The arrival and expansion of article 8 and article 9 funds
Since March 2021, asset managers (as well as players in the financial markets) must classify their funds (or other investment products) depending on their sustainability purpose, in order to ascertain which reporting obligations to fulfill under the Sustainable Finance Disclosure Regulation (SFDR)1.
Besides funds that do not take into account sustainability risks (commonly known as “article 6” funds), there are: funds i) which promote, among other, environmental or social characteristics, provided the companies in which investments are made follow good governance practices (commonly known as “article 8” funds) or ii) that have sustainable investment as its objective and comply with the “do no significant harm” principle to environmental or social objectives (or “article 9” funds).
Theoretically, the difference is simple: unlike article 9 funds, actively attempting to achieve environmental and social features, in article 8 funds this designation can be accomplished with or without sustainable investment (as long as there is the promotion of environmental or social characteristics). For example, one fund may be an article 8 fund if it has adopted mandatory principal adverse sustainability indicators (“PASIs”) and integrates sustainability risk indicators into its investing choices (i.e. even though technically it does not intend to advance sustainable investments).
Article 8 and article 9 funds have grown in number and size dramatically over the last two years. Below are some statistics which illustrate the expansion of these types of products in the European investment landscape:
- 20 days after the Regulation has come into force2, articles 8 and 9 funds accounted for up to 21% of the European funds and 25% of the total European fund assets. At the time, Amundi and BNP Paribas top the list of the largest providers of article 8 or 9 investment products and Nordic and Dutch assets had the largest percentage of fund assets invested by these funds;
- In the first quarter of 2021, the net assets of article 8 funds totaled 3.7 trillion euros, which represented 22% of the European fund market. Luxembourg stood out, accounting for 35% of the funds analyzed by the EFAMA’s study3. Concerning article 9 funds, net assets totaled 340 billion euros, close to 2% of the European fund market with 71% being equity funds;
- In the last quarter of 20214, the net assets of article 8 and 9 funds totaled 4.05 trillion euros, accounting for 42.4% of all funds sold in the EU and 29% of the EU fund universe (an increase of 16% compared to the previous quarter). 25% of the funds were article 8 funds and only 3% were classified as article 9 funds. In this quarter alone, nearly 200 new funds were classified as either article 8 or 9 funds, especially funds linked to environmental matters (close to one-fifth);
- At the end of the first quarter of the present year5, net outflows from article 8 funds totaled 3.3 billion euros, and net inflows from article 9 totaled 8.6 billion euros. The two categories represent a percentage of 45.6% of the total European fund assets.
SFDR articles 8 and 9 funds (and respective capital flows) have grown considerably. In fact, it is anticipated that soon article 8/9 fund’s assets may equal half of the total assets covered by the SFDR6.
Classification of sustainable funds
Although with the SFDR there has been some progress in helping investors understand and compare the sustainability characteristics of funds, it was not meant to be a labeling system: its vague concepts and the resulting differences in interpretations pose a major challenge for asset managers.
Classifying funds continues to be one of the most difficult tasks in complying with the SFDR. As a result of the flexibility of the Regulation to self-define, with unclear and ambiguous wording, different methods of fund categorization have been used by asset managers. This scenario has led to distinctions in results (funds with similar characteristics are being classified in different categories) and has even led to misunderstanding and accusations of greenwashing, contrary to what was the aim of the legislator.
Article 8 has become an all-encompassing category, home to a diverse range of asset types with disparate strategies on ESG. Due to the plasticity in the language of article 8, it is feared that some asset managers will claim to consider ESG factors only to be classed within this category. While some funds have aligned their strategies with the objectives defined by the SFDR, others have only formalized ESG exclusions without changing any characteristic of their investment process or strategy. Many asset managers justify the article 8 classification simply by stating that ESG considerations are "included" in the investment decision.
A study of MainStreet Partners7 concluded that in 21% of situations, the article 8 fund classification is questionable, and Morningstar has removed nearly 1,200 funds with $1.4 trillion in assets under management (AUM) off its European sustainable investing list, the majority of those are self-declared article 8 funds.
The scope of article 9 is narrower, covering funds with a greater focus on impact or with good screening (funds applying thematic/impact investment approaches). However, there are also funds of this kind that end up being classified under article 8. The conclusion is that some asset managers are prudish, while some are being too kind: the classifications differ because there is a different ESG risk rating among asset managers.
To add to the complexity, managers are reclassifying funds through improving ESG integration procedures, introducing ESG exclusions, or adopting different approaches. According to Morningstar8, more than 1,800 funds have reclassified their funds from article 6 to article 8 or 9 or from article 8 to 9 since March 2021.
Considering the broad and hazy definitions, certain jurisdictions such as Germany, Spain or Ireland, are creating their own procedures for disclosures and labeling in order to clarify the
differentiation between sustainable funds. For instance, France's AMF (Autorité des Marchés Financiers) mandates ESG funds to remove 20% of the investable area based on ESG considerations, and BaFin, the German financial regulator, proposed additional minimum standards for a fund to be considered sustainable.
In addition, some companies have introduced other criteria to differentiate between article 8 and article 9 funds. According to JP Morgan Asset Management and Fidelity International, for a fund to be designated as article 8, it must invest at least 50% of its net assets in firms with excellent environmental or social qualities. Other asset managers believe that funds should only be classified as article 8 funds if the promotion of E and S characteristics is a mandatory component of its investment strategy.
At the EU level, there has also been talk about the possibility of introducing a minimum sustainability benchmark for article 8 funds9 or even creating a new category between article 8 and article 9, a so-called “Article 8 plus”. This new category (already adopted informally) is regarded as the outcome of the MiFID II draft sustainability assessment (more stringent than the one under the SFDR).
Level 2 Regulation
With so much to be clarified, the regulatory technical standards produced by the European Supervisory Authorities (“ESA”) (RTSs) are sorely needed to curb the feeling of laxity in fund classification. These have been embodied in Commission Delegated Regulation (EU) 2022/1288 of 6 April 2022, commonly known as level 2 SFDR, which will be implemented in January 2023.
The RTSs were published by the ESA on 4 February 2021 and approved by the European Commission on 6 April 2022 and, together with ESAs explanations on some of the RTS’s most important features, have clarified some key points of the SFDR.
Under the RTS, asset managers must justify their fund classifications with a myriad of information such as list of PASIs, the proportion of sustainable of investments in the fund and
justification as to why the classification under articles 8 or 9 is warranted. Furthermore, this additional information is required to follow a standardized template, akin to a KIID.
It is expected, thus, that with much more detailed information required to be disclosed under SFDR level 2 many original classifications will necessarily need to be revisited.
All in all, the trend will be towards expanding SFDR articles 8 and 9 funds. However, considering the sheer bar for obtaining article 8 status, creating minimal sustainability standards is essential to guarantee consistency and give credibility to SFDR labels. Without a uniform categorization and demanding thresholds, it will be hard for investors to assess the real level of ESG integration in the products they are invested in; also, in a more political level, it will only give ammunition for ESG nay-sayers to dismiss the field as pure fluff.