The Retail Market for Sustainable Fund Investing

An Exploration

April 2022 Report AFM.nl/sustainability

Table of Contents

1. Introduction 3
2. How does sustainable investing work? 5 2.1 Exclusion 5 2.2 Engagement 6
3. What do we see in the exploration? 7 3.1 Definition of the sustainability theme 7 3.2 Information provision 9 3.3 Image formation and advertising 10
4. What are points of attention? 11

1 Introduction

Sustainable investing continues to gain strong popularity. The assets invested in ESG funds rose in the EU in the second half of 2021 by 9% to over 1600 billion euros, after having already increased by 20% in the first half of that year. ESG1 funds thus make up slightly less than 20% of the total number of publicly offered funds. Inflows into ESG bonds increased by 19% in the same period.2 We therefore also see efforts at virtually every provider to meet this demand.

However, the market is still developing and risks may arise for retail investors. Sustainability is a complex concept and, for the time being, not a uniform one. Financial institutions can still determine for themselves exactly what they mean by it, although the Taxonomy Regulation brings more uniformity with regard to qualifying environmentally sustainable activities.3 Furthermore, there is limited insight into the sustainability performance of companies, partly because reporting and disclosure standards are still under development. Relevant, comparable, and reliable data on the sustainability performance of issuing companies or financial products are therefore not yet commonplace. ESG ratings play an important role in the market and must make sustainability information more accessible. However, due to differences in measurement methods and definitions, these ratings can vary greatly, which limits their effectiveness.

Finally, consumers seem willing to accept lower returns for the same risk with sustainable investments. This is positive with regard to financing the sustainability transition, but only if the proceeds are actually used for the sustainability transition. The question is to what extent consumers delve into the actual sustainable characteristics and performance of sustainable investments to determine whether the way the provider defines sustainability aligns with their expectations. There are indications that consumers are primarily attracted by the green image of an investment and make less distinction between the degrees of greenness within the sustainable offering.5

There is much new legislation in force and more coming regarding sustainable investing. Since March 10, 2021, the Sustainable Finance Disclosure Regulation (SFDR) has been applicable. This regulation contains requirements for the provision of information on sustainability (ESG factors) by financial market participants and financial advisors. The SFDR determines, among other things, that financial market participants offering sustainable products (and thus also fund managers) must be transparent about how a product gives substance to sustainable objectives or characteristics, both pre-contractually and on a periodic basis. Additionally, new obligations regarding the handling of sustainability risks from AIFMD and UCITS, and regarding the inventory of sustainability wishes among customers under MiFID II, will follow in the autumn. The arrival and further development of this legislation is important context when investigating possible risks for investors.

This exploration provides insight into how the offering is developing and to what extent risks for retail investors can be seen in practice. For this exploration, we conducted both a literature study and a quick scan of a selection of twelve sustainability-promoted funds from prominent providers on the Dutch market. We did not look at other financial market participants, such as banks, insurers, and pension funds. We looked at how these funds translate sustainability into parts of their investment policy and how the funds are presented to the investor. The observations and points of attention resulting from this are described in this publication. This is explicitly a first exploration with the aim of obtaining a generic image of the offering and possible risks, and not to investigate compliance with specific laws. We want to substantiate the insights from the (mainly international) literature with observations from (Dutch) practice in this context. Although these observations are not necessarily representative of the entire market, we want to share the findings via this publication and open the discussion about it. We are aware that both the offering of funds and the legislation regarding it are still strongly developing.

1 ESG is often used instead of the term sustainable and stands for environmental, social and governance 2 ESMA, 2022 3 See European Commission. A 'social' taxonomy is also in the making. 4 AFM, 2020 5 See for example Heeb et al, 2022

2 How does sustainable investing work?

Sustainable investments come in many shapes and sizes. There are many different types of sustainable investments and many different choices underlie a sustainability strategy. Below we discuss some elements that are part of a sustainable investment strategy. As with funds that do not specifically focus on sustainability, there can be active and passive funds. A passive fund follows a (sustainable) index. This makes a difference in that part of the sustainability strategy (namely fund selection) is in fact determined by an index provider. With active funds, the fund provider does this themselves. The elaboration of the elements below does not make a further difference.

2.1 Exclusion

Exclusion means that (groups of) companies are excluded from investment by the provider, based on sustainability characteristics. The exclusion policy usually consists of generic exclusions and additional exclusions. The generic exclusions relate, for example, to weapons, tobacco, and sanctioned entities, in which no fund of the provider invests. With the additional exclusion policy, fund-specific exclusions are defined that fit the sustainability objectives of that fund.

In this exploration, we distinguish three exclusion strategies: 'responsible', 'sustainable', and 'impact'. The market uses various (grades of) exclusion strategies. We can summarize these strategies in three main strategies which we call 'responsible', 'sustainable', and 'impact' here (Figure 1, left panel). Under 'responsible' strategies, only companies with serious ESG issues are excluded. Think here of major polluters such as the raw materials industry. This usually involves a limited number of exclusions, so that the largest part of the investment universe remains available. Under the heading 'sustainable', in addition to the 'responsible' strategy, companies are excluded that do not meet a certain ESG score or another criterion set by the provider. Within this category, several funds are often offered with different criteria for the required ESG score or by making further distinctions based on the current or future adaptability of the companies in which investment is made. Companies that, for example, score poorly on sustainability but are making demonstrable steps in that direction can then still be selected. Finally, 'impact' strategies are the strictest, and only companies are selected that make a demonstrable positive contribution to a stated sustainability goal. Note that multiple variants of these strategies are used in the market, with names that differ per provider. See Figure 1, right panel, for an illustration of some strategies from practice based on the MSCI Europe indices.

Figure 1 Exclusion strategies for sustainable investing; illustration of main strategies (left) and example of MSCI Europe indices (right). Source: AFM Source: MSCI, AFM

2.2 Engagement

Engagement refers to any form of contact between the provider and the issuing institution that aims to safeguard the long-term interests of investors, including those in the field of sustainability. The idea behind engagement is that excluding non-sustainable companies is not sufficient to achieve sustainability goals and that it is actually more effective to urge these companies to change as a shareholder. The two most important components here are the dialogue with the institution to move them towards certain goals and the voting policy at the general meeting of shareholders. This can take place in collaboration to make more impact. Examples of collaborations are Eumedion and Climate Action 100+. In the context of voting policy, director appointments and remuneration policy are the most common topics. Providers with a sustainable engagement policy try to ensure via this route that, for example, directors with sustainability affinity are appointed, and that the remuneration policy promotes sustainable value creation. Furthermore, voting takes place on specific sustainability proposals from (other) shareholders.

3 What do we see in the exploration?

3.1 Definition of the sustainability theme

With funds promoted as sustainable, sustainability is operationalized in different ways in the fund objectives. Sometimes the sustainability objective relates to all ESG elements, sometimes only to one of these elements. The generic distinction we see is between general sustainable funds and thematic sustainable funds. General funds do not focus specifically on a sustainability characteristic but strive for a good all-round sustainability score. Thematic funds focus on a specific sustainability characteristic or a specific sector, and therefore have a more limited investment universe to choose from. Note that all these different definitions can be offered under the banner of 'sustainability'.

Especially with funds with a broad sustainability objective, it is often not easy to understand how strict the selection is and on which criteria shares are included or excluded. These funds (referred to in this publication as general funds) usually use general ESG ratings to make fund selection, which are an average of various indicators falling under the E, S, and G headings. It is therefore not possible to say which of these are decisive in the inclusion or exclusion of a given share. It is also not always clear how strict a selection is (other than the difference between the strategies described in paragraph 2.1), because it is not always visible how many shares fall away compared to a relevant fund that is not specifically promoted as sustainable.

Engagement is not used as a distinguishing factor for specific sustainable investments, but to strengthen the sustainable profile of the provider as a whole. A sustainable investment strategy usually consists of both an exclusion and an engagement policy. The engagement policy is conducted over the entire portfolio, thus also and sometimes especially aimed at the least sustainable shares in the portfolio. After all, the greatest sustainability gain can be achieved with the least sustainable shares. However, these shares are usually not in the sustainability-promoted funds of the provider. Although the engagement policy is therefore an important part of the sustainability policy where a provider can make an important contribution, engagement is in principle not used to achieve the objectives of specific (sustainability-promoted) funds. An investor who wants to invest sustainably must therefore assess the quality of the engagement policy at the level of the provider and not at the level of a specific (sustainability-promoted) fund.

The distinction between sustainable and non-sustainable funds does not always become evident in the fund positions. In the exploration, it is striking that many shares in the sustainability-promoted funds usually also form an important part of funds that do not specifically focus on sustainability. It seems that specifically non-sustainable names (e.g., oil and gas extraction) have been excluded. The not very pronounced character of general sustainable funds seems to suggest that within the companies in which investment is made, there is a limited group of clearly lagging companies with regard to sustainability, but also a limited group of clear leaders. The majority of the included shares seem to be in between. However, these shares form the core of many sustainable funds. The sustainability leaders are more clearly visible in impact funds.

An illustration of this is the large share of tech shares in sustainability-promoted funds. In general sustainability-promoted funds, tech shares make up up to 30% of the fund.6 Common shares in these funds are, for example, Microsoft and Alphabet (Google). On average, the share of tech shares in sustainable funds is higher than in funds that do not specifically focus on sustainability (Figure 2). The hypothesis is that these shares receive a large share in the sustainability-promoted funds due to their high liquidity and return, combined with a good all-round ESG score. Other categories in which sustainability-promoted funds invest, on average, more than funds that do not specifically focus on sustainability are healthcare and financial services, although the differences in the shares of these sectors per fund are somewhat larger.7 Common shares in healthcare are large pharmaceutical companies (Roche, Novartis, AstraZeneca, Novo Nordisk; Figure 3). In financial services, we see the large financial conglomerates (UBS, Allianz, Bank of America, etc.). Finally, large providers of consumer goods also often appear, such as L'Oréal, Unilever, and Nestlé.

Figure 2 Difference in sectoral investments between ESG and non-ESG funds Source: ECB, 2020 6 FT, 2021 7 MSCI, 2021

Figure 3 Most common shares in sustainability-promoted funds

Funds promoting sustainable characteristics (SFDR Article 8)	Sector	Funds with sustainable investments as objective (SFDR Article 9)	Sector
1. Alphabet	Communication	1. Schneider Electric	Industry
2. Microsoft	Technology	2. ASML	Technology
3. Novo Nordisk	Healthcare	3. Vestas Wind	Industry
4. Roche	Healthcare	4. Microsoft	Technology
5. ASML	Technology	5. Novo Nordisk	Healthcare
6. Schneider Electric	Industry	6. Roche	Healthcare
7. TSMC	Technology	7. Unilever	Consumer Goods
8. Alibaba	Consumer Goods	8. Koninklijke DSM	Materials
9. SAP	Technology	9. SAP	Technology
10. Sanofi	Healthcare	10. Thermo Fisher Scientific	Healthcare

Source: Morningstar, 2021

With thematic sustainable funds, the sustainable character is more clearly visible in the portfolio selection. Many thematic funds have a water or energy theme. In the portfolio of these funds, we see more names in the selection that on first glance make an active contribution to the sustainability transition. In the sector breakdown of the portfolio, we see much industry, as well as healthcare and technology, but of a different kind than with general funds. This usually involves specialized companies that fit the theme of the portfolio (e.g., special measuring equipment, semiconductors needed in sustainable energy generators, etc.).

3.2 Information provision

The extent to which funds provide information on sustainability performance varies greatly. Funds provide information on sustainability performance in different ways and to different degrees. In most cases, CO2 emissions and an ESG rating are reported. In the most extensive reports regarding the environment, we see CO2 emissions, water usage, and waste production relative to a relevant benchmark, as well as a percentage of shares excluded from a relevant benchmark.

An ESG rating is the most provided information, but the applicable SFDR article is also increasingly appearing. In concise overviews of funds from providers ('fund finders'), the sustainable character of a fund is usually demonstrated with an ESG rating, outside the name of the fund. The applicable SFDR article is also increasingly seen here. Although this can help consumers make a choice for a fund, the risk is that the SFDR article is wrongly seen as a label to prove that the fund is sustainable. The classification into one of the product categories from the SFDR is intended to determine which transparency obligations a fund must comply with. The underlying information must show how substance is given to sustainability. The classification itself is no guarantee for a certain degree of sustainability and within it, great diversity can exist.

Many funds state that reporting on sustainability performance is under development. Several funds state that they are working on building up and further expanding the reporting of relevant sustainability data. Furthermore, innovation is taking place regarding relevant sustainability indicators. New ratings and indicators are emerging, particularly for environmental objectives, that attempt to show something about the sustainability performance of the funds in a simple manner. The value of this will have to become apparent in the long term, but the aim to make sustainability performance visible in an accessible way is a positive development.

The effort and results of engagement are difficult to demonstrate and assess by investors. The effectiveness of engagement trajectories is inherently difficult to assess, even for the fund provider and the company concerned. Engagement takes place on a large playing field with many different players, developments in legislation, and (non-)financial incentives. The effectiveness of engagement by a specific provider (or within collaborations) is therefore difficult to isolate and convey. Reporting on engagement is generally extensive, especially regarding voting policy, but this does not mitigate these concerns. When it comes to engagement, it is usually described per institution on which subject engagement is applied, but not what goals have been set. So, while there is much documentation available, it remains difficult for investors to assess what the actual impact and intentions are.

3.3 Image formation and advertising

With virtually all providers we have seen, sustainability plays a prominent role on the website. With these providers, sustainability is the first thing visible on the website, and reference is made directly to various documents such as the sustainability policy, engagement policy, voting reports, etc. On the websites, no concrete claims are usually made that create specific expectations, but the nuances and choices underlying sustainable funds also do not come into play.

The use of the word 'sustainable' in the fund title is the main way to convey sustainable characteristics. The fund name is the most important way to show what a specific fund is for. The use of the word sustainability, or a related concept in the name, is therefore one of the most important 'expressions' that creates an expectation of sustainability in the investor. At the same time, we see that various strategies are used under this name, which can differ greatly from each other (see also paragraph 2.1).

Providers make little advertising for specific sustainable funds. An inventory of advertising expressions of sustainable funds shows that little advertising is made for specific funds. The advertising expressions that do exist are usually at the provider level and point investors to the possibility of investing sustainably with the provider. Usually, no specific claims or promises regarding sustainability are made to investors here.

4 What are points of attention?

There is a risk that the definition of sustainability by providers and the expectations of investors regarding this diverge. The market for sustainable investing is still developing. There is much demand and new products are emerging. Moreover, there is much new legislation and sustainability information is becoming increasingly available. In this dynamics, excluding the most polluting investments seems to be becoming a dominant strategy carried out under the banner of 'sustainability'. However, there are many more possibilities under the banner of 'sustainability', and it is questionable whether the definition chosen by providers aligns sufficiently with the expectations of investors. The AFM will therefore conduct further research into the expectations of retail investors in the context of sustainable investing.

Despite the fact that there is already much (new) legislation regarding information provision, further legislation could help to provide investors with better information. The new and upcoming legislation makes much information available to assess the sustainable characteristics of a fund and is important for the further development of the market. Nevertheless, there is still no uniformity regarding which strategies or which claims belong to specific fund names or titles. This leads to a great diversity of strategies that differ in their sustainable contribution but are all called 'sustainable'. Further clarification of this could help to prevent disappointments among investors.

Providers are expected to make even more effort to make the choices made visible. Sustainability is a complex concept, the definition of which can also develop over time. This requires providers to make more effort to make the choices underlying the sustainable strategies visible.