Synthetic exchange-traded funds find themselves at the heart of the latest controversy to hit ESG ratings.

Synthetic ETFs use swaps to offer investors exposure to indexes such as the S&P 500. Nine of the 10 biggest such funds registered in Europe currently have environmental, social or governance ratings of at least AA at MSCI ESG Research, according to data compiled by Bloomberg. At the same time, all of them are listed as Article 6 funds under European Union guidelines, meaning they don’t market themselves as ESG.

The absence of consistency in ESG classifications shows the hurdles investors face when trying to allocate capital. Against that backdrop, MSCI has said it’s planning to dramatically reduce the number of funds that it gives top ratings. The changes, which will take effect by the end of the month, were triggered by feedback from MSCI’s clients.

Across all public fund categories, 31,000 now face ESG ratings downgrades, with the proportion of AAA funds set to plunge to 0.2% of the total from roughly 20%. AA funds will contract to make up about 22% of the universe from 33%.

For swap-based ETFs, MSCI is changing its methodology to move away from scores that reflected the characteristics of a synthetic fund’s collateral to instead look at the constituents of the underlying index being tracked. Though MSCI has made clear there will be far fewer top-rated funds, it hasn’t made public how individual products will be affected.

Invesco Ltd. manages the world’s largest synthetic ETF — the $15 billion Invesco S&P 500 UCITS ETF (ticker SPXS LN). Though Invesco hasn’t registered the ETF as an ESG product, the fund now sits in at least three other portfolios that claim to “promote” ESG in Europe, according to data compiled by Bloomberg.

While the firm expects the fund to be impacted by the MSCI downgrades, it says SPXS will sidestep the changes that target its swap-based peers.

That’s because MSCI rates these funds based on third-party holdings data, which is compiled from what swap-based ETF providers submit. Unlike its peers that provide collateral data, Invesco already submits index constituents, said Chris Mellor, the firm’s head of EMEA ETF equity product management.

Assessing ESG ratings based on a synthetic fund’s collateral “has no real relevance for the performance of an ETF,” Mellor said in an interview. He expects the proposed changes to improve the reliability and consistency of MSCI scores.

It’s the latest headache to descend on the market for ESG investing, where existing classification systems are facing serious questions. In Europe, the fund industry ended 2022 by stripping the highest ESG tag off €175 billion ($190 billion) worth of client assets, with analysts predicting more to come. The upheaval has led the EU to reconsider its ESG investing rules, and explore major changes to fund labels.

Mellor said it makes sense to assign ESG ratings to swap-based ETFs, provided the methodology holds up.

“If you think about what the ESG rating is telling an investor, it’s telling them what the risks are to that investment from an ESG perspective,” he said. “That will affect the performance of a synthetic ETF in exactly the same way as it would affect the performance of a physically replicating approach. So, it is as relevant for a synthetic as it is for a physical fund.”

In response to a European Commission consultation on ESG ratings, MSCI has suggested investors are better served if ratings models are diverse.

“Today, the lack of uniformity in ESG ratings is often described as a weakness; we believe it demonstrates the diversity of opinions and methodologies. By analogy, there would be limited utility if all investment advisers came to the same buy/sell/hold determinations in their assessments of securities. Dispersion of views and approaches demonstrates a dynamic and competitive market where investors have choices to select providers that reflect their perspective or multiple providers that provide varying and diverse inputs. A mandated one-size fits-all approach to ESG ratings would reduce the thoroughness, innovation, effectiveness and evolution of the ratings,” MSCI said in June.

Assigning ESG ratings to synthetic ETFs is a controversial step in itself. Other ESG score providers have shied away from trying to assess the sustainability of products that are based on derivatives.

After debating the issue a few years back, Sustainalytics parent Morningstar Inc. decided that whether a ratings methodology was based on collateral or underlying indexes wasn’t really the issue, said Hortense Bioy, the firm’s global director for sustainability research.

“Both options had flaws and the potential to mislead investors,” she said. “So we don’t assign ESG ratings to synthetic ETFs.”

ISS ESG, another competitor to MSCI, said few swap-based ETFs would be rated within its methodology.

“To the extent we cover synthetic ETFs, we do so on the basis of the actual holdings, not on the basis of the index they are tracking,” said Till Jung, managing director and global head of ESG products at the sustainable investment arm of Institutional Shareholder Services.

Invesco, which offers a total of 62 synthetic ETFs with more than $30 billion of client assets according to Bloomberg data, only markets one as having any ESG attributes.

“If there’s scary things in the basket, then I’m making a mistake,” Mellor said. “The approach we take is to ensure that the collateral basket restrictions are aligned with the restrictions of the index itself. We also apply some additional constraints around ESG score, and so on.”

Amundi SA, whose owner Credit Agricole SA is the biggest provider of swap-based ETFs in Europe with well over $70 billion in client assets according to Bloomberg data, says investors shouldn’t rely on a single ESG ratings provider when deciding how to allocate their money.

“Third-party fund ratings help investors compare different products using the same methodologies,” but “changes like this show the issues that reliance on one data vendor can bring,” said an Amundi spokesperson. “Amundi works with several data providers and uses its own scoring methodology and due diligences to assess issuers and funds’ ESG characteristics.”

Meanwhile, the ESG ratings industry is facing a crackdown from policymakers across jurisdictions. The European Commission is planning to unveil new industry rules in the first half of this year. And the UK has just launched a consultation on the extent to which ESG raters need to be reined in by clear rules.

(Bloomberg LP, the parent of Bloomberg News, also provides ESG scores.)

--With assistance from Akiko Itano, Amine Haddaoui, Carlo Maccioni and Sam Potter.

This article was provided by Bloomberg News.