Forrest
Partner Content by Royal London Asset Management

In praise of choice

Mike Fox assesses the potential shortcomings of the new regulatory framework for sustainable investing.

Recent years have seen a staggering shift as sustainable investing has gone from being a quirky backwater to the ‘next big thing’. This evolution was catalysed by the pandemic, with record-breaking inflows in 2020. While much of this was driven by increased awareness of ESG issues, some undoubtedly stemmed from the positive impact of Covid-19 on the sector’s performance.

Technology made lockdown feasible, facilitating remote working and ecommerce, while the healthcare sector delivered Covid-19 treatments and vaccines with unprecedented speed. In addition, governments focused fiscal packages on environmental initiatives, such as transport and renewable energy. Meanwhile, industrial demand cratered, augmenting the relative performance of funds with no exposure to the oil and mining sectors. Likewise, the weakness of many financials stocks was positive as banks tend to perform poorly against sustainable metrics.

This year we are seeing some of these factors unwind. Despite this more challenging environment, which is impacting the relative performance of sustainable funds, inflows continue to be strong. Investors increasingly understand that sustainable investing doesn’t have to mean weaker performance: indeed, over the longer term, we believe that considering a wider range of risk factors is likely to improve returns.

At times of rapid change, it can pay to step back. While many developments have undoubtedly been positive, other elements have arguably been less so. The sheer number of new funds being set up may involve compromises in standards. With so many new managers entering the sector, there must be a risk that ‘me too’ funds, with poorly designed investment processes, deliver sub-optimal results. It would be naïve to believe that the asset management industry is above greenwashing.

You might think that I would be happy that there are efforts to impose more structure on the sector. However, I’m ambivalent about this. While no one would oppose regulation that applies clear standards and helps investors to make informed choices, more prescriptive frameworks could ultimately disadvantage investors.

In 2019, the UK’s Investment Association introduced its Responsible Investment Framework as “the lack of a common language has been a significant barrier to date to the promotion and growth of responsible investment.” Following widespread consultation with the industry, the IA’s framework introduced clarity and consistency “to make it easier for all savers to understand the opportunities available to them”. This is clearly good for investors.

I’m less enthusiastic about more recent developments. Two related pieces of legislation, the Sustainable Finance Disclosure Regulation (SFDR) and EU Taxonomy Regulation, have significant implications for the industry. I’m broadly happy with the SFDR as it will give investors more transparency, yet asset managers will have the choice of how to classify particular funds according to standardised categories. However, the Taxonomy Regulation feels more prescriptive, imposing an inflexible structure that may not be so positive.

At its heart is an apparent assumption that diversity is bad. This seems surprising as other sectors, such as global equity funds, thrive with diverse approaches offering investors a range of solutions. Instead of diversity and choice in sustainable investing, this more directive approach risks over-concentrating funds on limited parts of the market, leading to potential bubbles.