End of Week Notes
SEC Proposes New Rules for Sustainable Funds Aimed at Standardizing ESG Disclosures
Proposals should help investors find ESG funds that match their preferences.
The U.S. Securities and Exchange Commission has proposed two rules that if adopted, will help investors better identify, understand, and compare funds that feature environmental, social, and governance (ESG) criteria in their investment process.
One proposal would require funds with “ESG” or related terms, such as “sustainable”, in their names to commit at least 80% of assets under normal conditions to investments that meet their ESG criteria.
The other proposal would require funds that use ESG in their investment process to disclose more about how they do so in their prospectuses and annual reports.
Why are the Proposed Rules needed?
ESG investing has grown significantly over the past few years as many more investors have become concerned about the sustainability challenges facing the world. Investors are concerned about the impact of climate change and other ESG issues on their investments, and they are concerned about the broader impact of their investments on the world.
A wave of sustainable funds launched in recent years to meet that demand, and many conventional funds have adopted ESG criteria in a more limited way. We now count more than 550 funds available to U.S. investors in which ESG plays a central role. The universe has more than doubled over the past five years and has grown more than fivefold over the past decade.
These funds use similar terms in their names, which may imply to investors and advisors that they are all alike. But as we have shown in our Sustainable-Investing Framework, there are numerous ways to address sustainability issues in an investment strategy.
And because there are no ground rules for how funds should disclose exactly how they use ESG criteria in their investment process, it is difficult for investors and advisors to understand what a given fund is doing and how it compares to other similarly named funds. This can leave investors confused and result in a mismatch between investor expectations and investment outcomes.
These proposals aim to provide greater transparency, accountability, and comparability to sustainable investing.
What’s in the “Names Rule” proposal?
The Investment Company Names Rule has been around since 2001. It requires a fund with a name suggesting a focus on a particular type of investment to invest at least 80% of its assets in that type of investment, under normal conditions. The rule applies to fund names that include terms like “stock”, “bond”, “tax-exempt”, or terms that reference particular sectors, industries, countries, or regions.
The proposed amendments would broaden the Names Rule to apply to funds using ESG or any related terms. Funds would have to define the terms used in their names in their prospectus. (The proposal also would extend the Names Rule to funds using style terms like “growth” and “value” in their names.)
Funds the SEC refers to as “ESG integration” funds, which consider ESG but not as a central feature (more on this below), would not be able to use ESG or related terms in their names.
What’s in the ESG Disclosures proposal?
The proposed rule would enhance and standardize ESG disclosure. It identifies and defines three broad types of funds: ESG Integration, ESG Focused, and Impact.
An ESG Integration fund is not truly an ESG fund, but one in which ESG considerations are applied alongside other investment factors, such as earnings growth, for example, but do not play a central role in the strategy, and may not be determinative in any given investment decision.
Such funds, of which there are many, would be required to describe how they incorporate ESG into their process.
An ESG Focused fund is one for which ESG criteria are central to the strategy and figure into investment decisions and/or engagement and proxy voting decisions. Most funds that we think of today as ESG or “sustainable” funds belong in this group.
Such funds would be required to say what approaches or combination of approaches they use in an “ESG Strategy Overview” table in their Summary Prospectus. Funds would have to state which of the following approaches are included in their strategy:
- Tracks an index
- Applies an exclusionary screen
- Applies an inclusionary screen
- Seeks to achieve a specific impact
- Proxy voting
- Engagement with issuers
In addition, ESG Focused funds must provide a description of “how the fund incorporates ESG factors in its investment decisions” and “how the Fund votes proxies and/or engages with companies about ESG issues”.
An Impact fund is a type of ESG-Focused fund that seeks to achieve specific ESG outcomes, by investing in companies that help customers reduce greenhouse gas emissions, for example. These funds would have to provide additional disclosure on how they measure progress towards the stated impact, the time horizon used to measure progress, and any expected tradeoff between the impact being sought and investment returns.
Are there any climate-related provisions?
Yes. Funds that claim to consider greenhouse gas emissions as part of their ESG strategy would have to disclose the portfolio’s carbon footprint and weighted average carbon intensity.
Do the rules also affect advisors?
Yes. SEC registered investment advisors would also have to improve their disclosure of how they define and practice ESG in their registration and marketing materials.
Three things I like about the proposals
First, the proposals would help investors by requiring funds to provide better information about how they are incorporating ESG. Here are some examples of how this will help:
- Most of the many funds that the SEC proposes to call “ESG Integration”, provide scant detail of how ESG fits into their overall investment process. To be clear, these are not funds that claim ESG plays a central role in their process, but the disclosure proposal would force them to demonstrate the supporting role ESG plays. Investors could then determine whether that approach matches their preferences.
- ESG index funds generally appear to be much like conventional market-cap weighted index funds, and most simply disclose the index they follow with little additional information about the index. This leads investors to think that any one ESG index fund is just like the other. Yet there are significant differences in how ESG indexes are constructed and the ESG metrics they use. The disclosure proposal would require ESG index funds to say much more than “we follow the ABC ESG Index”.
- Funds for which ESG plays a central role, which the SEC proposes to call “ESG-Focused” or “Impact” funds, would be required to provide more detail about the role ESG plays in their investment process, as well as about how engagement and proxy voting furthers their ESG objectives and, if applicable, about how they define and measure their impact objectives. I’ve noticed a heightened level of detail from many of these funds already, but the disclosure proposal will lead them to better articulate their theory of engagement and proxy voting, and how they address impact.
Second, the proposals should help investors understand the difference between so-called ESG Integration funds and ESG-Focused/Impact funds.
- ESG Integration funds are those in which ESG criteria play only a supporting role; they are otherwise conventional funds that may use ESG information as part of the broad mosaic of information they consider, and ESG criteria may come into play only occasionally in any given investment decision. They are generally not named or marketed as ESG or sustainable funds.
- By contrast, ESG-Focused/Impact funds are those that are broadly recognized as intentional ESG funds, in which ESG criteria figures prominently in the fund’s overall investment and, in most cases, engagement strategies.
The problem is that, currently, ESG Integration funds may leave the impression that they are approaching ESG in much the same way that ESG-Focused/Impact Funds are.
A financial advisor recently told me he recommended a fund he thought was an ESG fund to a client. The fund was a conventional bond fund for which we could not find any reference to ESG in its disclosures or marketing materials. It turned out that the fund company had indicated that the fund considered ESG factors answering a third-party questionnaire used by the advisor’s central office due-diligence team, who put it on the platform of available ESG funds.
The disclosure proposal would allow investors to rely on prospectuses to understand whether ESG is important enough to a conventional fund for it to merit mention. And disclosure would draw a distinction between these funds and those with a real commitment to ESG.
Third, the proposals would help investors compare ESG focus/Impact funds. These funds use ESG criteria in quite a few different ways. In our Sustainable-Investing Framework, we identified six types of approaches and any given fund may combine some or all of them. Currently it’s hard to make comparisons based on offering documents, but the proposed ESG Strategy Overview table and other disclosures should go a long way toward making comparisons easier.
Two relatively minor concerns I have with the proposals
First, the 80% rule could reinforce a widespread misunderstanding that securities can be objectively bucketed as “ESG” and “non-ESG”. Even for ESG-Focused funds, ESG metrics are used in an overall evaluation of a security and funds will weigh ESG factors in different ways. As a result, a given security may make it into some ESG funds but not others. The application of the 80% rule for ESG, therefore, should make clear that it applies to securities that emerge from a fund’s particular process, rather than be based on some universally agreed-upon (but non-existent) definition of an “ESG” security.
Second, the required disclosure could lead funds in the ESG Integration group to drop ESG altogether. That’s probably a good thing for those that are actually doing very little. But this remains a developing field. Making it too hard for otherwise conventional funds to practice ESG in some form might stifle innovation and keep them from moving towards a greater commitment.
What happens next?
The proposals, once published in the Federal Register, will enter a public comment period of 60 days. Anyone can comment, and all will be made public. The SEC will then consider public comments before finalizing the rules. Some modifications should be expected.
But overall, the SEC is making it easier for investors to understand how funds are using ESG and to make comparisons across funds. This should go a long way towards reducing the mismatch between investor preferences and how a selected ESG fund actually invests.