18 September 2024
As the popularity of Environmental, Social, and Governance (ESG) funds continues to grow, investors and regulators alike are grappling with the ambiguity surrounding what truly qualifies as an ESG fund. Despite numerous efforts to define ESG investing, the term remains broadly applied and inconsistently understood across the financial industry. In response to this challenge, Chris Fidler and Nicole Gehrig of the CFA Institute have introduced a new framework aimed at refining ESG fund classification. This proposed system seeks to categorize ESG funds based on three distinct, observable features, providing much-needed clarity to investors and industry stakeholders.
The framework classifies ESG funds by examining three core aspects: the integration of ESG information to improve risk-adjusted returns, the management of exposure to systemic ESG issues, and the targeting of specific environmental or social outcomes. Unlike previous attempts to define ESG investing, which often relied on vague principles or intent, this system is grounded in measurable and actionable criteria. It aims to simplify the categorization process and offer greater transparency for investors making decisions in the growing ESG market.
Key highlights of the proposed classification system include:
• Risk-Adjusted Returns: ESG data is integrated into the investment process to enhance financial performance, ensuring that ESG factors are considered in a way that drives value and minimizes risks. This encourages fund managers to account for long-term ESG risks in their strategies.
• Systemic ESG Issues: The framework emphasizes managing funds’ exposure to systemic ESG issues, such as climate change or social inequality. By mitigating these risks, funds can align with broader societal goals while offering financial protection to investors.
• Targeted Environmental and Social Impact: ESG funds are also assessed based on their intentionality in driving positive change. These funds have specific, measurable goals related to environmental or social outcomes, providing investors with a clear understanding of the impact their investments are intended to achieve.
This classification system is expected to benefit not only investors but also regulators and fund managers. By standardizing the criteria for ESG funds, it ensures consistency in how these funds are defined and evaluated. Investors will have better tools for selecting funds that align with their sustainability values, while regulators will have a clearer basis for oversight and enforcement. Additionally, fund managers will be able to communicate their ESG strategies more effectively, helping them attract investors seeking both financial returns and positive impact.
The authors of the report hope to inspire further dialogue and improvements in the classification of ESG funds, recognizing that this framework is a crucial step toward a more transparent and effective ESG investment landscape.