Vanguard Group Inc is to use an exclusionary approach in expanding its offering of passive ESG funds in Europe, likely driven by confusion around ESG standards, metrics and regulation.
Vanguard will grow its $7.5 trillion in assets under management by offering two new exclusions-based fund offerings in the EU and the UK. The firm sees these funds giving investors additional choice, and reducing the risk of greenwashing claims.
The exclusionary theme, one of the earliest in responsible investing, may be seen as a way around tighter EU rules around ESG reporting and disclosure. Yet these funds fall into the Article 8 category, which has invited ratings scrutiny of late.
Expanding ESG ETF offerings may also be a response to the relative resilience of sustainable investing amid a market sell-off. However, the rise of green and sustainable debt may attract more investors in the medium- to long-term.
Vanguard plans to add two new funds to its offerings in the EU and the UK, raising the number of index-tracking funds that screen out weapons manufacturers, oil and gas producers, and firms with human rights violations to eleven.
According to investor protection principles contained in MiFID II (Markets in Financial Instruments Directive) firms will have to include a client’s sustainability preferences from August 2, 2022 onwards. This may give socially responsible investing a boost, and may weigh on so-called ‘sin’ stocks.
Vanguard manoeuvres around SFDR and Article 8 scrutiny
Vanguard’s newest ETF offering based on screening out objectionable industries is both a growth opportunity and a way to minimise the impact of the new SFDR and MiFID II regulations. The move is also a way to mitigate greenwashing suspicions, as an exclusion strategy clarifies the ESG goals of the ETF.
The two new funds, classified as Article 8 funds with the SFDR definition, add to nine other such ETFs already being marketed in the EU and the UK, as well as seven in the US. Article 8 funds have come under increasing scrutiny by funds rating agencies – Morningstar recently found that 23% of the Article 8 funds it surveyed did not meet standards.
ETF market dynamics lend insight into move
ETF industry data shows that while funds based on the broader market saw outflows in the first half of 2022, sustainable funds actually grew by 2.5%. Also, although the latter category says outflows in the second quarter of 2022, it was a fraction of that seen by the overall market. Among ETFs, exclusion screening has been among the few strategies that continued to attract funds in the first half of 2022.
By contrast, active ESG funds focused on integrating ESG metrics and risks, described as “General Integration”, “Best-in-Class” and “ESG Thematic”, all saw outflows. Complexities with defining standards, metrics and regulations, could be the likely cause.
A development that may provide insight into the future of sustainable investing is the growth in the overall bond market, and in particular in green, social, sustainable and sustainability-linked (GSSS) bonds. The use of proceeds bonds in particular help clearly identify the objective of the related investments, giving investors further means to align their investments with their principles.
Back to the future with exclusions strategy
Exclusionary or negative-screening is the oldest and most predominant responsible investment theme in Europe and the US, although integration of ESG risks has been the fastest growing.
Negative screening, or values-based investing was one of the earliest forms of responsible investing, dating back to 17 and 18th century guidelines provided by Quakers and Methodists to their followers. In more modern times, the establishment of the Pax World Fund during the Vietnam War (1971) was the first ethical mutual fund, offering an investment option to investors opposed to the production of military and nuclear arms.
Innovation in the financial services industry could be seen as partly rooted in its response to new regulations and standards, with new products or expanded offerings often seen as a way of circumventing compliance.