Investor demand for sustainable investment funds has been growing in recent years. This has led to competitive market pressure for fund managers to include environmental, social and governance (ESG) and sustainability-related terms in their fund names. Without clear standards, such practice can result in misleading sustainability disclosures and greenwashing. The absence of specific regulations for fund products, coupled with the increasing attention to fund names internationally, has finally triggered a regulatory response.
The European Securities and Markets Authority (ESMA) recently published its final Guidelines on funds’ names using ESG or sustainability-related terms. The guidelines are anchored in the requirement for good business practice in the Alternative Investment Fund (AIF) Managers (AIFM) Directive article 12 and the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive article 14. They are also a follow-up of the overarching requirements for clear and non-misleading marketing. The name of a fund is a strong marketing tool, and can have a significant impact on investment decisions. The aim of the guidelines is to ensure that fund names reflect the actual investment strategy of the fund. The guidelines thereby intend to counteract greenwashing, enhance investor protection and improve transparency in the financial market.
A new basis for supervisory control
Research shows that roughly 32 percent of the Sustainable Finance Disclosure Regulation (SFDR) article 8 and 9 funds – which represent around EUR 2 trillion in assets – can be affected by ESMA’s new guidelines due to their use of sustainability-related terms. A number of these funds, named as sustainable or green, may not meet sufficient sustainability standards. The failure to meet the guidelines’ regulatory requirements may necessitate renaming the funds or altering the investment strategy.
The ESMA guidelines apply to managers of UCITSs and AIFs. They apply regardless of whether the funds are subject to SFDR article 6, 8 or 9. ESMA has announced that other financial products may also be subject to similar guidelines in the long term. The guidelines do not currently capture all the financial products covered by the SFDR. While the SFDR has a broader scope, there is now a strange gap left behind. Financial products that fall under the SFDR’s broader scope, such as insurance, pension products or securities that may be covered by the SFDR’s disclosure requirements, fall outside the scope of the ESMA guidelines. Even though these products must meet certain sustainability criteria under the SFDR, their name could still be misaligned with consumer expectations. This disconnect creates uncertainty in how sustainability is defined and communicated in the financial market.
Fund managers are obliged to make ‘every effort’ to comply with the guidelines. National competent authorities of EU member states are expected to ensure that fund managers comply, which means that the guidelines are expected to be used as a basis for supervisory control. The guidelines thus provide a supervisory framework for national regulatory authorities to supervise and enforce compliance.
Quantitative thresholds and minimum safeguards: Key compliance requirements
The guidelines regulate when a fund’s investments are considered sufficient to defend the name of the fund. Which specific rules that apply will depend on the used terminology. ESMA has outlined six categories: transition, environmental, social, governance, impact and sustainability. Any word in the name of a fund that gives the investor an impression of an investment strategy related to these categories falls within the scope.
However, the guidelines contain quantitative thresholds for all funds that fall under one or more of the mentioned categories. Common for all naming categories is that at least 80 per cent of the fund’s investments must be tied to the environmental or social characteristics that the fund promotes, or be sustainable-investment objectives. ESMA also recommends compliance with minimum safeguards, including exclusion criteria for adaption to the Paris Agreement (‘Paris-aligned Benchmark’) and the EU’s climate reference values for climate transition (‘EU Climate Transition Benchmark’). Investments in, for example, controversial weapons, tobacco and global-norms violations will breach the recommendation.
Funds with sustainability-related names are also required to make a minimum of sustainable investments. The original quantitative threshold in ESMA’s draft from 2022 – allocation of at least 50 percent of the fund’s investments to sustainable investments – was taken out before the final report. ESMA has in the final report stated that funds must invest ‘meaningfully’ in sustainable investments referred to in SFDR article 2(17). As ‘meaningfully’ is not defined, it is currently unclear what the threshold is.
Actors interpret the requirements for sustainable investments or environmental and social characteristics very differently. The guidelines do not solve this. The quantitative thresholds set in the guidelines may therefore lose some of their impact with the discretion that the actors are given.
Are existing funds facing urgent compliance deadlines?
On 21 August 2024, ESMA published the official translations of the guidelines in all EU official languages. This gave national competent authorities until 21 October 2024 to notify ESMA whether they will comply or intend to comply with the guidelines. The guidelines apply from 21 November 2024.
So, must managers of funds take immediate action to ensure compliance within the short timeframe? Not necessarily! Managers of new funds created after the application date are expected to comply immediately. Managers of existing funds are given a transitional period. They have until six months after the application date to comply. For those fund managers, the date of application is 21 May 2025.
Transparency in the financial markets has become increasingly important due to the growing interest in sustainable investments. The regulation of fund names can be seen as a natural extension of the ongoing development within sustainable finance, including the fight against greenwashing and the broader push to ensure adherence to social standards. Fund managers are already obliged to comply with sectoral rules that require clear, fair and non-misleading marketing. The new guidelines will impose a further tightening for the use of ESG and sustainability-related terms in fund names. With these guidelines, fund managers must now walk the talk and ensure that fund names reflect genuine efforts and practices.
