SFDR is an IFA Headache, so How Are Advisers Getting on?

Recent amendments to the MiFID II Directive that came into effect in August 22 mean that financial advisers have a host of new sustainability obligations to fulfil  

Catherine Elliott 2 November, 2022 | 8:55AM
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ESG Headache

Advisers and portfolio managers must uncover whether their client wants to invest sustainably, the objective of their current or proposed investment, and how it is meeting its environmental, social, and governance (ESG) considerations. In short, sustainability factors must be demonstrated in the policies and procedures used to provide any advice.

To help things, a new European ESG template, or EET, has been developed by industry representatives (FinDatEx) to ease the exchange of data between asset managers and distributors. (Asset managers marketing their funds in the European Union started to submit EET data voluntarily from 1 June.)

While the introduction of the EET is a positive initiative that intends to simplify and standardise the collection of data, certain pitfalls mean advisers may struggle to fulfil their obligations. Notably, patchy data and a lack of direct comparability between products that’s largely driven by the different approaches asset managers are taking to calculate "sustainable investments" in line with the EU’s definition.

We wanted to see how advisers are navigating new reporting obligations and the roughly 580 sustainable data points that are covered in the EET, to draw some conclusions about the application of the new template in its early stages. Before we get into the data, let’s take a look at the first hurdle advisers face – outlining what actually constitutes as a sustainable investment.

How Does The EU Define It?

Amalgamated from two separate but related pieces of EU regulation – the Sustainable Finance Disclosures Regulation, SFDR, and the Taxonomy Regulation – sustainable preferences are defined in relation to financial instruments that are:

  • invested in EU Taxonomy-aligned, environmentally sustainable investments;
  • Taxonomy alignment defines the proportion of a product or company activity that is directly related to environmental objectives. Overall, there are six objectives but until 2023, disclosures are only required on the portion of investments that contribute to climate change (mitigation and adaptation);
  • Invested in environmental or social-economic activities as defined in SFDR.

SFDR introduced three classification labels that are used to identify sustainable funds. An Article 8 fund is defined as promoting environmental or social characteristics (light green funds). Article 9 funds are those that have a sustainable investment objective (dark green funds). Article 6 funds are all other managed products.

From January 2023, Article 8 & 9 funds will have to disclose how they meet the sustainable characteristics/objectives and the minimum portion of the fund in sustainable investments.

The Article 8 & 9 fund flags are the most widely available data points currently available in meeting the EU’s definition of a ‘Sustainable Investment Product’. According to Morningstar research, as of 31 September 2022 there were 8,459 funds classified as Article 8 and 1,080 classified as Article 9 in Europe.

These labels are not without their problems, however. Varying interpretations of the technical criteria mean that the classification process has been largely left to the discretion of asset managers.

Considering PIAs Determined by a Client

Principal Adverse Impacts (PAIs) refer to negative indicators that are taken into consideration and will most likely be narrative based at a product level. Examples of what you might expect to see are things like carbon emissions, fossil fuel exposure, violations of UNGC principles, gender pay gap and board diversity. These are intentions by the fund manager to consider these types of issues in their investments.

If a client wants to include investment products that fall under type 1 or 2, they must also specify the minimum proportion of their portfolio they want to be invested in this way as defined by the SFDR or the EU Taxonomy. This leads to a second challenge, which comes in the form of data availability.

While products are on the hook for disclosing their minimum proportion of Taxonomy alignment, the companies in which they are invested do not have to begin disclosing this information until 2023. An adviser's work will also be hamstrung by the mere fact that many funds haven’t reported the required information yet or have reported zero exposure to sustainable investments.

What The Data Says

As of mid-October 2022, Morningstar has collected EET data on 87,229 share classes, accounting for 61% of all share classes in scope of Mifid II, representing 17,084 funds. We looked at the coverage and values of PAI consideration, sustainable investment exposure, and taxonomy alignment, including 7,169 article 8 funds and 886 Article 9 funds.

Here’s what we have found so far…

All Article 8 and Article 9 products are required to disclose whether they consider principal PAIs, explaining the high percentage of 95% of surveyed funds that populated the PAI consideration field. However, fewer than half (48%) of the surveyed Article 8 and Article 9 funds reported a minimum percentage of sustainable investments and only one third disclosed a minimum percentage of taxonomy-aligned investments.

Since mid-July when we first looked at the data, the distribution of Article 8 funds' minimum exposure to sustainable investments hasn't changed much. We note a similar level of Article 8 funds (36%) with 0%-values; a slight increase in Article 8 funds targeting between 0% and 10% exposure (30% versus 25% in July) and in those targeting an allocation greater than 50% (6.1% versus 3.8%).

Surprisingly, Article 9 have decreased their targeted exposure to sustainable investments. Only 47.1% of Article 9 products now plan to have more than 70% exposure to sustainable investments, compared with 55.7% three months ago, while 43.4% of Article 9 funds (up from 39.4%) target less than 50% of sustainable investments.

That said, a higher number of Article 9 funds now target between 90% and 100%: 4.8%, compared with just 2.3% mid-July. As of October 13th, we identified only 26 Article 9 funds targeting 100% exposure to sustainable investment, up from eight previously.

Is There Too Much Room for Interpretation

Different translations of the regulation have led asset managers to adopt different approaches to the calculation of sustainable investment exposure and taxonomy alignment, rendering it impossible to compare competing products directly.

Without a standardised approach, we expect to see asset managers continue to implement a variety of methodologies, including ones that enable them to report higher sustainable investment allocations and meet the sustainability preferences of clients expressed under the new Mifid II suitability assessment.

Investors should brace themselves for a confusing investment product landscape over the next few months while advisers get to grips with the new requirements. Many will have to teach themselves while they educate their clients about the new, complex, and growing landscape of sustainable investments.

Although the EU Taxonomy and SFDR were designed to clarify the definition of sustainable investment and reduce opportunities for greenwashing, we are in the early days, and there is much work to do. Additional clarifications are expected soon, but in the meantime, caution and thorough due diligence will remain key.

To find out more about EET and MiFID II amendments, you can download the full report here, or get the latest SFDR Article 8 & 9 figures in our Q3 report

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Catherine Elliott  is a content writer at Morningstar

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