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EU Taxonomy: The SFDR impact on fund flows has begun

Synopsis: EU Sustainable Finance Disclosure Regulation (SFDR) has already become a major driving force for how the sustainable finance industry grows in Europe. MORNINGSTAR, in its report on global ESG investment flows for Q2 2021, writes “In Europe, the sustainable fund universe is going through a significant transition following the introduction of the EU Sustainable Finance Disclosure Regulation in March”. While the flows had a minor disruption and were lower than 1Q 2021, the growth in ESG will be strong as asset managers recalibrate their offerings. Article 8 (environmental and socially promoting) and Article 9 (products targeting sustainable investments) funds have been growing fast, accounting for 30.3% and 3.7%, respectively, of fund assets. It is clear that SFDR has already led to a shift in the thought process for the direction of the sustainable funds’ industry in Europe and this trend will continue getting stronger: a) Article 8 and 9 funds will remain a focus area for asset managers and hence, will continue to grow quickly, b) The preference for ESG compliant companies will increase among asset managers and they will continue to get more expensive, c) the active vs. passive debate will continue. This means that asset managers will come under more scrutiny on what they are claiming and how they are investing.

Global Sustainable Fund Flows for Q2 2021

MORNINGSTAR has recently published its report on global ESG investment flows titled Global Sustainable Fund Flows: Q2 2021 in Review: Inflows falter but asset growth remains strong. Page 1 of the report mentions: In Europe, the sustainable fund universe is going through a significant transition following the introduction of the EU Sustainable Finance Disclosure Regulation in March. The new disclosure requirements will likely result in a significant increase in the number of options available to ESG-oriented investors.

We think the above point hits the bull’s eye. But there are other important takeaways as well;

  • The sustainable fund assets grew by 12% globally to USD 2.24 trillion at the end of June 2021.
  • Except for Australasia and Japan, net inflows declined across geographies in 2Q 2021.
  • The fall was 24% to USD 139 billion globally from an all-time high of USD 184 billion in 1Q 2021.
  • Europe accounted for over 81% of these flows, while the U.S. accounted for 13%.
  • 177 new sustainable products launched globally. Asset managers continued to repurpose and rebrand.

Europe: Under a transition phase for Sustainable funds

As we have discussed in our previous insights on EU taxonomy, the Sustainable Finance Disclosure Regulation (SFDR) that was launched on March 10th, 2021 has been a big reason for the impact on sustainable fund inflows in Europe because SFDR requires asset managers to provide considerably more ESG and Sustainability information. The Morningstar report says;

  • For the second-quarter report, 286 funds were added to the European sustainable universe, which brings the total to 3,730 offerings at the end of June 2021.
  • In the second quarter of 2021, the European sustainable fund universe saw USD 112.4 billion in net inflows, 25% less than USD 150.2 billion in the first quarter.
  • The inflow in 2Q 2021 is lower than the USD 124.7 billion inflow in the fourth quarter of 2020. But it is higher than the USD 67.9 billion seen one year ago in the second quarter of 2020.
  • Sustainable fund flows represented nearly 42.7% of overall fund flows in Europe over the period (USD 112.4 billion out of USD 263 billion).
  • As of June 2021, sustainable fund assets account for roughly 13.4% of total European assets. The assets in European sustainable funds rose to a new record high of USD 1,830 billion at the end of June, from USD 1,641 billion at the end of March, representing an 11.5% increase.

The more interesting part is on the repurposed funds. With the increasing popularity of ESG and Sustainability-based investment filters, there is a new trend visible on repurposed funds. SFDR is likely to increase the number of repurposed funds in Europe. The data is not yet complete, but Morningstar has captured 28 funds that were rebranded in the second quarter of 2021. It is different in different cases such as:

  • Transforming into a fully ESG-integrated strategy targeting companies expected to improve their sustainability practices.
  • Complete overhaul of investment mandate and changes like the conversion from broad-based equity fund to ESG-integrated fund benefitting from sustainability trends.
  • Popular themes include automation, climate change, consumer trends, and health protection. Some of the funds made a switch from index funds to new Paris Aligned Benchmarks.

Article 6, 8, or 9 of the Sustainable Finance Disclosure Regulation (SFDR)

Under the new classification, an investment strategy is classified under either Article 6, 8, or 9 of the Sustainable Finance Disclosure Regulation (SFDR):

  • Article 6 covers funds that do not integrate any kind of sustainability into the investment process and could include stocks currently excluded by ESG funds. These will be allowed to continue to be sold in the EU, provided they are clearly labeled as non-sustainable.
  • Article 8 or ‘environmental and socially promoting’ is applicable where a financial product promotes environmental or social characteristics and the portfolio companies follow good governance practices.
  • Article 9 or ‘products targeting sustainable investments’, covers the funds which have sustainable investment as their objective and also where an index has been designated as a benchmark.

Article 8 and 9 Funds: How are they performing?

In another report from Morningstar dated 27th July 2021 titled “SFDR: Four Months After Its Introduction – Article 8 and 9 Funds in Review”, there have been some interesting findings of the impact the new Sustainable Finance Disclosures Regulation has had.

  • The marketing of the funds becomes easier with Sustainability as an edge. Since the introduction of SFDR in March, asset managers have upgraded strategies and launched new funds that meet Article 8 or 9 requirements.
  • The growth is phenomenal for these funds. Article 8 and 9 funds account for 30.3% and 3.7%, respectively, of reviewed fund assets and amount to EUR 3 trillion in total. Morningstar estimates that Article 8 and 9 products could reach half of the total assets within the next 12 months.
  • The active vs. passive debate is alive. Active management largely dominates the post-SFDR ESG fund landscape. Passive funds account for only 11% and 10% of the assets in Article 8 and 9 funds, respectively.

In our view, certain things could lead to confusion. The report talks about how the fund companies have taken different approaches to product classification based on their interpretation of the regulation, resulting in a wide range of ESG approaches represented in Articles 8 and 9 funds, with similar strategies featuring in both categories.

There are also certain points that indicate dichotomy. For example, the same Morningstar report also mentions that the Article 9 funds typically have lower involvement in controversial weapons, tobacco, fossil fuel, and severe controversies. This is expected in our view. But what is strange is that while these funds have higher exposure to carbon solutions, at the same time they also exhibit higher exposure to thermal coal.

What next for Sustainable funds and for the industry in Europe

We believe that the global sustainable funds as a whole will continue to grow although regional disparities will remain. Over the next two to three years, we think;

  • The base effect will start to play a role and the growth will slow down a bit for the sustainable fund, on year-on-year or quarter-on-quarter terms.
  • Nevertheless, the overall assets under sustainable funds will continue to grow and Europe will continue to lead. Although it will take time, the United States will begin to catch up.
  • The new launches of sustainable products will continue across regions. More asset managers will join this bandwagon, purely for better marketing.
  • The growth in sustainable funds is as such not a problem but the red flag emerges when asset managers merely rebrand their products without changing much in investment philosophy.

The Sustainable Finance Disclosure Regulation (SFDR) has already led to a shift in thought process for the direction of the sustainable funds’ industry in Europe and this will get even stronger.

  • The Article 8 and 9 funds will remain a focus area for asset managers and hence, will continue to grow quickly. There will certainly be more money flowing into these funds.
  • The preference for ESG compliant companies will increase among asset managers. Also, the investment managers will assert themselves more on how companies do on sustainability.
  • The ESG compliant companies will continue to get more expensive as there will be more money chasing them. The sector allocation decisions will become more important.
  • The active vs. passive debate will continue. This means that asset managers will come under more scrutiny on what they are claiming and how they are investing.

How EMAlpha can help

While the global sustainable funds will continue to grow faster than the average industry, the SFDR will be a major driving force in Europe. This requires that the ESG ecosystem needs to be better prepared. At EMAlpha, we have incorporated a Flexible Framework Management System, based on EMAlpha’s proprietary technology making inferences framework agnostic. This also offers a quick adaptation for the users (asset managers, companies, and investment advisors).

As such, the EMAlpha’s ESG and Sustainability offering is centered around addressing some of the most critical issues. The EMAlpha algorithms provide a choice for separate relevant frameworks and these can be used to review the performance more transparently. This not only helps the investment advisors but also makes the clients understand the granular details better which in turn is helpful for them to understand their preferences better. To achieve this, we focus on the following;

  • Go beyond the official reported version – The data source matters and there is a need to look beyond what the companies are reporting and what the official version is. It is essential to rely on the company-reported data because other sources might not be collating as much information. Although often, there are other sources as well for environment-related information. They include the information disclosure as mandated by regulators and the EMAlpha algorithms scan through unstructured data to pick up the unofficial information as well.
  • No two ESG scores are the same despite the same headline figure – It is the composition that makes a big difference and all the three parameters that make up ESG need to be evaluated separately. The EMAlpha algorithms provide separate scores for E, S, and G so that an investor can review the sectoral performance more transparently. Over and above, a key feature of EMAlpha’s NLP algorithms is that the attribution analysis is fairly simple and straightforward.
  • An ESG score without context and background is meaningless – The ESG is as much about intent as it is about execution. For this balanced evaluation, having an understanding of the local factors is very crucial. A very good ESG track record (probably more driven by excellent performance in E and/or S) may hide serious Governance related risks and the investors can only ignore them at their own peril. EMAlpha analysis meticulously incorporates this critical part of the ESG evaluation jigsaw puzzle.

EMAlpha’s extensive coverage on EU Taxonomy

Among all the economic blocks globally, the European Union (EU) has been the most proactive in dealing with the challenges the world collectively is facing, in particular the challenge of ‘climate change’ which has been under focus for the EU. To address the issues related to damage to the environment and climate change, the European Commission has developed a classification system to provide more clarity to the companies on the economic activities in terms of where they stand on environmental sustainability.

This system is called EU Taxonomy and it has an objective to nudge the companies operating in the EU to report on and disclose how their business activities are aligned with the EU Taxonomy’s definition of what is sustainable and what is not. To the best possible extent, the EU taxonomy wants to create a level playing field for businesses in terms of how they report the information and relevant data. If done effectively, this will help investors in making better choices on the companies’ efforts to control damage to the environment.

EMAlpha has been actively tracking the major developments related to EU Taxonomy and we have also received very encouraging feedback on our insights on EU Taxonomy. Based on many of our conversations, we realize that there is a very high level of interest among clients which include institutional investors and the companies which are making serious attempts to better understand this regulation. On EU Taxonomy, we have so far published.

  • If industries assess that the EU Taxonomy will have a significant negative impact on their businesses, they will be apprehensive and will lobby hard against it. And with support for the local industry from the political brass, EU Taxonomy could see dilution in its stringent proposals. (EU Taxonomy: Momentum building against controversial proposals , 8th July 2021)
  • The next hurdle for EU Taxonomy may come as “requests for exemption”. Sweden’s Financial Supervisory Authority is already arguing that Sweden’s pension foundations should be exempted from the Taxonomy rules. It would be intriguing to see where the pendulum swings next. (EU Taxonomy: Will “Requests For Exemption” be the Next Challenge, 7th June 2021)
  • As it happens with any deal involving multiple stakeholders who hold contrasting viewpoints on critical issues, developing a consensus is the biggest challenge. This was the case with EU Taxonomy too. Did ‘practical’ and ‘acceptable’ facet get precedence over what was ‘stringent’, ‘scientific’ and ‘effective’? (EU Taxonomy: Political Realities vs Positive Change, 13th May 2021)
  • We discuss how the Coronavirus pandemic played a key role in shaping the thought process at the EU and how that may have impacted the EU Taxonomy proposed regulations. (EU Taxonomy: How the Covid-19 Pandemic triggered the April 2021 Package, 10th May 2021)
  • It will be an understatement to state that the rapid developments in EU Taxonomy and the proactive stance of European Commission on Sustainability matters will alter the playing field for the companies in the EU, investment managers and investment advisors. (EU Taxonomy: The Game Changer for Sustainability Reporting and Investment Advice,  30th April 2021)

References

  1. Global Sustainable Fund Flows: Q2 2021 in Review: Inflows falter but asset growth remains strong https://www.morningstar.com/content/dam/marketing/shared/pdfs/Research/Global%20ESG%20Q2%202021%20Flow%20Report_Final.pdf?utm_source=eloqua&utm_medium=email&utm_campaign=&utm_content=27223 (Accessed on 03rd August 2021)
  2. SFDR (Sustainable Finance Disclosures Regulation): Four Months After Its Introduction – Article 8 and 9 Funds in Review https://www.morningstar.com/content/dam/marketing/emea/shared/pdfs/SFDR_The_First_20_Days.pdf?utm_source=eloqua&utm_medium=email&utm_campaign=&utm_content=30688 (Accessed on 03rd August 2021)
  3. EU Sustainable Finance Disclosure Regulation https://www.robeco.com/en/key-strengths/sustainable-investing/glossary/eu-sustainable-finance-disclosure-regulation.html (Accessed on 03rd August 2021)
  4. Sustainable Investing Glossary: Article 6, 8 and 9 funds https://www.robeco.com/en/key-strengths/sustainable-investing/glossary/article-6-8-and-9-funds.html (Accessed on 03rd August 2021)
  5. REGULATION (EU) 2019/2088 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 27 November 2019 https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019R2088&rid=1 (Accessed on 03rd August 2021)
  6. EU taxonomy for sustainable activities: What the EU is doing to create an EU-wide classification system for sustainable activities https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/eu-taxonomy-sustainable-activities_en#delegated (Accessed on 03rd August 2021)
  7. Sustainable finance: TEG final report on the EU taxonomy https://knowledge4policy.ec.europa.eu/publication/sustainable-finance-teg-final-report-eu-taxonomy_en (Accessed on 03rd August 2021)
  8. “Greenwashing”— phenomenon of pretend environmentalism https://www.prospectmagazine.co.uk/politics/greenwashing-the-growing-phenomenon-of-pretend-environmentalism (Accessed on 03rd August 2021)
  9. Sustainability Funds Hardly Direct Capital Towards Sustainability: A Statistical Evaluation of Sustainability Funds in CH & LUX https://www.greenpeace.org/static/planet4-luxembourg-stateless/2021/06/ac190a73-inrate-study-on-sustainability-funds-for-greenpeace.pdf (Accessed on 03rd August 2021)
  10. New EU sustainable finance rules: ‘blunt instrument not silver bullet’ https://chinadialogue.net/en/business/new-eu-sustainable-finance-rules-blunt-instrument-not-silver-bullet/ (Accessed on 03rd August 2021)
  11. The EU’s Much-Flaunted Climate Leadership is Full of Loopholes https://carnegieeurope.eu/strategiceurope/84506 (Accessed on 03rd August 2021)
  12. U. Ignores Science-Based Advice, Labels Gas As Green In Sustainable Taxonomy Proposal https://www.greenqueen.com.hk/e-u-ignores-science-based-advice-labels-gas-as-green-isustainable-taxonomy-proposal/ (Accessed on 03rd August 2021)
  13. Sustainable Finance and EU Taxonomy: Commission takes further steps to channel money towards sustainable activities https://ec.europa.eu/commission/presscorner/detail/en/IP_21_1804 (Accessed on 03rd August 2021)
  14. Assets in SFDR funds rocket but number of funds is “unexpected” https://www.funds-europe.com/news/assets-in-sfdr-funds-rocket-but-number-of-funds-is-unexpected (Accessed on 03rd August 2021)

EMAlpha Products and Services

In most Emerging Markets, information discovery is a major challenge. For example, even if global investors do show interest, how do they solve the problem of timely access to information? The world’s largest capital allocators hold USD 60 trillion and they include GPIF (Japan), GPF (Norway), ADIA (Abu Dhabi), GIC (Singapore) etc. However, only 10% of the capital gets allocated to EMs and ~90% goes to G10. The big hurdle for EMs is: Foreign investors cannot access relevant local information in a timely fashion.

Most market participants and investors from across the world realise that the low rates in G10 makes EM attractive for investors. But, a) Information access is usually a cost and time intensive process for investors, and b) In many EMs, language is a big barrier and because of multiple regional languages, there is a significant delay before news makes it to the mainstream English language. To address these issues, you need solutions like, a) Real time news collection from multiple languages and, b) Instantaneous machine translation and text analytics leading to actionable recommendations for investors.

There are further challenges such as ensuring that companies behave responsibly and that they adopt sustainable business practices. There is a need to ensure that the investors are contributing towards making the world a better place by making investment decisions which reward responsible behaviour of companies. Case in point, ESG (Environmental, Social & Governance) which is increasingly being used as a filter for investment decisions. There are other issues as well such as which data to use and a lack of a standardized framework for evaluation.

Some of these issues are too important to be postponed to a later date and it is in this regard that EMAlpha is making its contribution. EMAlpha has developed a Flexible ESG Framework Management System which is a proprietary technology that makes ESG scores framework agnostic, thus allowing for quick adaptation. In addition, the users decide what matters to them and the EMAlpha system does a classification into E, S, G and more granular categories.

EMAlpha also has solutions for Multilingual data collection and real time targeted information which are based on proprietary processes to collect relevant data across multiple markets. The coverage expands across emerging market equity, currencies and commodities and the work has also been very successful in testing the signals in some key markets for live trading strategies. This is a continuous cycle and a virtuous loop that allows for iterative improvement through AI-human feedback.

With developments in AI and technology in areas like NLP, there are considerable new possibilities to bridge the gap in information between Emerging Markets and the more Developed Markets. This is an area which is turning out to be very exciting because some of the tools mentioned were not available even a couple of years ago. This implies that the evolution in the field will only get faster as time goes on. While the Emerging Markets and the Capital Flow Conundrum is a complex one, there is now much more hope and optimism that with the usage of technology, things will only get better.

At EMAlpha, the ESG team is doing further research on why some issues like Social get more prominence as compared to others like Environmental or Governance issues. To look at specific cases in the context of ESG is a very intense yet interesting exercise and this has been an incredible learning experience for the EMAlpha Research team. The data, information and ratings are a humongous challenge for ESG and it takes time to reach to the depth of the issues as the field is evolving very quickly.

EMAlpha is making a solid contribution in tackling these challenges. EMAlpha has solutions for ESG which are practical, user friendly and although not too simplistic yet easy to use. EMAlpha has developed a Flexible ESG Framework Management System which is a proprietary technology that makes ESG scores framework agnostic, thus allowing for quick adaptation. In addition, the users decide what matters to them and the EMAlpha system does a classification into E, S, G and more granular categories.

We strongly believe that the entire ESG ecosystem requires multiple stakeholders to pull in the right direction in order to make it operational and that will be the most critically determining factor for ESG’s success in making the corporate responsibility actually work. Most importantly, the investors should view ‘E’, ‘S’ and ‘G’ individually and should not confound issues when it comes to the comprehensive ESG evaluation. It is important to understand the right reasons behind ESG investing because this bias could hurt their investment decision making and portfolio performance.

Research Team
EM Alpha LLC

For more EMAlpha Insights on Emerging Markets, please visit https://emalpha.com/insights/. To know how you can use EMAlpha’s unstructured data and ESG (Environmental, Social and Governance) solutions for better investment decisions, please email us at research@emalpha.com.

About EMAlpha:

EMAlpha, a data analytics and investment management firm focused on making Emerging Markets (EMs) more accessible to global investors and unlocking EM investing using machines. EMAlpha’s focus is on Unstructured Data as the EMs are particularly susceptible to swings in news flow driven investor sentiment. EMAlpha works on information discovery and ESG solutions for Investors in Emerging Markets, using AI and NLP tech. Our mission is: “To help increase capital flow, in terms of FDI and FPI, to Emerging Markets by lowering information barriers using AI/NLP”. EMAlpha Products help achieve both alpha and ESG solutions and the idea is to help asset allocators, asset managers, banks and hedge funds along with companies with cost and time efficient access to relevant information. We use thoroughly researched machine learning tools to track evolving sentiment specifically towards EMs and EMAlpha pays special attention to the timely measurement of news sentiment for investors as these markets can be finicky and sentiment can be capricious. Our team members have deep expertise in research and trading in multiple Emerging Markets and EMAlpha’s collaborative approach to combining machine learning tools with a fundamental approach help us understand these markets better.

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