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Exchange-traded funds will fall foul of country-by-country ‘green’ fund rules for the second time in weeks, under new UK legislation.
ETFs are not eligible for a range of new ‘sustainable’ labels being introduced by the UK’s Financial Conduct Authority. This means that anyone looking to invest only in funds that meet this threshold will find very few passive funds, and no ETFs, to buy.
This comes just weeks after France tightened its rules on funds with the ‘socially responsible’ ISR label in a way that ETF providers must adhere to unless they impose the sweeping new restrictions on all their investors across Europe.
In both cases, ETFs are hampered because, at least in Europe, they are typically cross-border products, usually based in Ireland or Luxembourg and ‘passported’ to other countries.
In contrast, fund regulations are often set at the national level and are better suited to the more traditional world of domestically based mutual funds.
The latest setback for ETFs focuses on the UK Sustainability disclosure requirementswhich will come into effect at the end of July.
The regulations aim to tackle claims of ‘greenwashing’ by preventing asset managers from making misleading sustainability statements about their products, and to improve transparency. They allow funds claiming to have sustainability features to use one of four FCA-approved labels to signal this to investors.
However, these labels are only available for UK-domiciled funds, meaning ETFs are excluded, even those listed on the London Stock Exchange.
Considering that “most [of the 1,960] passive funds for sale in Britain are overseas ETFs. . . the limited number of labeled passive funds will reduce the choice offered to sustainability-focused investors in Britain,” said Hortense Bioy, Global Director of Sustainability Research at Morningstar.
Morningstar predicts that “almost all UK funds with the words ‘sustainable’, ‘sustainability’ or ‘impact’ in their names [will] choosing a label” because of “among other things commercial interests and the risk of being accused of greenwashing”.
Of the 300 funds with combined assets of £110 billion, Morningstar will have adopted the new labels by the end of this year. Only 20 are likely to be passively managed, largely due to the absence of ETFs.
“I counted fifty [UK-domiciled] passive funds with ESG related to their names: 20-23 may be able to use the labels, but many of these would need to make some changes,” Bioy said. The labels are not available for funds that only use exclusions or negative screening to filter out unsuitable stocks.
“It is a real problem for both asset managers and investors, because it limits freedom of choice. It is clear that investors really like the passive approach when it comes to ESG,” Bioy said.
In total, Morningstar calculates that around 1,370 of the 1,780 funds available in Britain with sustainability-related terms in their names are based abroad.
Under the SDR regime, fund sponsors can choose from four sustainability labels that they can apply to each fund: Sustainability Focus, Sustainability Improvements, Sustainability Impact and Sustainability Mixed Goals.
The categories are based on whether a fund mainly invests in assets that focus on sustainability; invests in assets that are currently unsustainable with the aim of improving their sustainability; maintains underlying holding companies that seek to provide solutions to sustainability problems; or is a mixture of these three.
In any case, the regulations allow fund distributors to apply the labels themselves to offshore funds that are otherwise excluded from the regime.
“When we first saw this, I thought this doesn’t work. Half of the funds we use are offshore,” says Jack Turner, head of ESG portfolio management at Seven Investment Management, which uses many passive ETFs to build its investment portfolios.
However, Turner said the FCA had made it clear that 7im “can look through the assets held in these funds or ETFs and decide for themselves whether these funds are sustainable”.
As a result, the Sustainable Balance Fund may be able to adopt the Sustainability Mixed Goals label, even though some of its investments are ETFs that cannot apply for this label.
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Distributors like 7im will have to apply a “robust, evidence-based standard” to determine whether an asset is sustainable, something that is likely to go beyond ESG-focused DIY retail investors looking to build their own portfolios.
“In a perfect world, it would be easier if all our investments had an underlying label,” Turner said.
“It is the investors who are being punished for this [omission],” said Bioy. “They still have access to these ETFs, [but] it reduces the attractiveness of the label.”
The FCA has said that to support a level playing field, “we want all companies marketing their products in Britain to be subject to the same broad requirements”, but that the extension of SDR to foreign funds “is a matter for” the British Treasury.
The Treasury has pointed the Financial Times to a written statement from Bim Afolami, the city’s minister, who said the UK government “intends to consult on whether to extend the scope of the SDR to include funds are recognized under the OFR. [Overseas Funds Regime]”.