The rise of ESG Investing in the Funds Industry

ESG is a growing phenomenon affecting the funds industry in many ways. When assessing a company, one must give importance to a significant critical element, that is how the targeted company factors in Environmental, Social, and Governance (“ESG”) considerations in its daily operations.

Traditionally, investors’ concerns were primarily concentrated around the level of returns provided by an investment, with general ambivalence towards how those returns have been generated. Nowadays, the industry is seeing a drive towards responsibility in its stewardship of investor money, with investors seeking to understand how their money is being invested.

Ethical or sustainable investing is not a new development as many asset managers offer funds or investments which are ESG compliant. Furthermore, standards and regulations have been implemented to evaluate and ensure that companies operate in respect of the environment, the people and whether they govern themselves in a responsible manner.

Various regulations have been imposed by the EU in order to reach sustainability objectives such as the Paris Agreement, EU Taxonomy, Corporate Sustainability Reporting Directive (CSRD), Sustainable Finance Disclosure Regulation (SFDR) and Sustainable Development Goals (SDGs). Regulation plays a pivotal role when integrating ESG within the financial markets. Furthermore, one might note that the interest of investors is shifting towards sustainable investment approaches as well as focusing on climate transition factors.

ESG investing allows for better portfolio diversification, thereby reducing the exposure to traditional risk and further enhancing long-term performance of investments. With that said, one might argue that the negative impacts outweigh the benefits, due to high amounts of regulatory changes and ever-increasing reporting costs, thus impacting the fund’s performance.

Integration of ESG in Investment Strategies

Various integration methods are used to incorporate ESG elements in investment strategies such as, screening methods which allows portfolio managers to use positive or negative screening to invest in companies based on their ESG criteria. For instance, investing in renewable energy firms rather than tobacco companies.

Another integration method is thematic investing, whereby the focus is on specific ESG themes such as clean energy, water sustainability, or gender equality.

Lastly, a portfolio manager may opt for impact investing, whereby the main aim would be to invest sustainably whilst generating financial returns, thereby investing in projects or companies that address specific issues like mitigating poverty or climate change.

The Sustainable Finance Disclosure Regulation (SFDR)

The SFDR is a regulation which aims to promote sustainability in the finance sector and sets out mandatory ESG disclosure requirements for financial market participants, to ensure investment strategies are more transparent and to reduce instances of greenwashing.

SFDR regulates how financial market participants, including fund managers, should disclose sustainability-related information. The key provisions of SFDR focus both on entity-level disclosures as well as product-level disclosures, also enforcing companies to disclose their Principle Adverse Impacts (PAIs).

Furthermore, SFDR classifies funds into 3 categories; Article 6 funds which are funds without any sustainability scope. Article 8 funds are those funds that promote environmental or social characteristics whilst Article 9 funds are funds that have sustainable investment as their main objective.

SFDR was aimed at enhancing disclosure requirements and has set clear parameters to distinguish between different levels of ESG integration in the fund management industry. 

ESG considerations are likely to become a focal point in analysing investments. Studies suggest that funds with an ESG focus can perform in line with or better than traditional funds having less exposure to risks which are becoming increasingly important by investment participants.

Greenwashing is a factor that investors need to be aware of as companies may overstate their ESG credentials to attract interest, which may lead to concerns about transparency and authenticity. To further reduce such risk, the financial industry is to expect more stringent regulations and disclosure requirements in the near future. With more regulation coming into force, portfolio managers must stay agile and proactive in their ESG efforts to meet both regulatory requirements and stakeholder expectations.

Samantha Jayne Abela, is a Risk Analyst at BOV Asset Management Ltd. The author and the company have obtained the information contained in this article from sources they believe to be reliable, but they have not independently verified the information contained herein and therefore its accuracy cannot be guaranteed. The author and the company make no guarantees, representations, or warranties, and accept no responsibility or liability as to the accuracy or completeness of the information contained in this article. The author and the company have no obligation to update, modify or amend the article or to otherwise notify readers thereof if any matter stated therein, or any opinion, projection, forecast, or estimate set for the herein changes or subsequently becomes inaccurate. The value of investments may go down as well as up. If one invests in a product, they may potentially lose some or all of the money they invest. BOV Asset Management Limited is licensed to conduct investment services in Malta under the Investment Services Act by the Malta Financial Services Authority.