New CFA Institute report argues ESG Fund classification needs more rigor

A report published today by the CFA Institute Research and Policy Center seeks to improve ESG fund classification through an in-depth review of current classification frameworks and rigorous definitions of fund-level features, as well as providing examples of rigorous definitions in practice.

The paper, How to Build a Better ESG Fund Classification System, examines a selection of existing regulator and industry ESG fund classification frameworks in the United States, the European Union, and the United Kingdom. It finds these frameworks are problematic when put into practice due to a lack of focus on observable features, imprecise definitions, or an incomplete logical structure for assigning funds to mutually exclusive groups.

The paper will be particularly useful for regulators establishing and tailoring rules 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 much disagreement about how to categorically define and identify ‘ESG funds.’ And when ambiguous terms like these are used in regulation to create special rules for certain kinds of funds, it can create significant uncertainty in the marketplace. This paper shows how to build strong fund category definitions, and we hope it ultimately leads to clearer regulation which would benefit both 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 system exists.  If different evaluators assign the same fund to different groups, revisions are 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 of one or more processes that consider ESG information with the aim of improving risk-adjusted returns;
• The existence of one or more policies that control fund investors’ exposure and contribution to specific systemic ESG issues; and 
• The existence of an 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’m concerned 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 to fund classifications. The SEC should either eliminate the 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