The environmental, social and governance (ESG) funds industry reached a turning point on August 26, 2021.
On that day, investigations by the SEC and German regulator BaFin into allegations that Deutsche Bank’s DWS overstated the claimed ESG integration of some of its funds were closed. reported in the press.
With the end of this Age of Innocence, ESG marketing jargon has turned into real regulatory risk with real consequences: DWS stock fell around 15%, wiping €1.2 billion from capitalization stock market, and has not yet recovered significantly.
Potential mis-selling by DWSa serious accusation in the UK, was raised by the FinancialTimes and sent tremors of terror reverberating throughout the sector.
The transnational nature of the heightened regulatory scrutiny of the ESG fund complex represented another step change.
The American investigation showed that the new Climate and ESG Task Force was more than just regulatory greenwashing. Indeed, BaFin only began its investigation of the Germany-domiciled DWS after the SEC launched its investigation. The German regulator reportedly struggled to explain why it did not look into allegations against a company under its direct supervision when a foreign counterpart was.
Shortly before the DWS news broke, the The Financial Conduct Authority (FCA) had urged all UK asset managers to ensure ESG fund products were adequately resourced amid the avalanche of new ESG fund launches.
Managers must balance the parabolic growth of the ESG fund industry with the higher costs of managing these products and potentially significant regulatory risks. The winners of this lucrative race will be those who can concretely demonstrate that various ESG inputs are genuinely integrated into products at the fund level.
This is a natural part of the sector’s maturation process. The priorities of asset owners when allocating ESG funds continue to evolve. The graph below, based on data from BNP Paribas, shows the speed and direction of this development:
Most important factors when selecting an ESG manager
|ESG Values / Mission Statement
|ESG reporting capacity
In 2017, a compelling ESG “mission statement” was the most critical data point in selecting ESG managers.
Subsequently, fund performance and reporting took on greater importance.
The manager’s ability to demonstrate how ESG considerations are integrated into a fund’s investment and research process will be the next major selection criteria.
As recent events show, the pressure will not just come from asset owners, but increasingly from regulators and non-governmental organizations (NGOs).
Obviously, all fund products should do what they say on the tin. But given the societal importance of ESG goals and the prioritization that most G7 governments give them, regulatory scrutiny of ESG funds will only grow.
There are three key priorities for asset managers managing ESG funds:
- Control skyrocketing ESG costs, including those related to data and stewardship.
- Demonstrate that fundamental and ESG considerations are integrated at the fund level. ESG criteria in themselves are not enough. A wallet cannot operate on carbon data alone. Other basic data is needed.
- Make sure the quantity of ESG inputs and their integration is appropriate for the fund product. This can differ significantly from fund to fund.
The wide range of fund objectives and the diversity of ESG factors applied to the funds are illustrated in the following table:
Few managers, not even those with sophisticated and longstanding ESG processes, have overcome the challenges associated with the space. Managers need to value and allocate inputs, including ESG databases and proxy advisors. These do not lend themselves to the document/interaction count that often leads to the evaluation of basic research. And different types of funds — Sections 6, 8, and 9 — impose different considerations in different amounts.
With these challenges in mind and based on insights from CFA UK, CFA Institute and Stanford University, Frost Consulting developed a three-dimensional framework for valuing and allocating ESG inputs while integrating them into the fundamental research – at fund level and across an unlimited variety of multi-asset class products.
This can conclusively demonstrate to asset owners and regulators that a manager’s ESG products have sufficient and appropriate inputs, while addressing cross-subsidy issues.
This process has the ability to “close the loop” for managers to systematically accelerate the launch and development of their ESG products across all asset classes.
Managers who can rise to the challenge and demonstrate true ESG integration to asset owners and consultants will be well positioned to seize the growth potential of the ESG category.
If you liked this article, don’t forget to subscribe to the Enterprising investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / Greg Pease
Professional Learning for CFA Institute Members
CFA Institute members are empowered to self-determine and report professional learning (PL) credits earned, including content on Enterprising investor. Members can easily register credits using their HGV tracker online.