FCA’s ESG fund review offers insight into upcoming SDR policy statement

The FCA originally set out its guiding principles on ESG and sustainable funds in a July 2021 ‘Dear Chair’ letter. At the time, the letter was viewed by many as a response to the introduction of the EU Sustainable Finance Disclosures Regulation (SFDR) – and as a prelude to the equivalent SDR regime in the UK.

The latest thematic review remains a prelude to SDR, although the final policy statement is expected imminently. The timing of this thematic review, therefore, is interesting and provides important context to the SDR rules soon to be published.

The FCA’s thematic review highlights existing rules and principles which will be relevant for asset managers seeking to comply with SDR. The key findings of the thematic review give strong hints regarding the FCA’s expectations for SDR compliance, and mirror the stances taken by other regulators in a number of ways.

The FCA found that some funds with ESG terms in their name did not have an explicit ESG objective. In its Dear Chair letter, the FCA outlined that where a fund uses ESG terms in its name it could be misleading unless the fund pursues ESG or sustainability characteristics, themes or outcomes in a way that is substantive and material to the fund’s objectives, investment policy and strategy.

Existing rules require a fund’s prospectus to include its objectives and policy. Accordingly, the lack of an explicit ESG objective in an ESG-labelled product falls short of regulatory expectations. Subject to detailed guidance in the SDR, it can be anticipated that AFMs will need to review the alignment of fund names with their investment objectives and policies, possibly resulting in a change that may need to go to shareholder vote.

The FCA took a strong stance on stewardship activities, stating that the design of AFMs’ stewardship approaches generally did not meet its expectations. Reading between the lines, this hints at a higher bar for AFMs to meet if they are to rely on stewardship for a sustainable investment label under SDR, particularly if the “sustainable improvers” label remains. The FCA appears to be taking a much stricter stance on stewardship than European regulators under SFDR where stewardship is one of a number of approaches that asset managers can implement under their SFDR binding criteria.

This regulatory attitude corresponds with the Financial Reporting Council’s (FRC) updated UK Stewardship Code which places greater emphasis on identifying and reporting on positive outcomes resulting from stewardship. Therefore, we expect firms to consider whether uplift is required from currently SFDR-compliant stewardship practices.

The FCA also observed that it was not clear from fund literature whether stewardship activities were led by investment teams or a central firm-level stewardship team. In practice, the approach an asset manager takes to stewardship falls on a spectrum from more centralised to more fund led. It is notable, therefore, that the FCA highlighted embedding stewardship activity within investment teams as “good practice” and AFMs should apply this across to product design for sustainable investment labels.

The FCA reviewed the holdings of ESG funds and observed that some appeared inconsistent with a fund’s ESG or sustainability objectives. Putting aside the controversial debate over whether there is any “objective truth” in ESG analysis, the FCA directs AFMs to consider explaining any apparently contradictory fund holdings to investors in order to comply with the requirement to be “fair, clear and not misleading” in fund disclosures.

This strongly hints that the FCA will retain its “unexpected investments” disclosures under SDR, through which AFMs should provide a summary of the types of holdings which it might reasonably expect consumers of the product to find “surprising”. Although SFDR does not require similar disclosures, this regulatory stance does correspond to an ESMA supervisory briefing of May 2022 in which it directed national regulators to consider the portfolio holdings of Article 8 and 9 funds and to evaluate whether they reflect the name, investment objective and strategy of the funds.

It is clear from the FCA’s thematic review that there will be a strong focus on robust delivery of the ESG objective in practice and that policies alone will not be enough. Many asset managers have spent considerable time and effort implementing SFDR although changing regulatory goalposts have often left firms to pursue tactical solutions. With SFDR remaining somewhat stable pending the European Commission’s consultation which will take a number of years to lead to significant changes in the regulatory text, the implementation of SDR is an opportune time to consider uplifting practices to more long-term strategic solutions for ESG investment activities.

Additionally, the FCA’s findings paint it as suspicious of asset managers being overly reliant on third party data vendors, particularly when data is based on black box methodologies that managers cannot fully vet. This problem is more prevalent in listed markets where asset managers are more reliant on third party data vendors. Although such vendors have improved the transparency of their data methodologies and the associated limitations, asset managers should re-evaluate how the use of third-party data supports ESG objectives in their funds.

The emphasis on delivery is likely to lead to the FCA clamping down on ‘competence-washing’ by evaluating whether firms have adequate resources to achieve the ESG objective of the fund, a principle set out in its Dear Chair letter but not yet the subject of any enforcement action.

The FCA observed that AFMs frequently did not provide contextual information to their ESG disclosures in fund documentation which ran the risk of the disclosures not being fair, clear and not misleading. The FCA has indicated it will carry out a thematic review of TCFD disclosures by asset managers and asset owners under the ESG Sourcebook which is likely to include a more detailed review covering this issue and providing guidance to asset managers for SDR.

Additionally, the FCA observed that it was common for AFMs to point up to firm-level policies rather than making fund-level disclosures. While good practice would be for all funds to provide for more specific fund-level information, this is likely going to require the greatest uplift of disclosures for managers seeking to use a sustainability label for their products.

It is likely that the FCA will not prescribe disclosure templates in its final SDR policy statement, so asset managers will need to take particular care to comply with this principle. This should also ease the accessibility of ESG information which the FCA found lacking in some cases.

AFMs should consider this thematic review in tandem with the SDR policy statement when it is published shortly. They should also consider this review in light of the Consumer Duty where it is becoming clearer that the FCA expects to see a sea change in the manner in which firms approach the clarity of disclosure, and that failure to meet regulatory expectations is increasingly likely to lead to regulatory intervention.