SEC ESG proposal impacts on ESG integration funds

Published: Jun 2, 2022
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On May 25, the SEC proposed amendments to the rules and reporting forms to promote consistent, comparable, and reliable information to investors concerning funds and advisers’ incorporation of environmental, social, and governance (ESG) factors in their investment decisions and/or strategies.

The big question here is: What will change in the life of a registered investment companies, business development companies (together with registered investment companies, “funds”), registered investment advisers, and certain unregistered advisers (together with registered investment advisers, “advisers”)?

The proposed amendment to the rules and forms under both the Investment Advisers Act of 1940 (“Advisers Act”) and the Investment Company Act of 1940 (“Investment Company Act”) will require registrants to provide additional information regarding their ESG investment practices in the fund registration statements and the management discussion of fund performance in fund annual reports and adviser brochures. The proposed amendment will also impact private advisers that manage hedge funds and private equity firms that are subject to the Advisers Act and this amendment.

Before we go deeper into the specificities of the requirements and the implications to fund managers, it is important to distinguish three types of ESG-related funds. First, there are the ESG integration funds, which integrate ESG aspects together with non-ESG factors in the investment decisions. Second, there are the ESG-focused funds, for which ESG factors are the major decision elements to create the investment strategy. Finally, there are the impact funds, which are a subset of ESG-focused funds that seek to achieve a particular measurable ESG impact on the environment, society, or both.

For the purpose of this article, let us focus on the ESG-integration funds. For this type of funds, the SEC will require funds and advisers to describe how they incorporated ESG into their investment process, , including what ESG factors it considers.

In fact, ESG integration funds must have a clear description of the process they used to incorporate ESG into their investment strategy, investment policy, and asset allocation. Remember, we are not talking about targeted ESG funds, where the SEC requirements are stricter.

In any case, there are many ways that ESG factors can be integrated into a fund’s investment strategy, policy, and asset allocation. For instance, a fund might incorporate ESG factors alongside financial, macroeconomic, and industry-specific indicators, and analyze the impact of these ESG factors, including issuer-specific corporate governance, labor practices, environmental performance, etc. and that the consideration of these factors would not necessarily result in a company being included or excluded from the evaluation process but rather would contribute to the overall evaluation of that company.

There are clear steps a fund can take that will pave the way toward compliance with the SEC requirements. The first step is to review the fund’s existing investment strategy. Leveraging from what already exists is the most efficient way to start. There are specific questions the fund managers should ask themselves to begin the review.

Fund managers should bear in mind that the results of integrating ESG elements into the investment decision must be longstanding and not short-term. Therefore, the first question is whether there is a comprehensive investment strategy which accounts for long-term trends. The fund must be able to account for evolving trends in the investment industry and future-proof its investment strategy.

The fund strategy must describe external ESG topics they consider such as social, technological, economic, environmental, and geopolitical and regulatory trends. For example, the social component should describe how it considers changes in demographics, consumer preferences, human rights, labor practices, diversity, and others. With respect to technology, the funds should consider social media, cybersecurity, renewable energy technology, biosciences, artificial intelligence, and more. Environmental considerations include climate change, resource utilization, energy consumption, biodiversity, and issuer-specific environmental risks and opportunities. These are only examples of ESG elements to consider; this is not meant to be an exhaustive list.

The funds and advisers should also define their investment principles, which should be a set of clear, impactful statements that will help select the investment strategy, inform the asset allocation, and align all investment decisions. Fund managers should consider clarifying their guiding investment approach in specific elements such as the value and importance of diversification; their view on the impact of excluding certain investments; and their expectations and views of a long-term investment outlook. They should also determine preferred investment horizons, and types of risks incorporated in the investment strategy, and decide whether ESG factors are material to investment returns (through risk or opportunity), including their willingness to exclude or screen any investment out or in (regardless of the financial attractiveness of the asset). Fund advisers should also ascertain whether a positive impact on people and the planet is a primary or a secondary objective, and which ESG areas are the most important for the fund to be successful. They should also define their view on active ownership, proxy voting, and others. Finally, firms must also consider changing their code of ethics and compliance manuals to incorporate the commitment to adhere to the new rules, including onboarding materials for new staff and implementing comprehensive training programs as soon as possible.

The strategy process is the foundation of the investment policy and starts with a comprehensive analysis of the external ESG trends incorporated into the fund’s capabilities, investment convictions and principles. Integrating ESG and properly disclosing how this has been implemented, which is what the SEC requires, will enable an efficiently, transparent, and strategically future-proof execution of strategies and allocation of capital.