The implementation of the Sustainable Financial Disclosure Regulation (SFDR) by the European Securities Market Authority (ESMA) has not been without confusion and controversy. This is perhaps inevitable given its groundbreaking nature. This confusion is unlikely to be eliminated by the updated guidance coming into force in 2023.

The original directive, which was implemented in March 2021¹, is the first serious attempt to force banks, asset managers, financial advisers and other market participants to improve the disclosure and transparency of ‘Sustainable’ investments and, by implication, direct more capital to such causes. These rules are due to be replicated almost entirely by the FCA through its Sustainability Disclosure Requirements (SDR) in 2023².

The areas of confusion surround the criteria for, and meaning of, the respective Article 8 and Article 9 designation. Article 8 requires that funds are ‘ESG Integrated’ and has come to be seen as a minimum standard amongst European marketed funds. However, the definition of ‘Integrated’ is in practice very broad and, with SFDR being hitherto largely self-regulated, the degree of variability is wide.

Exclusion zone

Article 9 funds achieve the valuable ‘Sustainable’ accreditation. Article 9 funds disclose their ‘Sustainable Investments' and set exclusions to ensure they do no significant harm. They also report regularly on sustainability factors. To do this, funds establish the extent to which 'Sustainable Investments' are made within the portfolio and monitor how this develops over time.

One method of doing this is to create a sustainable ‘benchmark’ to beat. In practice, some funds have achieved this by creating a carbon benchmark and then setting various exclusions to ensure that they do no harm.

While these outcomes are broadly venerable, the nature of these rules has allowed a wide range of funds to qualify as Article 9. These include passive vehicles that don't target sustainable investments but instead simply exclude companies that are detrimental to the aforementioned goals.

Important to be active

As multi-managers, we define sustainable companies as those that are actively contributing to, or seeking to contribute to, sustainable economic solutions and the circular economy. They also satisfy positive Social and Governance criteria. Engagement with company management is crucial element of this.

In March 2022, ESMA updated its guidance to improve the clarity of the rules³. One key change has been the specification that Article 9 funds should only include investments that can be explicitly defined as 'Sustainable'. As a result of these rules, we expect to see a number of funds changed from Article 9 to 8.

Altruistic alpha?

While this is eminently sensible, there is one crucial consideration. Take Robeco, which has reclassified multiple Article 9 funds, two of which we are invested in. Robeco seeks to benefit from companies that are on the transition towards being sustainable and believes that the market will re-rate these stocks. Here we see the opportunity for sustainable investors to potentially beat the market by producing stock-specific alpha.

In order to achieve this, however, Robeco will invest in companies that are not currently rated positive under its own internal sustainability criteria and therefore, under the new guidance, cannot be Article 9 accredited.

As multi-managers, we support ESMA’s latest change, but our positive assessment of these funds is unaffected, and we will continue to invest in both Robeco funds. We believe that achieving altruistic outcomes and producing excess returns are not mutually exclusive. We hope to benefit from the powerful demand dynamics behind the transition and adaption to climate change, while also investing in fund managers that are able to spot tomorrow’s potential winners in this environment without having to pay premium multiples.

Diversified data

Accordingly, we believe it’s important to augment the SFDR Classification, and those of external providers such as MSCI and Sustainalytics, with proprietary scoring methodology. We also think it’s vital to actively monitor the underlying holdings, firstly to ensure they meet exclusion criteria, and secondly to make sure it's possible to challenge those to which we've entrusted client capital.

We are very supportive of the ESMA regulations and the spirit in which they are made. But for the reasons outlined above, we prefer not to rely on a single name or designation.