Hugh Wheelan: HLEG could unblock the sustainable retail funds market

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One of the most interesting recommendations to come out of the High Level Expert Group on Sustainable Finance’s (HLEG) final recommendations to the European Commission last week is its focus on how to resolve the conundrum of retail investment in sustainable investment products.
It’s a wise move. If countries are increasingly shifting policy towards sustainability – notably the COP21 climate agreement – then they need to do two clear things: mobilise regulation and capital to that end.
Public support for sustainable retail savings is key on many levels. As HLEG notes: “The direct result would be to bring a substantial part of the EU’s financial assets into pools of capital contributing to sustainable finance.”
Why focus on personal savings?
Well, for better or worse, corporate underwritten defined benefit (DB) retirement saving is yesterday’s money, despite still representing the rump of pension assets now. Indeed, one of the factors inhibiting pension schemes from looking at ESG factors is that many are closed to accrual, winding down their assets and focused on liability matching/insurance-style asset coverage. Another is that trust-based arrangements are reluctant to take so-called ethical positions that they say may not represent the ‘pool’.
Both are wrong in our view, but they are the real-world pushback to long-term, sustainable thinking.HLEG has made important proposals on shifting this blockage.
Defined contribution (DC) pensions savings, however, through individual and (hopefully) much larger collective retail funds, allied to personal financial arrangements, is the future of pensions and long-term saving. And a lot of it is needed if the concept of ‘retirement’ is to mean anything to current working generations. It also opens the door to a much more personalised savings market; and choice is the mantra of good capitalism.
Here’s the bind at a European level, which is broadly representative of the global situation.

• Household savings represent 40%+ of total financial assets in the EU.
• Most surveys show that a high level of people would like to invest sustainably, with the caveat that they don’t want to lose money and want good investment performance (How this question is asked is key, of course)
• ESG funds represent less than 2% of the overall European retail funds market.

This sounds like a demand-side issue. But, HLEG posits the problem – rightly so…with caveats – as
a supply-side issue, saying: “very few retail investors currently have the opportunity to invest according to these preferences.”
Chicken or egg?
HLEG says there are a few key incentive reasons for the blockage, wrapped up in the old saw of ‘performance’. This can be resumed in the following circular argument:

Investment advisors have little incentive to push the few sustainability funds that are in the market because asset managers have little incentive to create them, because advisors aren’t recommending them because they don’t believe they perform compared with other funds (despite multiple studies pointing to the opposite) and therefore they are not selling them, so there’s no client demand.

And on it goes….like a stuck record. There’s not enough space here to run through the multiple structural, psychological and incentive barriers here; it’s a whole research topic in itself. But – and we would be really interested in your views – here’s a few starters:

• DC options are often labelled as ‘ethical’ which still has negative connotations.
• Cost: as in supermarket surveys, people always say they want to buy organic/sustainable but go for the cheapest product when they get to the shelf.
• Investment managers like to sell existing funds, rather than create new strategies (unless they have a clear audience in mind)
• Financial advisors like to sell existing, top performing funds (unless they have a clear audience in mind)* Sales and marketing people at fund managers don’t like complicated sells, and ESG is a complex subject.
• Can investment houses be ‘half pregnant’; i.e. sell sustainability funds and non-sustainability funds?
• Many SRI and ESG integration options in funds are a pragmatic solution to an institutional problem, but their investment or ‘sustainability’ output is unclear.
• The biggest shift in asset management right now is towards lost-cost passive solutions. Many sustainability funds are active and require more research (and potentially higher costs).
• Some sustainable funds perform badly, but they get lumped together as if ‘sustainability’ was an asset class.
• Some sustainable funds perform well, but no-one champions the sustainability premium.

HLEG also recognises another major philosophical question that underpins any product sale, especially funds: if the product is self-assessed – in this case as green or sustainable – how can investors know what that actually means?
For investment managers, the problem is how to demonstrate ‘sustainability’ in an investment context: fund managers (ex index funds) don’t sell widgets, they sell strategies. It’s perhaps no surprise that when Fundsmith, the UK asset manager run by Terry Smith, a renowned portfolio manager, recently made the surprise launch of a first sustainability fund targeting institutions,
it focused on exclusions, and long-term company analysis. Why? Because it’s easy to understand. Tapping into existing European MiFID (Markets in financial instruments directive) regulation, which requires advisors to “offer products which are suitable to their customers’ needs”, HLEG argues that this should include investment preferences concerning impacts on sustainability. The first question then is what is ‘sustainable’? This is vital to avoid green/sustainability washing. HLEG has tried to cover this with its ‘taxonomies’ work, as highlighted in RI’s article last week
This is work in progress, but it aims to tap into all the existing minimum sustainability standards that are out there. Using that taxonomy, it says the Commission should then ensure that sustainability funds can meet minimum SRI standards, consisting of a small range of simple and understandable metrics. Beyond that, it says the EU should administer a green label for green themed funds. This, it says should be based on an EU Green Taxonomy with green investment thresholds, indicators of incompatible business (such as the fossil fuel sector), and clear understandable impact indicators on environmental issues. It should also include an ESG risk screen (human rights, governance, etc.).
HLEG’s answer to the conundrum is nothing revolutionary – minimum standards, plus a voluntary label – but it may be a smart and simple evolution. Just like the products you buy in the supermarket, permitted products could be badged under the existing EU Ecolabel, with the hope this would happen by end-2018/early-2019.It would apply to retail funds but also later on to other retail products that fall in the scope of the PRIIPs (Packaged Retail and Insurance-based Investment Products) regulation, as well as non-life insurance and mortgage products. HLEG says it should build on the most advanced European labels so far such as the French TEEC, LuxFlag Climate Finance, and Germany’s FNG kite mark. HLEG recommends that at a later stage, the Commission also examine the development of a European social label to finance social objectives in a framework to be defined.
The idea of a floor (minimum standards) for all sustainability funds, and an aspirational and very visible, public label (to encourage all funds providers to step up their game) is an interesting one. France has already taken a major step here by enabling funds within its huge life assurance funds market (assurance vie) to badge themselves with a ‘prima’ label if their investments meet environmental investment criteria. Its tax-exempt retails savings funds, known as ‘livrets’, that are labelled ‘sustainable development’ – an €100bn market – will also have to clearly demonstrate the greenness of their investments. HLEG’s work here is, at the least, a pragmatic, uncomplicated set of recommendations that should find favour with EU regulators, instigate change and start to chip away at the supply-side retail funds blockage.

There are a couple of useful RI articles to read on labels:
1. European sustainable labels could be a strong tool to mobilise savings for the transition to a low-carbon economy: Link
2. ESG Magazine: Can the EU draw up a credible label for sustainable funds? Link