New CFA Institute report argues ESG Fund classification needs more rigor

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A report publishedtoday by the CFA Institute Research and Policy Center seeksto improve ESG fund classification through an in-depth review of currentclassification frameworksandrigorous definitionsof fund-level features, as well as providing examplesof rigorous definitions in practice.

The paper,How to Build a Better ESG Fund Classification System, examines a selectionof existing regulator and industry ESG fund classification frameworks inthe United States, the European Union, and the United Kingdom. It finds these frameworks are problematic when put into practice due to a lack of focusonobservable features, imprecise definitions, or an incompletelogical structure for assigningfunds to mutually exclusive groups.

The paper will be particularly useful for regulators establishingand tailoringrules for ESG funds and for industry participants seeking to both market and select funds. It offers guidelines, examples, and case studies to support practitioners who must deal with the complexities of ESG fund classification in practice.

Chris Fidler,Head of Global Industry Standards, CFA Institute said:

"There is muchdisagreement about how to categorically define and identify 'ESG funds.' And when ambiguousterms like these are used in regulationto create special rules for certain kinds of funds, it can create significant uncertainty in the marketplace. Thispaper shows how to build strong fund category definitions, and we hope it ultimately leadsto clearer regulation which would benefitboth fund investors and fund managers."

"The ultimate test of a classification system is to have different evaluators classify the same set of funds. If they do it the same way, a good systemexists. If different evaluators assign the same fund to different groups, revisionsare required."

The paper, How to Build a Better ESG Fund Classification System, defines three observable features by which funds can be classified.

These are:

• The existence ofone or more processes that consider ESG information with the aim of improvingrisk-adjusted returns;

• The existence ofone or more policies that control fund investors' exposure and contribution to specific systemic ESG issues;and

• The existence ofan explicit statement of intent, and an action plan, to help bring about a target future state in environmental or social conditions and a process to measure progress.

Chris Fidler added:

"The SEC can learn from the EU's mistakes. I'mconcerned that the Enhanced Disclosures Rule has the same sort of ambiguous definitions that SFDR has and that, if passed as proposed, the US market will experience the same sort of disruption that the EU market experienced with regard tofund classifications. The SEC should either eliminatethe definitions and requirements that are likely to result in a de facto fund classification system, or alternatively, intentionally define minimum standards for funds that are marketed as sustainable."

The How to Build a Better ESG Fund Classification System paper is available at https://rpc.cfainstitute.org/en/research/reports/2024/how-to-build-a-better-esg-fund-classification-system