The environmental, social and governance (ESG) fund industry reached a crossroads on August 26, 2021.
On that day, the press was informed of investigations by the SEC and German regulator BaFin into allegations that Deutsche Bank’s DWS had exaggerated the purported ESG integration of some of its funds.
With the end of that era of innocence, ESG marketing jargon morphed into a real regulatory risk with real-world consequences: DWS shares fell 15%, wiping €1.2 billion off the market cap of the market and have not yet recovered significantly.
Possible mis-selling by DWS, a serious charge in the UK, was raised by the Financial Times and sent tremors of fear through the entire sector.
The transnational nature of enhanced regulatory scrutiny of the ESG fund complex represented another sea change.
The US investigation showed that the SEC’s new Climate and ESG Task Force was more than regulatory greenwashing. In fact, BaFin only started its investigation into Germany-domiciled DWS after the SEC started its investigation. The German regulator would have been hard pressed to explain why it did not investigate allegations against a company under its direct supervision when there was a foreign counterpart.
Shortly before the DWS news, the Financial Conduct Authority (FCA) had urged all UK asset managers to ensure ESG fund products were adequately resourced amid a flurry of new launches ESG fund.
Managers must balance the parabolic growth of the ESG fund sector with the higher costs of running these products and the potentially significant regulatory risks. The winners of this lucrative race will be those who can concretely demonstrate that various ESG inputs are actually embedded in products at the fund level.
This is a natural part of the industry’s maturation process. Asset owners’ priorities as they allocate ESG funds continue to evolve. The following chart, based on data from BNP Paribas, shows the speed and direction of this evolution:
Most important factors when selecting an ESG manager
| 2017 | 2019 | |
| ESG values / Mission statement | 38% | 27% |
| Song history | 14% | 46% |
| ESG reporting capacity | 11% | 29% |
Source: BNP Paribas
In 2017, a compelling ESG “mission statement” was the most critical data point in selecting ESG managers.
Subsequently, fund performance and reporting became more important.
The manager’s ability to demonstrate how ESG considerations are incorporated into a fund’s investment and research process will be the next important selection criteria.
As recent events show, pressure will come not only from asset owners, but increasingly from regulators and non-governmental organizations (NGOs).
Clearly, all foundation products should do what they say on the tin. But given the societal importance of ESG goals and the prioritization of them by most G7 governments, regulatory scrutiny of ESG funds will only increase.
There are three key priorities for asset managers running ESG funds:
- Control spiraling ESG costs, including those related to data and management.
- Demonstrate that fundamental and ESG considerations are incorporated at the fund level. ESG criteria alone are not enough. A wallet cannot work on carbon data alone. Other key data is required.
- Make sure that the amount of ESG inputs and their integration is appropriate for the fund product. This can differ significantly between funds.
The broad spectrum of fund objectives and the diversity of ESG factors applied to the funds are shown in the chart below:
Few managers, not even those with longstanding and sophisticated ESG processes, have overcome the challenges associated with the space. Managers must assess and allocate inputs, including ESG databases and intermediary advisors. These do not lend themselves to the document/interaction count that often drives fundamental research assessment. And different types of funds (Articles 6, 8 and 9) require different considerations in different amounts.
With these challenges in mind, and drawing on insights from CFA UK, CFA Institute and Stanford University, Frost Consulting has developed a three-dimensional framework for valuing and allocating ESG inputs while integrating them with fundamental, bottom-line research and everywhere an unlimited variety of multi-active class products.
This can conclusively demonstrate to asset owners and regulators that a manager’s ESG products have sufficient and appropriate inputs, while addressing cross-subsidy issues.
This process has the ability to bring managers ‘full circle’ to systematically accelerate the launch and development of their ESG products across asset classes.
Managers who can rise to the challenge and demonstrate true ESG integration to asset owners and consultants will be well positioned to capture the growth potential of the ESG category.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / Greg Pease
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Neil Scarth
