SFDR one year out: An ESG operational and data perspective

How are asset managers reacting to ESG market demands one year after the EU's regulation?

Grappling with ESG's evolving landscape

It has been one year since the introduction of the EU's Sustainable Finance Disclosure Regulation (SFDR), and there appears to be little added clarity for asset managers large and small still grappling with lack of definitive guidance and industry agreement on comprehensive, quality data around environmental, social and governance (ESG) investing.

"What has become more challenging is that we went from little data a decade ago to now a proliferation of data, which is great, but then how do you use it?" commented a senior executive at one of the world's largest asset managers, BlackRock, last fall. "It's being disclosed, but not from a regulatory lens and there is not much consensus."

Asset managers, hedge funds, and wealth managers of all sizes and strategies understand the importance of active and effective participation in this important market. ESG adoption is strong while barriers remain: 67% of asset managers have prioritized ESG integration into their portfolio while 23% cite data integration and cost as an obstacle, according to Linedata's latest Global Asset Management Survey. It's no surprise that 31% cite lack of industry standards as a headwind.

Most ESG data providers only cover a selection of securities, which can lead to data gaps. ESG regulations such as SFDR should be helping to improve this. We do see increased demand from corporates as well as investors and, data coverage is improving. The challenge remains for asset managers in easily accessing and integrating data and scoring into their workflows.

So a year on from SFDR, how can asset managers separate the signal from the noise when it comes to ESG data integration?

SFDR and greenwashing

One of the primary goals of the SFDR framework from the EU was to protect investors from greenwashing, requiring that managers disclose sustainability levels in their portfolios and investment process. But the general market consensus is that there is no consensus: the subtlety of greenwashing is not easily definable or entirely preventable. Separating the marketing hype from reality in ESG is heavily debated today.

Despite this, record demand has fueled the increase in the number of ESG funds, and those that have been classified as Article 8 or Article 9 have commercially benefitted.* This has in turn increased the number of ESG data providers and measures available within the market.

Measuring the flow into ESG funds

But does this mean the asset management industry is seeing a 'real' increase in ESG funds? Bank of America research found that 4 out of every 10 dollars globally went into ESG-focused equities in 2021, up 135% on 2020. And according to data from Morningstar, Article 8 and Article 9 funds reached €4.05 trillion at the end of December 2021, which represented 42.4% of all funds sold in the European Union.

Additionally, Morningstar's research found more than half of all new fund launches in the EU were Article 8 and Article 9 funds, accounting for nearly 200 in Q4 of 2021. These funds will all be required to extensively report on their ESG products and will be impacted by data challenges.

Categorizing funds gets more complicated

But have these definitions changed based on criteria from regulators or other metrics like AUM? In February of this year, Morningstar announced that it had removed 27% of the funds on its "sustainable" list following the implementation of SFDR rules. The culling represented more than 1600 funds with $1.2 trillion in AUM. Many were Article 8 self-identifying funds and confirmed many in the industry's fears about the prevalence of greenwashing.

This represents complexity for the industry, besides the fact that funds get categorized further into two categories, Article 8 and 9, under the regulatory technical standards (RTS) of SFDR. This is very limiting as well-clearly it cannot also represent the full spectrum of ESG funds and the range of data available.

Additionally, the rise of the Gen Z and millennials in both the workforce and as influential investors has built momentum around the "Social" and "Governance" in ESG. Millennials invested $51.1 billion in sustainable funds in 2020, compared with less than $5 billion five years ago. Nearly one-third of millennials exclusively take ESG factors into account, compared with 19% of Gen Z, 15% of Gen X and 2% of baby boomers, according to a CNBC poll. While "Environmental" has largely been the focus for most asset managers, Covid and the events of summer 2020 have highlighted both the need and challenge around incorporating social data into analysis.

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The 'Data Gap'

Despite there being more independent providers than ever, data-and subsequent access, integration and pricing-remains one of the toughest barriers. The impact of legislation like the EU's SFDR, only a year on, will continue to reshape the industry as investors demand more disclosure.

In turn, asset managers report that the biggest challenges around ESG data are the lack of standards, data availability and data inconsistency. Data needs also differ for different investment strategies. While listed equities have the most available data, private equity funds may find themselves trying to collect their own data, which has its own obstacles.

A recent report by research firm bfinance found that 60% of asset owners now indicate ESG issues are a major consideration in manager selection-up from 41% in 2018. But another report found that more than 80% of the 256 asset owners surveyed, representing $7 trillion in assets, reported problems obtaining consistent reporting across both asset managers and asset classes.

Funds that initially declared as Article 8 may also not have looked forward enough to their data requirements. This may be especially true for smaller fund managers who do not already have some data in house, and there is a reputational risk to upgrading before a fund is ready.

Asset Managers need to ask themselves how they can get access to everything that they need, how to navigate data costs and how to integrate scoring into their portfolio systems. The results are only going to be as good as the data source but for some asset managers, there is fear in being first mover and committing to a data service or structure with a long lock-in period.

At Linedata, our clients struggle, too, with ESG data selection and data integration. We've worked to make their process easier, by directly integrating data and scoring into portfolio workflows in collaboration with ESG analytics firm, Arabesque. The goal is lowering barriers to ESG market participation through ease of access, lower costs, and the ability to use various strategies with the same ESG data set.

Taking stock

So how are asset managers handling these hurdles?

Some are partnering with technology providers or taking on an in-house build out. But whatever the approach, ESG reporting and increased transparency to regulators and investors can help companies differentiate and enhance their competitive position, per Linedata's 2021 GAM Report. In one example, an established European hedge fund reported ESG scoring of its portfolios to clients, not only which scored high and low but how they improved over time. The fund stated that the ability to track, monitor and manage ESG performance sent a strong message to investors.

Each asset manager will take an approach and methodology to the ESG data challenge which meets their needs today. And while a year on from SFDR-and with additional frameworks coming from the UK and Level 2 regulatory technical standards imminent-there is much to be optimistic about for ESG-driven investment decisions, there is also much work to be done.

SFDR definitions: Article 8 or "light green" funds: promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices.

Article 9 or "dark green" funds: have sustainable investment or a reduction in carbon emissions as the objective.

About the author, David Boot

David Boot is Global Product Manager for institutional asset management clients. He has 20 years experience in the industry bringing innovation and adaptability to clients' toughest risk, data and analytics challenges.

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Sources:

OMFIF, "ESG and US asset management: The Future is Now," December 2021

Linedata, "Global Asset Management Survey 2021," 2021

Responsible Investor, "Friday Funds: $4 out of every $10 are invested in ESG," February 2021

Financial Times, "Morningstar culls more than 1,200 funds from 'sustainable' list," February 2022

Linedata, "The Fund Oversight Challenge: Helping asset managers meet their NAV oversight, ESG, and data management obligations," October 2021

Alicia Adamczyk, "Millennials spurred growth in sustainable investing for years. Now, all generations are interested in ESG options," (2021)

bfinance, "From Laggards to Leaders? Hedge Funds Slowly Embrace ESG," April 2021

Linedata, "Accelerating ESG in Asset Management," 2021