CFA Institute Global Industry Standards Team Takes on ESG Fund Classification

Posted In: Disclosure, ESG, Standards, Ethics and Regulations (SER), Sustainability

For our exploration into the current challenges of ESG fund classification, we define environmental, social, and governance (ESG) funds as funds that take ESG information, issues, and/or conditions into account. As such, they attract investors who seek to ensure that material ESG risks and opportunities are properly evaluated; who want to avoid exposure to systemic ESG issues; and who aim to make a positive impact through their investments.

However, the wide variation in ESG fund characteristics and the lack of clarity in their definitions make it challenging for investors to find funds that match their needs and preferences. These factors also complicate regulators’ efforts to establish naming and disclosure rules for different types of ESG funds.

This is why CFA Institute is developing a whitepaper on building better ESG fund classification systems. The paper aims to address the current challenges in ESG fund classification and provide clearer, more consistent guidelines.

Current ESG fund classification efforts face three main problems:

First, there is a lack of well-defined boundaries. While high-level conceptual definitions are a good starting point, precise criteria are needed to sort funds into distinct categories. For example, the Securities and Exchange Commission (SEC) has proposed three ESG fund categories: Integration Funds, ESG Focused Funds, and Impact Funds. The difference between Integration Funds and ESG Focused Funds depends on whether ESG factors are considered “significant,” but the SEC has not provided details on determining the significance of these factors.

Second is the use of subjective criteria to define what is good for the environment and society. This normative basis is problematic because it is difficult to reach a consensus on what constitutes “good” environmental and social practices. Opinions vary and evaluating a fund’s “goodness” is subjective. For instance, while weapons manufacturing is essential for national security, it also leads to increased violence and loss of life. In addition, measuring the net impact of investments on the environment and society is challenging.

The third issue is using vague terminology to describe fund groups. Terms like “ESG aware” can be confusing. Retail investors might think “ESG aware” funds positively contribute to the environment and society, but these funds might only limit fund investors’ exposure to certain systemic ESG issues. Vague descriptors can lead investors to purchase funds that do not align with their investment objectives.

In conclusion, existing ESG fund classification systems are inadequate. They lack the logical structure needed to sort funds into distinct, useful groups, are not based on observable features, or have poorly defined boundaries. Our forthcoming whitepaper, which we expect to publish by September 2024, aims to provide better guidelines for ESG fund classification. We hope the paper will help designers make more effective classification decisions and inspire further ideas and conversations to improve fund classification practices.

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About the Author(s)

Nicole Gehrig

Nicole Gehrig is a director of Global Industry Standards at CFA Institute. She is responsible for the research, development, and promotion of ESG codes and standards. Prior to joining CFA Institute in 2022, she worked at PGIM Fixed Income for 15 years, most recently as an ESG specialist. In this role, she contributed to the development of the proprietary ESG ratings framework, ESG investment policies and processes, and ESG product development. Previously, Gehrig held management positions in product pricing, marketing research, and performance measurement. She received a BS in finance from the University of Delaware and an MBA in finance from Fordham University.