beyond Article 8 classification already and are treating this category as an extension of conventional funds group, especially given the fact that Article 8 funds constitute majority of UCITS fund in EU (by assets under management).
• In the last 2 years, there have been accusations of greenwashing addressed towards some of major financial institutions and reports by supervisors and independent researchers point to the the fact that for considerable amount of investment funds their claimed ESG profile might not be aligned with their actual ESG risk profile.
• There is still no full clarity on crucial questions, e.g.: does Article 9 funds need to have 100% of sustainable investments and what does sustainable investment mean (despite the recent statement that funds with Paris-aligned benchmarks are treated as sustainable) or to what extent Article 8 funds are different from Article 6. What is more some of the players see national fragmentation of the regulation implementation practice. This leads to divergence in practices among fund managers.
• In the EU the regulation enabling ESG reporting by corporates (CSRD) is still pending - until then investment funds face serious data limitations and there is no compulsory audit of data already available.
• Initial studies on fund fees reveal that for the EU market costs are lower for ESG funds for all active type funds analysed, with ESG ETFs being more expensive compared to their conventional peers. The opposite was found for the US market.
• The ESG portfolios are not free from ESG risks. Given the circ*mstances more oversight is necessary to what you invest in. One has to look beyond the Article 8 or Article 9 classification and look deeper. This is especially true for institutional investors and service providers acting on behalf of their clients.
• European Commission has launched public consultation regarding the review of implementation of SFDR

Introduction

The ESG (Environment, Social and Governance) is the title that seems to be omnipresent in recent years. It is no different for the investment industry. Indeed, more and more investors are becoming aware of the sustainable investing notion and are consequently demanding investment products that would address that need (also updated MIFID requires "green" products for clients with sustainable preferences). And the investment industry has responded widely to that demand. Many fund managers declared their investment funds offered in the European Union (EU) as Article 8 (light green) or Article 9 (dark green) funds in line with Sustainable Finance Disclosure Regulation (SFDR). The EU has been the trailblazer of ESG investing with over 80% of sustainable investment funds AuM globally invested in Europe and it has been the main driver of positive capital inflows into this universe for the last 3 years, as can be seen in the graphs below.

However, this is not coming without pains, misunderstandings and misconceptions. The main provisions of the SFDR have been live in the European Union (EU) since March 2021 (so called Level 1 regulation), and Regulatory Technical Standards (RTS, so called Level 2) came into force on January 1st this year. Yet there is still some confusion about how to implement ESG funds and what can be called “promoting” environmental and social aspects or what sustainable investment really is. How does the ESG investment fund environment look like two and half years after the inception of SFDR regulation?

Greenwashing

First of all, I must point to a greenwashing, as the major issue in the ESG investing. One of the goals of the regulatory effort towards ESG investment funds was preventing greenwashing from happening (e.g. ESMA Supervisory briefing ‘Sustainability risks and disclosures in the area of investment management’ issued in May 2022 lists ‘Combating greenwashing by investment funds’ as one of its two major goals). Greenwashing is usually understood as an act (or omission) of providing misleading or false information regarding the sustainability profile and soundness of the investment product, where sustainable profile covers environmental, social and governance factors and risks of such a product. Importantly, it includes both intentional and unintentional actions. Given the attractiveness of the ESG investments on the demand side there is no denying that the ESG label is tempting and can be sought after in the capital-hungry industry. However, in some cases the classification as an ESG investment might be premature, not to say fraudulent and aimed only at enticing capital from investors looking for sustainable investments. In the last year there were greenwashing accusations and investigations for notable financial institutions e.g.:

Regardless whether the accusation in the cases above are justified or not, the problem might be there, as ESMA in a recently published consultation report on naming guidelines for sustainable fund names, has revealed that as much as 13% of Article 6 funds - theoretically not classified as funds either following or promoting ESG aspects in their strategy - had ESG-related word in their name. Were they in fact following ESG strategies, but simply did not classify as one, or were they trying to jump on the bandwagon of sustainable-investment related inflows? It can only be determined by detailed analysis of every single case. However initial findings of supervisors and independent research companies indicate the problem of greenwashing might be there as well.

What is more ClarityAI - sustainability tech platform provider - in November last year has analysed (ClarityAI 2022) sustainability of the investments undertaken by 750 Article 9 funds (which theoretically should follow only sustainable investments), with conclusions that a considerable part of the funds’ population (between 9% and 38% - depending on Principal Adverse Impact - PAI - concerned) by far did not meet sustainable investments definition in more than 10% of their portfolios.

What is important to note - SFDR initially did not formally introduce any minimal thresholds for sustainable investments for article 8 or article 9 funds (for the latter it was later determined to be a minimum 100%). That is why regulators, being aware of that problem, are taking actions with regulations they produce and actions they take. The level of effectiveness of those measures in preventing greenwashing in the investment industry remains to be seen. Nevertheless, both retail and institutional investors must be aware that even placing their investments with large money managers is not a guarantee that their investment vehicles are as sustainable as they claim it to be.

Flows, AUM and number of products

How does Article 8 and Article 9 funds’ universe look like two and a half years after the introduction of SFDR and how does it compare to Article 6 (conventional) funds?

The number and AuM of Article 8 funds are systematically increasing. Number of funds with this classification dubled in 2.5 years, by going from approx. 5,000 to over 10,600 (according to Morningstar reports) due to both product creation and reclassifications from Article 6.

Studying fund flows, Article 8 funds are gradually becoming the most important fund group, despite outflows or modest inflows at best experienced for the last year, with 52.9% of total fund assets as of June 2023 month end (Article 6 constituting 43.6% and Article 9 - 3.5%). Article 9 funds displayed consequent net inflows throughout the period, which is especially impressive given the difficult market conditions and outflows for all other types of funds in the last quarters. Based on that information alone we might draw the cautious conclusion that Article 9 funds are fulfilling their role as not-only profit oriented sustainable investment vehicles, as investors are continuously pouring money into them, no matter the market situation.

The number of Article 9 funds were also gradually increasing (from 643 up to 947 in Q2 2023), however there was a noticeable drop in number in the last quarter of 2022 - this was caused by wave of reclassification of Article 9 funds back to Article 8 funds, mainly as a result of supervisory expectation expressed in Jun 2022 that financial products that have sustainable investment as an objective should only make sustainable investments. Given the vagueness of sustainable investments definition, divergent interpretations of thereof and conservativeness - prescribed by supervisors - in self-declaring percentage of investments that are sustainable, many asset managers as a precautionary measure decided to downgrade their Article 9 funds. The trend reverted after European Supervisory Authorities answers to questions on the interpretation of SFDR on April 2023, where it was stated that:

• SFDR does not prescribe a specific approach or minimum requirements regarding the main parameters defining a ‘sustainable investment’
• Products tracking a Paris-aligned Benchmark (PAB) or a Climate Transition Benchmark (CTB) are deemed to make sustainable investments(i.e. can be classified as Article 9 funds)

The former - answer to the question addressed by ESMA to the EU Commision - “What is the definition of ’sustainable investment’?” - was a key one in the view of what can be classified as Article 9. However, the answer provided does not seem to bring enough clarity, as it is still up to the manager to interpret what sustainable really is. The latter, on the other hand, allowed some of the fund managers to reclassify back funds with Paris-aligned Benchmark (PAB) to Article 9.

Going forward, number of Article 9 funds should be driven by individual interpretations of the current sustainable investment definition, which is undesirable from the market point of view as it can spurr divergence in practical approach to the problem. Unless there is more clarification provided by the EU or national regulators, should the more lenient approach be accepted by market participants, then we can expect a handful of funds moving back to Article 9 again.

Based on the best data available, we have performed the analysis of fund flows broken down to SFRD classification and their relation to each other. The results are presented in the table below.

We can see that Article 6 fund flows are highly correlated with Article 8 fund flows and this relation is stronger than between Article 8 and Article 9 funds. Correlation is also considerably lower between Article 6 and Article 9 funds. Although no definitive conclusions can be drawn based on flows data alone, it seems fair to say that the investors are looking beyond Article 8 classification already and are treating this category - due to its rather ‘light’ sustainability requirements and heterogeneity - as an extension of conventional funds. Flows for Article 9 funds - the ones with much stricter sustainability requirements and hence giving investors more confidence about their investment strategy being sustainability-focused - are showing different behaviour.

Strategies, asset classes and portfolio compositions

Looking from the strategies and asset classes point of view, the following highlights and conclusions can be drawn about EU ESG funds:

• Sustainable funds are, by and large, actively managed. Until Q4 2022 we have seen a more considerable proportion (24.1%) of Article 9 funds passively managed, but it changed following the downgrade wave and that rate fell almost 5-fold. It bounced back to a bit less than 12% a as a result of mentioned reclassification of funds with Paris-aligned benchmarks back to Article 9.

• Article 6 and 8 funds - representing the vast majority of UCITS funds universe, are diverse with respect to the underlying asset class, with 40-50% funds investing in equities, 30-40% in bonds and other fixed income strategies. Article 9 funds are more equity focused, with approximately 70% of them following equity strategies.

• Article 9 funds are not only focus on equities, but are also skewed towards large caps - we can most of assets in this classification invested in the categories like Global Large-Cap Blend Equity, US Large-Cap Blend Equity, Global Large-Cap Growth Equity or Europe Large-Cap Blend Equity. It seems that medium and small public companies might be underrepresented in Article 9 funds total assets. It might be related to the fact that there are not yet reporting obligations for such companies and due to lack of data investment managers are avoiding investments in these types of companies.

From the portfolio composition point of view equity focused Article 8 funds on average have similar sector structure to large-cap indices such as S&P500 or MSCI World Large Cap, which should come as no surprise given the fact that they represent majority of UCITS assets. Article 9 funds invest - as expected - in companies more focused on sustainability - either by nature of their operations or as a result of the focus of their strategies. With the current approach towards sustainable investments definition, we should not expect those portfolios to be fully representative of the economy as expressed in large-cap indices composition. Interestingly, although Article 8 funds are more diversified when it comes to strategy and there are more assets invested in them, they are more concentrated as compared to Article 9 funds - with average portfolio weight of top20 positions of 3% for the former and 1.8% for the latter as of June 2022.

Data for article 8 and 9 funds based on Morningstar data covering top 20 equity portfolio holdings by average portfolio weight and number of funds holding a position, for 3 timepoints for Article 9 funds and 2 for Article 8 funds. The analysis did not cover the entire funds’ population (e.g. sector data only covers top holdings of the portfolios) and did not include most recent data for Article 8 funds.

Fees of ESG funds compared to traditional ones

When it comes to fund fees there is no reliable data on Article 8 and 9 funds costs as compared to conventional funds yet for a longer time horizon, as the studies available only partially cover the period after SFDR came into force. The results from the data available are inconclusive. One one hand, according to Morningstar study for the US market in 2020 (which is based on sustainable funds in general - as defined by Mornignstar), ESG funds on average charge up to 50% higher fees as compared to traditional peers. On the other hand, for the EU market, the most comprehensive analysis was performed by ESMA within their annual market statistics analysis, with the crucial results for years 2020 and 2021 for retail-only UCITS, according to which costs are lower for ESG funds for all active type funds analysed (equity, bond and mixed). Only ESG ETFs were proven to be costlier compared to their conventional peers.

Logically one would expect that there are two major forces driving different cost structure for ESG funds:

• upward - having to cover additional cost of ESG data and research
• downward - smaller investment universe to cover, as exclusion strategies are one of the easiest and hence one of the most popular among investors

Surprisingly, as found out in the study of lower costs drivers by ESMA (analysis performed for the period Apr 2019 – Sep 2021) mere fact of being a sustainable fund led to ongoing costs to be lower by 0.080 percentage points. Other factors were controlled for when performing the analysis, confirming the intuition that factors to which ESG funds are more exposed to (namely large-cap stocks from more developed economies) lead to lower costs. Yet still there is something else that drives fees for sustainable funds lower that is yet to be explained on longer time horizon.

Concluding remarks and what to expect next?

Over two years after the inception of the SFDR, there are still some current future key limitations. There is still no clarity on:

• Article 8 funds definition – to what extent is it different from Article 6? Due to loose requirements for Article 8 funds, we can see those groups to show some similarities
• Article 9 funds definition – does it need to have 100% of sustainable investments? If so, what does sustainable investment mean - can it include e.g. companies in the transition process?

Moreover, there is a risk of national fragmentation, with different interpretations by local supervisors and call for additional criteria for Article 8 and 9 funds (e.g. AMF calls for fossil fuels to be cut from Article 9 funds). Also, parts of the European regulatory landscape are still yet to come fully into force (most notably EU Taxonomy - Level 1 and Level 2 - came into force this year - and CSRD). This is a huge limitation due to lack of data or data quality issues from investee companies, who were not (or still are not) required to gather and publish data necessary for determining their sustainability profile. What is noteworthy, even if data is there, there is no compulsory audit/assurance of data. Both of those things are to be delivered by CSRD, which is pending.

As a result of lack of: clarity of definitions, common practice or understanding, we can also notice divergence in practices both on funds level (regarding strategy) as well as companies (investees) level, leading to various interpretations of sustainability, incoherence of standards and disclosures and finally difficulty in comparison between ESG investment products.

Currently, Article 8 funds are a very wide and heterogeneous group, encompassing various strategies and different levels of sustainability alignment. Initially attracting new products and flows in large numbers, but in the last quarters it started to be treated by investors like the rest of the funds universe – i.e. funds not declaring sustainability.

Article 9 funds are a more hom*ogenous group, with lesser instruments and investment strategies. Initially there were more products and funds coming into this category, after regulatory/supervisory expectations that Article 9 funds should only cover sustainable investments, managers started to withdraw products from this category, but now the number of funds started to increase again. Nevertheless, we should expect it to be a more hom*ogenous group going forward.

Importantly, regardless of the classification, the ESG portfolios are not free from sustainability related risks. Especially given the investors expectations towards sustainability of their investments (as cited by Morningstar, investment companies feel pressure to have Article 8 or 9 funds, as distributors and funds buyers will only consider these categories in the future). This is one of the reasons investors and service providers must beware of the greenwashing risk in those products.

What to expect next? For Article 8 funds it seems like we are moving towards the world where this classification will cover most of fund's universe, given:

• The volume of funds reclassified to article 8
• Higher requirements towards article 9 funds (products migrating back to article 8 classification)
• Attraction of ESG label
• Regulatory process still in progress

For Article 9 funds, it most probably be a group with the most strict requirements. In consequence, it leads to a higher level of confidence regarding the sustainability of those products, although the fact that the interpretation.

Importantly, even if remaining regulations are entered into force, more non-financial reporting is available for investee companies, more clarity on regulatory expectations and definitions provided (which we all hope for - European Commission launched public consultations - review of SFDR implementation), unfortunately we shall expect greenwashing still taking place - especially given the investors sentiment towards ESG investing (although we already began to witness some swings in that sentiment, especially in the US).

There most probably will be more regulatory and supervisory scrutiny over the area. That is why it is also advised to product manufacturers to take a closer look into their portfolios and either adjust their portfolios or their external communication and documentation before those agencies come in.

Given the circ*mstances more oversight is necessary to what you invest in. One has to look beyond the article 8 or Article 9 classification and look deeper. This is especially true for institutional investors and service providers acting on behalf of their clients.

References

ALFI 2022 - ’European Sustainable Investment Funds Study 2022’, ALFI, Zeb, Morningstar, Jun 2022

ClarityAI 2022 - ‘SFDR: Just How Sustainable Are Article 9 Funds?’, ClarityAI

Morningstar reports series: SFRD Article 8 and Article 9 Funds in Review:

• ’SFDR Article 8 and Article 9 Funds: Q2 2023 in Review’, Morningstar, Jul 2023
• ’SFDR Article 8 and Article 9 Funds: Q1 2023 in Review’, Morningstar, May 2023
• ’SFDR Article 8 and Article 9 Funds: Q4 2022 in Review’, Morningstar, Jan 2023
• ’SFDR Article 8 and Article 9 Funds: Q3 2022 in Review’, Morningstar, Oct 2022
• ’SFDR Article 8 and Article 9 Funds: Q2 2022 in Review’, Morningstar, Jul 2022
• ’SFDR Article 8 and Article 9 Funds: 2021 in Review’, Morningstar, Feb 2022
• ’SFDR: Four Months After Its Introduction - Article 8 and 9 Funds in Review’, Morningstar, Jul 2021

Morningstar reports series: Global Sustainable Fund Flows:

• ’Global Sustainable Fund Flows: Q2 2023 in Review’, Morningstar, Jul 2023
• ’Global Sustainable Fund Flows: Q1 2023 in Review’, Morningstar, Apr 2023
• ’Global Sustainable Fund Flows: Q4 2022 in Review’, Morningstar, Jan 2023

’EFAMA Fact Book 2022’, European Fund and Asset Management Association

’Performance and Costs of EU Retail Investment Products’, ESMA Annual Statistical Report 2022, Jan 2023

‘Costs and Performance of EU Retail Investment Products 2023’, ESMA Annual Statistical Report 2022, Jan 2022

‘The drivers of the costs and performance of ESG funds’, ESMA, 23 May 2022