Systematic Article 9 downgrades ‘likely over’, says Morningstar

Downgrades slowed to a trickle in Q1, but questions remain around re-upgrades and consistency of manager approaches.

Systematic downgrades of Article 9 funds are “likely over”, according to Morningstar’s latest review of trends in Article 8 and 9 funds.

In its report, which covers Q1 of 2023, the firm said that downgrades had slowed to a trickle since the start of the year, with just 14 further Article 9 funds dropping the classification.

Hortense Bioy, global director of sustainability research, told Responsible Investor that the systematic downgrade of funds, which had been prompted by uncertainty over requirements under the EU’s Sustainable Finance Disclosure Regulation (SFDR), was most likely over.

Uncertainty over the definition of a sustainable investment, as well as the exact status of funds that track a Paris-aligned or Climate Transition benchmark, had led to more than 350 funds reclassifying from the more stringent Article 9 to Article 8 in the second half of 2022. Clarifications from the European Commission in April helped address this uncertainty.

However, the first quarter was not entirely free of downgrades. Several large funds, including from LUX IM and AXA, were downgraded, as was a €333 million fund investing in catastrophe bonds.

Bioy said that the commission’s clarification would not mark the end of all Article 9 downgrades. Funds which change their strategy may still be reclassified and changes to a manager’s definition of a sustainable investment may result in some funds no longer meeting the 100 percent threshold, she said.

She also pointed to varying treatments of transitioning companies and transition funds as a potential source of downgrades.

Article 9 funds also posted their lowest net flows on record, pulling in just €4 billion of net new money, a third less than in the final quarter of 2022. Morningstar attributes this to the wave of downgrades, noting that new flows into Article 8 funds doubled versus the end of last year while Article 6 funds ended three consecutive quarters of outflows.

The large number of upgrades also continued, with 263 funds moving from Article 6 to Article 8, and 10 funds changing status to Article 9. The biggest fund to make the step up to Article 8 was M&G’s €3.7 billion European credit fund, which along with two other M&G funds changed its approach in February to include greater ESG consideration.

The pace of Article 9 downgrades has slowed to a trickle, and downgrades from Article 8 to 6 maintained the small numbers from previous months with just seven confirmed reclassifications.

Bioy said she had spoken to one manager in Q3 last year about a fund that was reclassified to Article 6 from 8. “They said they didn’t see a strong commercial interest in being Article 8, so if clients are not asking for more information on how ESG factors are considered they may not want to incur the cost of reporting on it,” she said.

The Article 9 return

The return of downgraded funds to Article 9 classification is starting, with Handelsbanken telling AM Watch it plans to re-upgrade seven PABs that it had reclassified last year, subject to checks.

Other managers are taking their time to analyse developments.

A spokesperson for BNP Paribas Asset Management, one of the largest owners of downgraded funds, told RI it was still considering the matter. Germany’s Deka said it was too early to assess and that the firm was waiting on other regulatory measures, including ESG labelling guidelines.

Other big names remain tight-lipped. Neither BlackRock nor Amundi responded to repeated enquiries as to their intentions.

“I would have bet on Handelsbanken [being the first] because there are Nordic rivals who didn’t downgrade PAB/CTB funds,” Bioy said. However, she admitted that she is unsure how larger managers will act.

“Maybe you only need one manager to move, and then there’s certainly commercial pressure to have a good range of Article 9 funds. It’s going to look odd if you have one large manager doing one thing and another large manager another.”