The “great reclassification” of Article 9 funds has been largely driven by downgrades of passive funds, especially Paris-aligned and climate transition benchmarks, according to new data from Morningstar.

The firm’s quarterly report on SFDR trends found that assets in Article 9 funds had shrunk by 40 percent, or €175 billion, following a wave of managers downgrading funds amid uncertainty over their status.

Leading managers including BlackRock, Amundi and HSBC Asset Management downgraded large portions of their Article 9 offerings last year, amid uncertainty over the definition of sustainable investments in the regulation. The European Commission is set to clarify this later in the year.

However, Morningstar’s figures show how far the wave of downgrades was driven by passive equity funds, in particular those tracking the EU’s flagship Paris-aligned and climate transition benchmarks.

The list of the 20 largest funds which dropped the Article 9 classification is dominated by ETFs, mainly from Amundi and BlackRock’s iShares range. BlackRock’s €9 billion US ESG ETF was the largest, followed by its flagship €5.5 billion clean energy ETF and two Amundi PABs investing in the US and European markets. Every passive fund previously in the top 20 largest Article 9 funds has lost the designation.

Morningstar said that a “disproportionate number” (41 percent) of the 307 funds it had identified as downgrading from Article 9 to 8 in the fourth quarter were passive funds and that the “quasi-totality” of these were funds tracking PABs or CTBs. The firm’s global head of sustainability research, Hortense Bioy, warned in July last year that funds tracking climate benchmarks could lose their Article 9 status.

Of the downgraded funds, 90 percent were equity strategies, and half of the assets in these strategies were in PABs and CTBs. The proportion of passive Article 9 funds dropped 19 percentage points to 5.1 percent from September last year to January.

While the two benchmark standards invest in companies with progressively lower emissions, the firms they hold cannot be considered inherently sustainable. As a result, without explicit clarification from the European Commission that they qualify as Article 9, many managers have chosen to downgrade them to reduce reputational and legal risk should they not automatically qualify.

A query on the issue was submitted to the Commission by European financial regulators, and there may be a boomerang effect if the answer is yes, with managers re-upgrading funds that had lost the Article 9 designation.

Raza Naeem, a partner in Linklaters’ financial regulation team, told Responsible Investor in November that the Commission would likely decide that the PAB and CTB labels do qualify for Article 9. “Surely Europe has to think that its own super-green benchmarks are sustainable,” he said.

The last quarter of 2022 also saw the first downgrades of Article 8 funds to Article 6. Two Natixis funds dropped the label, as did an iShares diversity and inclusion ETF, and an equity fund managed by Cicero Fonder.

However, while the majority of fund reclassifications were downgrades, a number of funds still made the leap to Article 9, with 20 rebadging from Article 8 and three making the jump from Article 6.

Rebadging under ESMA rules

The Morningstar report also examines the alignment of Article 8 and 9 funds with proposed ESMA rules on ESG and sustainability language in fund names.

Under the ESMA proposals, funds that mention sustainability in their name must invest at least 40 percent of their assets in sustainable investments. Of the Article 8 funds in Morningstar’s universe with sustainability in their name, only 26.7 percent meet the 40 percent threshold. This rises to 92.6 percent for Article 9 funds.

All the funds that do not hit this target will need to either rename or increase their allocation to sustainable investments.