As an ESG fund class facing mass downgrades attracts vast client flows, industry insiders confess they don’t understand why investors aren’t being more cautious.
The fund class in question is called Article 9—Europe’s top environmental, social and governance disclosure designation. The problem is that analysts, industry associations and lawyers advising fund managers acknowledge that a significant number of Article 9 funds don’t currently meet the EU’s strict sustainability requirements.
Dozens of funds have already lost their Article 9 tag, including offerings from Pacific Investment Management Co. and Goldman Sachs Group Inc.’s NN Investment Partners. Yet despite the cloud hanging over Article 9, the fund class drew almost €13 billion ($13 billion) in client flows last quarter, bringing the total over the first nine months of this year to €29 billion, Morningstar Inc. data show.
“I am somewhat mystified at the continuing inflows,” said Hugo Gallagher, senior policy adviser at the European Sustainable Investment Forum, whose members represent about $20 trillion in assets under management. “I can only suspect that it’s due to many end-investors not being entirely cognizant of the ambiguities around Article 9.”
Flows into Article 9 products, which Morningstar said were boosted by passive strategies, buck the overall trend. A less stringent designation within the EU’s ESG investing rulebook—the Sustainable Finance Disclosure Regulation—known as Article 8 saw €29 billion of outflows last quarter, bringing the total cash exodus over the first nine months to more than €120 billion.
There “could be hundreds” of Article 9 downgrades in the next six months, said Hortense Bioy, Morningstar’s global director of sustainability research, in an email last week.
Some investment managers are already announcing plans to remove Article 9 tags from funds. Axa Investment Managers, which oversees about €820 billion, said it has reclassified 21 funds to Article 8 from Article 9 in recent months and plans to downgrade another 24 in the near future.
“What I’d say to other asset managers and what we’re trying to do ourselves with our clients is around education,” Clémence Humeau, head of sustainability coordination and governance at Axa, said in an interview. “We’re trying to explain the long-term intention and the short-term challenges” of the EU rules, she said. It’s all about being “proactive and transparent in our communications with clients.”
SFDR was enforced in March 2021. The EU has since provided guidance to the fund industry that all Article 9 funds need to be filled with sustainable assets, with some allowances for hedging and liquidity. Industry practice had tilted toward a less strict interpretation of the rules.
Morningstar’s latest industry analysis shows that less than 5% of Article 9 funds “target sustainable-investment exposure between 90% and 100%.” That raises “questions about the feasibility of the new regulatory guidance,” the research firm wrote in an Oct. 27 report.