When you buy “organic” blueberries at the grocery store, you should be able to trust the label. When you buy “plant-derived” baby soap, you should be able to trust the label. So, when you buy shares in an “ESG” (environmental, social and governance) investment product, you should be able to trust that label too.
That’s the position that Securities and Exchange Commission Chairman Jay Clayton is taking on the labeling of investment funds. Earlier this month, the Commission requested public comment on a requirement to prevent providers of financial products from duping customers into buying funds that don’t live up to their billing. That’s particularly good news for investors concerned about greenwashing – the corporate practice of making environmental claims without being able to back them up. It’s such a problem that new rating agencies have sprouted up as ESG watchdogs, policing environmental claims.
Now, the investing world is taking a closer look at the liberal use of “ESG” in fund names, which has increased more than four-fold since 2007. Currently, registered investment companies have to make sure that funds with names suggesting a specific type of investment focus allocate a minimum of 80% of their assets accordingly. (It’s colloquially known as the Names Rule.) At least 80% of the assets of a purported bond fund must be in bonds, 80% of a technology fund’s assets should be in tech stocks, and so on. Clayton’s comments on the SEC’s announcement suggest he doesn’t believe the rules are serving their purpose.
“This request for comment is another important step in our efforts to better inform and protect Main Street investors and improve the investor experience,” said Clayton. “We are looking to investors and market participants for input on how . . . to help ensure that fund names inform and do not mislead investors.”
According to the SEC, the current guidelines pose challenges for regulators in modern market conditions. For example, what to do about the growing popularity of financial derivatives and hybrid instruments in investment funds (which aren’t well suited to an asset-based test)? And what if the constituent stocks in an index-based fund don’t match up with the fund’s name?
The SEC’s request for comment points out that an increasing number of funds are adhering to strategies that “that require some degree of qualitative assessment or judgment.” Currently, if these funds are applying “strategies,” the Names Rules doesn’t apply; on the other hand, the Names Rules does apply if a fund’s name refers to a specific type of investment.
Funds with ESG mandates have apparently been a major point of contention for the Commission. It’s difficult to say whether the ESG label refers to a “strategy” or a “specific type of investment,” and indeed, funds have gone both ways on the question. Comment letters from 2018 depict dialogues between the agency and registered invested companies – including Templeton Funds, Pax World Funds and Putnam Investments – over the nature of ESG investment strategies.
The new comment period may help clear up some of the confusion around the Names Rule, and point to more useful standards to apply to ESG and other funds going forward. At the very least, don’t be surprised if some funds end up re-branding as a result.