From hero to zero… and how to make sure the story ends with “…and back again”

The challenges of sustainable finance are numerous. From transparency and greenwashing concerns to data quality and collection issues, sustainable finance is under rigorous scrutiny. Its importance is undeniable, but how can the asset and wealth management industry set sustainable investments up for success? In this article, George Latham explores sustainable investing's cyclical journey and recent regulations like SFDR and SDR, and highlights how clear sustainability objectives, proper fund categorization, and transparent marketing can rebuild investor trust despite recent market turbulence.

I first got involved in sustainable investing in the late 1990s, and I’ve seen interest in this market come and go in cycles. The tech bubble of the late 90s was also a clean-tech bubble, which also subsequently burst. By the mid-2000s, clean-tech was back in fashion, and a range of renewables and carbon pricing funds were launched. These were then hit hard by the financial crisis in 2008-9, and sustainability was in the doldrums again. By a strange twist, the latest spurt in popularity for sustainable investing started around the beginning of the first Trump presidency. One might even argue that the polarisation of politics created a real motivation for concerned investors. So, in a surreal way, Trump perhaps created some of the momentum for what became known as the ESG stampede in the run-up to, and during, the COVID pandemic. What had been a specialist investment activity suddenly became ubiquitous.

Between 2017 and 2022, scores of new products were launched, and even more were rebranded as ESG or Sustainable. Sustainable investing was seen as the saviour of the active management industry, and the smart way to carve out a career in the investment world. In the rush to take advantage, a plethora of different approaches and interpretations of what sustainable investing means came into play. As a result, consumers were left confused and often disappointed when products didn’t match their expectations, either from the perspective of their risk-return profile, or indeed the ‘sustainability’ of their underlying investments. The rush into the space also drove valuations to a significant premium. This compounded the mismatch in investor expectations when the combination of higher inflation and interest rates, war in Ukraine and the Middle East, and the rise of a populist political backlash created a perfect storm to undermine returns in the sector. And so, a charge into the space by investors and investment managers has just as quickly turned into a rout.

The rise of regulation

Throughout the 2010s, at WHEB, we had been concerned about the lack of consistency in the industry around the use of language to describe sustainable investment strategies, and the risk of consumers becoming confused, or worse, misled by expectations of the products they were buying. We had frequently called for greater regulation and have been involved in several initiatives to try to improve governance in the industry.

The European Union moved first to regulate the sector with the adoption of the Sustainable Finance Disclosure Regulation (SFDR) in March 2021. However, this new regulation was fraught with several problems. It was designed as a hierarchy (with Article 9 being more demanding than Article 8, which in turn was more demanding than Article 6), a flawed taxonomy, and no differentiation between different approaches to sustainability. Its centralised and prescriptive design introduced rigid requirements which forced funds with differing objectives to measure and report performance in an overly standardised way. The industry also had to cope with shifting definitions of a sustainable investment.

So when the Financial Conduct Authority (FCA) introduced the Sustainability Disclosure Requirements (SDR) in the UK, we felt it was an opportunity to implement a regulation that provided more flexibility and also better met users’ needs. For a start, the SDR is principles-based, and has several features built around the core objective of building trust and helping consumers navigate their way to the products that meet their needs.

• It operates to a high bar. The regulator doesn’t seek to ratify products, but the regulation is designed so that only those investment strategies that can describe how they plan to achieve a “sustainability objective” should market themselves as a sustainability fund.
• A “sustainability objective” should be just that. Until now many managers have relied on saying what they do – screening out “bad” sectors or taking ESG factors into account – but in most cases, they hadn’t set out why they were doing it and what real-world outcomes they were seeking to achieve (beyond perhaps “because this is what we think our customers want to hear”).
• ESG analysis is just a form of investment due diligence. We believe ESG shouldn’t be part of the naming or marketing of funds. It is good and long-term thinking to want to know if your assets are well managed or well governed. But if the reason you do this is to protect investment returns, then it is on the same level as considering valuations or other forms of due diligence. That doesn’t justify branding a fund “ESG” by its mere presence in the investment process.
• Different approaches to achieving a sustainability objective are considered equal. “Improver” funds try to make investments more sustainable (implying that they aren’t necessarily sustainable today). They will look different from “focus” funds, which are invested in assets that already reach a high threshold of sustainability, and from “impact” funds, which seek to invest in assets that have a positive real-world impact. In each category, the manager needs to set out what they are trying to achieve and how they are going about it.

Both SFDR and SDR have had a tricky start to life and arguably have been botched in their implementation. For SDR, it seemed that the bar was initially too high, and the industry didn’t understand well enough what the FCA was looking for. The FCA has taken much of the blame for this, but I believe the industry also needs to take responsibility for not reading the essay question carefully enough. There continue to be questions about how widely across the value chain to apply the regime in the UK and its interoperability across borders into the EU. The European SFDR is now being reviewed and is likely to be redesigned. There remains some hope that a future framework for SFDR will look something like, and therefore interoperate well with, SDR in the UK.

Looking for the next upcycle

If we take a step back from the current market turbulence, there are some key takeaways:

• The underlying challenges and economic logic for investing sustainably have not gone away. The social and environmental problems we face only become more intense the longer we avoid addressing them. Meanwhile the technology available to address societal and environmental challenges has become more readily and commercially available.
• Regulation of how sustainable funds are marketed is here to stay. SDR and SFDR may have had difficult starts to life, but they will remain in place and evolve.
• The underlying investor demand for sustainable and responsible investing is far less volatile than the attention span of the investment industry. Surveys of investor demand have remained remarkably consistent over decades, and at a much higher level than the penetration of sustainable investment products.

Sustainability is a systemic and complex issue, and there is no one-size-fits-all approach to what a sustainable investment should look like. If we want to see more capital allocated towards solving global challenges, we need to build investor trust in the products and strategies that claim to do so. A good start is to clearly explain the sustainability objectives of products that are marketed as such, and better signpost to equip investors to make informed choices.

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George Latham is Managing Director of Foresight.

Foresight Group LLP does not offer legal, tax, financial or investment advice. It is intended for information purposes only and does not constitute or form part of any offer or invitation to buy or sell any security including any shares of the Fund. The information should not be relied upon to make an investment decision in relation to shares in the Fund or otherwise; any such investment decision should be made only on the basis of the Fund scheme documents and appropriate professional advice. The document does not constitute advice of any kind, investment research or a research recommendation, is in summary form and is subject to change without notice. Foresight Group LLP has exercised reasonable care in preparing this document including using reliable sources and makes no representation or warranty relating to its accuracy, reliability or completeness or whether any future event may or may not occur. Any opinions contained in this document constitute our judgment as of the date of the document and are subject to change without notice.

Foresight Group LLP is the investment manager and is authorised and regulated by the Financial Conduct Authority with Firm Reference Number 198020 and has its registered office at The Shard, 32 London Bridge Street, London SE1 9SG. FundRock Partners Limited is the Authorised Corporate Director of the Fund and is authorised and regulated by the Financial Conduct Authority with Firm Reference Number 469278 and has its registered office at Hamilton Centre, Rodney Way, Chelmsford, England, CM1 3BY. The state of the origin of the Fund is England and Wales.