The king is dead, long live the king: reflections on Article 8 funds

It is often said that “ESG is the place to be” for asset managers these days. Growth rates and inflows speak a clear language despite it not being a new phenomenon. According to recent Morningstar research about 42% of EU funds were (self-)labeled either Article 8 or 9 funds in accordance with the SFDR at the end of Q4 2021. Drivers of this growth is not only managers launching new products in these categories but also repurposing or just re-classifying so-called Article 6 funds – funds that do not consider sustainability in the investment process – to become at least Article 8 – defined by EU rules as those that promote environmental and social characteristics.

From a growth perspective there is no doubt that this makes sense. In addition, asset managers don’t just want the short-term growth satisfying the hunger of investors and distributors for ESG-tilted fund solutions right now, they also want to have a long-term sustainable business model.

Now going back about 12-15 months, SFDR Level 1 – the first set of disclosure measures to be implemented – was on the horizon and asset managers found themselves preparing for the 10 March 2021 deadline. The views and approaches differed significantly at the time. A few, long-established and recognised ESG-focused asset managers were somewhat clear as to how to approach the deadline overall. They were still discussing practicalities internally, but at least the commitment to get a meaningful proportion of funds classified as Article 8 was clear. Others struggled and some, if not the majority, said let’s wait, be cautious and not be among the first movers.

‘The untagged funds [in Morningstar’s recent review] will need a very good explanation to clients, investors and distributors why their self-classification is still credible’

Then two things happened around Christmas 2020. First, some larger fund investors and Fund of Funds managers engaged with asset managers and asked whether their respective fund(s) will be Article 6 or 8. If the answer was 8 or even 9 – funds that pursue sustainability objectives – all good.  If Article 6, they’d have to divest because of the consequences for their own funds of funds classifications or to mitigate their own reputational risk. Hence, some asset managers started to reconsider their cautious stance in terms of self-classification and, suddenly, self-declaration and not always necessarily a product’s improved ESG-tilt became more of a business differentiator than a disclosure enhancement for the benefit of investors.

Secondly, a small-scale herding effect kicked in. Firms heard about other firms having a certain percentage in Article 8 and maybe a few Article 9 funds from the start. This caused some further firms to reconsider and become bolder in the way they self-classified their products. On March 10, 2021 and the weeks after, one could witness how some asset managers acted boldly, while others were in some instances criticised having a small proportion of Article 8 and 9 funds. Suddenly, they had to explain why they had been cautious. All of this while only a few months earlier it had felt safe to be not among the first movers, despite having intensified ESG claims and marketing over 2020. So, they asked themselves what had happened.

Three aspects, amongst many, might be worth considering – and bear in mind, this was ahead of final MiFID II/IDD delegated acts introducing the sustainability preferences in the suitability testing concept:

• Distributors realised that Article 8 was going to be the ‘new normal’ for ESG investments in the UCITS retail but eventually also the professional and AIF space;
• Consequently, how Article 8 was achieved was not necessarily the biggest concern at the time as long as it was documented – while details could be worked out later; and
• For many investors, especially distributors, it might have felt more reassuring, also for their own pathway to sustainability, to have solutions for the masses to meet the growing demand for ESG products

Subsequently, one might say that Article 8 funds were seen as the solution for the average (retail) investors looking for general sustainability-tilted (“I want to invest in something green”) funds while Article 9 funds were much harder to achieve given data scarcity and regulatory uncertainty such as with the Taxonomy Regulation or SFDR technical standards. Article 8 funds might have even been considered as the ESG version of opium for the masses. But this changed during 2021.

What has 2021 brought to Article 8 funds? 

After the initial confusion and hype, the average sentiment, especially among advanced investors and distributors changed. They now wanted a better understanding of Article 8 and “what’s in it”. This has led to an increasing divergence between regulatory minimum standards and investor expectations.

But raising the bar is also an issue since the bar is not at the same level everywhere – investors and distributors raised it to reflect their own firm’s strategy or even national preferences, guidelines or requirements as we see emerging for example in Germany or France.

Now trying to simplify the regulatory dimension, where a product is providing for some limited basic environmental or social characteristic, such as voting and minimum exclusions, this could be interpreted as meeting Article 8 requirements. However, is it enough to say that “I vote at AGMs of my portfolio companies” or that I exclude sin stocks? Investors have formed their opinions and, I believe, seem to have concluded that no, it’s not enough. A self-declaration which is only at the minimum end of the Article 8 spectrum is nothing one can win, nor retain business on; it needs to be more.

Referring to their very recent release of the Q4 2021 Global Sustainable Fund Flows figures, Morningstar has recognised the need for more than just regulatory bare minimum and actually “untagged” 1,000+ European funds self-declared as Article 8 or 9 on or after March 10 from its sustainable funds universe (Q3: 6,147 vs Q4: 4,461 funds). And this is just the beginning: the report says the review is ongoing. What does this mean right now?

It means at least 3 things:

• The simple self-classification of a product as Article 8 or even 9 without tangible ESG impact on the product’s strategy and investment approach is not sufficient;
• Morningstar provides a potential direction of travel as it sets a scene for the wider public to scrutinize ESG claims and partially standardised disclosure language without meaningful substance; and
• It puts pressure on asset managers claiming a product is Article 8 while at the same time not meeting, for example, Morningstar’s criteria. The untagged funds will need a very good explanation to clients, investors and distributors why their self-classification is still credible, and that they aren’t greenwashing.

Coming back to the increasing realisation that “more” than bare minimum ESG requirements are needed for an Article 8 product to be credible, the rules introducing sustainability requirements in suitability tests have de facto created a new product category (often referred to as Article 8+ or 8.5), pushing the bar upwards in the retail distribution space. And, the European Commission is also expected to outline minimum sustainability criteria for Article 8 products – perhaps what’s starting to happen in the retail space because of suitability requirements will influence this work.

‘Claiming that everything is ESG while the real economy these products invest in is not, is not necessarily credible’

Meanwhile, amid increasing greenwashing accusations, asset managers and other financial product providers need to take ESG seriously across their entire value chain to truly be credible. With intensifying scrutiny and clearer market standards in development, in the end, firms will reach a point one day where they must ask themselves (if they don’t do so already), what’s my direction? What’s my ambition?

What matters in the end? 

Not all funds or financial products can be “ESG” in the near term. The industry is transitioning and so are its products. Claiming that everything is ESG while the real economy these products invest in is not, is not necessarily credible especially when the EU is, to put it mildly, in my view not fully aligned to the scientific approach of what is sustainable.

On the other hand, not all products need to be ESG-aligned in the short-term because not all clients and investors do or will have sustainability preferences – so, some demand for non-ESG or Article 6 products will likely remain.

Regardless, Article 8 products have a meaning. They, and thus their managers as well as affiliated organisations, claim they care about sustainability and apply ESG thoroughly. Article 8 products should do what it says on the tin and thus, strengthening the brand it is designed to be, for the benefit of the investor but also the manufacturer.

Asset managers can immediately take action to support this. Putting focus on what they can do in terms of ESG is as important as knowing what they cannot do (yet). By taking Article 8 status seriously, beyond its marketing and promotional value, it will help firms to be successful. It might mean classifying fewer, or even no funds, as being Article 8, 8+ or 9 in the short term – but Rome wasn’t built in a day.

To sum up, careful analysis, clarity in terms of capabilities with cost/benefit and risk mitigation in mind as well as a clear path for the entire organisation are going to be success factors not only but especially in ESG. For Article 8 products it means that after the initial almost royal hype, the subsequent need for more and scrutiny, there is an opportunity for those taking the matter seriously and being able to clearly articulate the value proposition of their products and consequently, their firms.

The king is dead, long live the king!

Michael Maldener is the Founder of Sustaide and former Managing Director of Nordea Asset Management’s (NAM) Luxembourg management company