SEC flags ‘potentially misleading claims’ by ESG fund managers

Portfolio management, proxy voting and negative screening in ESG funds not adhering to marketing claims, regulator finds

Investors risk being misled by investment managers who claim to invest according to ESG principles but don’t adhere to them, the US Securities and Exchange Commission (SEC) has said.

The financial regulator issued the warning after it uncovered instances where managers of ESG funds failed to implement policies relating to proxy voting, adherence to ESG frameworks and negative screening despite claiming to do so.

The SEC investigation found that portfolio management practices in some funds appeared to be inconsistent with their stated ESG approach; for example, by being predominantly invested in issuers with low ESG scores.

In other cases, the SEC said that managers of ESG funds lacked adequate compliance and oversight processes for ESG-related claims and performance metrics included in marketing materials. SEC staff concluded that such processes were “less effective” when compliance personnel had limited knowledge of ESG investment factors.

It also noted a number of “potentially misleading claims” by ESG funds. “For instance, the staff noted marketing materials for some ESG-oriented funds that touted favorable risk, return, and correlation metrics related to ESG investing without disclosing material facts regarding the significant expense reimbursement they received from the fund-sponsor, which inflated returns for those ESG-oriented funds,” it said. 

In addition, SEC staff found that fund advisors had made claims regarding their role in developing ESG products, when their roles were in fact “very limited or inconsequential”.

The SEC’s findings were issued by its Division of Examinations, which earlier this year announced an enhanced focus on climate-related risks and ESG claims as part of its updated priorities for 2021. The SEC’s exam staff have indicated that they will continue to review the policies of investment advisers, registered investment companies, and private funds engaged in ESG investing.

The SEC notice comes at a time of growing disagreement among investors over the merits of excluding firms seen as ESG laggards. While, historically, such an approach has been favoured among ESG-focused investors, some commentators argue that doing so would deprive companies of the capital and support needed to embark on low-carbon transition plans and broader sustainability initiatives. Recently, the controversial inclusion of tobacco, pharma and mining companies in a list of top ESG picks revealed the fault lines on the issue.

Last month, the Attorney General of West Virginia said he was prepared to sue the SEC if it decided to introduce mandatory requirements for ESG disclosure. In a letter sent to the regulator, state Attorney General Patrick Morrisey said: “Fundamentally changing the Commission’s mission would allow it to compel collection and disclosure of information to help some customers and investors advance animus towards groups and activities they disfavor.” 

“If you choose to pursue this course, we will defeat it in court,” he added. 

The SEC – and the US Federal Reserve – have announced a number of regulatory initiatives focusing on climate risks, sustainability disclosures and “ESG-related misconduct” since President Biden took office. The US has also been appointed to lead separate working groups on sustainable finance at the G20 and global regulatory body IOSCO.