Fund Name Rules: balancing sustainability, accountability and investment diversity

Financial regulatory policy often hinges on providing the right incentives to encourage desired behaviours. From applying capital charges against risk-weighted assets, to providing more favourable margin requirements on centrally cleared contracts, effective regulation customarily relies on correctly balancing the profit motive of individual participants against overall market stability and accomplishing public policy goals.

It is in this spirit that regulators in the EU and U.K. have introduced new fund name rules and guidelines to promote transparency and accountability in the accurate nomenclature of investment vehicles. The primary objective is to instill investor confidence in making decisions around products claiming to have sustainability goals. However, the requirements also present challenges that could prove counterproductive in the overall international mission of encouraging a broad transition to net zero.

Regulatory objectives: reducing greenwashing or driving transition?

One of the key questions surrounding the new fund name regulations is whether they simply seek to prevent misleading names (greenwashing) or are also intended to pursue the Paris Agreement goal of making investment flows consistent with a pathway toward lower greenhouse gas (GHG) emissions and promoting climate-resilient development.1

If the rules seek to accomplish the latter objective, imposing high thresholds for specificity and accuracy in sustainable investment labels and names may unintentionally restrict the investable universe available to climate-focused investors.

For example, many funds may find it challenging to meet the fund names criteria of an 80% threshold linked to the proportion of investments used to meet the sustainable investment objectives stated in the investment strategy, particularly those investing in companies that are still in the early stages of their sustainability transition. This could lead to self-defeating outcomes where the very industries that need the most investment to decarbonize are excluded from sustainable investment pools, ultimately slowing progress toward net zero.

Additional hurdles: PAB and CTB screening criteria

Managers of sustainability-themed funds in the EU face another layer of complexity in the form of requirements to screen funds to ensure they meet additional investment criteria, which is the same criteria as is required for a benchmark to be considered a Paris-Aligned Benchmark (PAB) or Climate Transition Benchmark (CTB).

These criteria aim to ensure sustainability alignment, but they also further restrict the investable universe to which the fund can allocate capital. Hard-to-abate sectors, such as the energy or transportation industries - which require substantial investment to transition or are already offering services to reduce emissions, such as carbon capture - are likely to find themselves excluded from these benchmarks, meaning capital will not be allocated to the sectors that need it most for effective climate action.

Evidence that this unintended outcome will ultimately be realized is already apparent. Research from Bank of America - discussed on a recent webinar with ICE - compared the constituents of the ICE BofA Euro Corporate Index (ticker ER00), a widely followed benchmark that measures the performance of euro-denominated investment grade corporate bonds issued in the eurozone, with the constituents of the ICE Euro Corporate Paris-Aligned Index (ticker ER00PAB), a PAB index based on the ER00 Index with additional constituent selection criteria applied as required under the EU Climate Transition Benchmarks Regulation. The research showed that over 30%2 of issuers included in ER00 were removed from ER00PAB following the application of the PAB screens.

Similarly, the research showed that when comparing the constituents of the ICE BofA Euro High Yield Index (ticker HE00), a benchmark that measures the performance of euro-denominated below-investment-grade corporate bonds issued in the eurozone, with the PAB equivalent index, the ICE Euro High Yield Paris-Aligned Index (ticker HE00PAB), 50% of the issuers were removed after the application of the PAB exclusions.

Furthermore, the effect is also felt from a sectoral diversity perspective. Once again comparing the ER00 constituents with the ER00PAB constituents, the weighting of issuers in the financial sector rose from 37% in the former to 46% in the latter and the weighting of issuers in the real estate sector increased from 5% to 9%, respectively. Conversely, issuers in the autos sector dropped from a 5.5% weighting to 1.4%, while those in the utilities sector dropped from 10% to 4%.

The reduction in the investible universe and the concentration of investment targets in certain sectors may also have an impact on the returns of a fund. A recent U.K. Investment Association survey of 1,081 retail investors with a propensity to invest sustainably found that 55% placed greater importance on fund returns than meeting their sustainability aims, with just 8% putting sustainability goals ahead of achieving returns.3

Given these results, it’s key to consider whether this is a further unintended consequence of the fund name regulations: a potential concentration of investment targets resulting in funds that don’t fully meet the investment goals of a majority of retail investors.

The challenge of defining ‘transition’

The objective of the Paris Agreement is to make finance flows consistent with a pathway towards low GHG emissions and climate-resilient development. In light of these goals, there have been efforts by the U.K. Financial Conduct Authority in its Sustainability Disclosure Requirements - and by regulators and industry bodies in various proposals for the EU - to introduce dedicated labels for investment products with a focus on transitioning activities. However, the relatively limited uptake of these labels in the U.K. perhaps demonstrates the challenges behind the reality of measurably demonstrating ‘transition’.

The somewhat amorphous definition of ‘transition’ or how to measure it, means investment funds face uncertainty in classifying their assets. The EU Taxonomy, and the growing number of other taxonomies developing around the world, was designed to provide a comprehensive classification system for sustainable economic activities and calls out those activities considered transitioning. However, its current application is fairly narrow and only identifies 28 activities (under five macro sectors) as falling into this category. As a result, fund managers struggle to identify sufficiently suitable investment targets or find acceptable ways to measure their transition progress.

Data challenges

The EU Corporate Sustainability Reporting Directive (CSRD) is another regulatory initiative aimed at improving transparency in sustainability reporting to help provide market participants with the data to make informed investment decisions. However, with the recent EU Omnibus proposal it faces revisions to scale back both its scope and breadth before it has made any inroads into improving disclosures. It also matches the rollout pathway of the EU Taxonomy, currently covering only large European listed entities and financial institutions, and so complete data coverage is not available for all investments and looks unlikely to change in that regard.

Fund managers need comprehensive data to accurately measure compliance with fund name thresholds, yet many companies still lack the necessary reporting infrastructure, particularly companies in emerging markets or private businesses. This further complicates adherence to the new guidelines.

For those seeking to navigate their way through the myriad of data and screening requirements, ICE’s Fund Names Rules Engine brings together the wide range of sustainability, security reference, company fundamental and pricing data on ICE’s platforms with a configurable rules engine that helps check alignment with the regulations as often as is required using the latest available data.

Conclusion: striking the right balance

These issues raise questions as to whether market participants will stay the course in the face of such challenges. Fund managers can already be observed voting with their feet on this issue, with over 820 EU and U.K.-marketed funds4 having removed sustainability terms from their names since 2023.

It's not just fund managers who are expressing skepticism about the requirements. The survey by the U.K Investment Association highlighted that only 6% of investors would sell their fund holding if it did not qualify for a sustainability label.5 While the EU and U.K. fund name rules and guidelines are well-intentioned, they present significant challenges in terms of investment diversity and transition financing.

To truly support the path to net zero, regulators should strike a balance between preventing greenwashing and ensuring that capital flows to industries undergoing necessary transformation are not unintentionally diverted. Successfully achieving such a balance will create a regulatory framework that supports both sustainability and investment flexibility.