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The regulations are designed to tackle claims of ‘greenwashing’ by preventing asset managers from making misleading sustainability statements © Bloomberg

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Exchange traded funds are set to fall foul of country-by-country “green” fund rules for the second time in a matter of weeks as a result of new UK legislation.

ETFs are not eligible for a series of new “sustainable” labels being rolled out by the UK’s Financial Conduct Authority. This means anyone wanting to only invest in funds that meet this threshold will find very few passive funds, and no ETFs, to purchase.

This comes just weeks after France tightened its rules for funds sporting a “socially responsible” ISR label in a manner that will be convoluted for ETF providers to abide by, unless they foist the sweeping new restrictions on all their investors across the whole of Europe.

In both cases, ETFs are hampered because, in Europe at least, they tend to be cross-border products, typically domiciled in either Ireland or Luxembourg and “passported” into other countries.

In contrast, fund regulations are often set at a national level and are better suited to the more traditional world of domestically domiciled mutual funds.

The latest setback for ETFs is centred on the UK’s Sustainability Disclosure Requirements, due to come into force at the end of July.

The regulations are designed to tackle claims of “greenwashing” by preventing asset managers from making misleading sustainability statements about their products, and to improve transparency. They allow funds that claim to have sustainability characteristics to use one of four FCA-approved labels to signal this to investors.

However, these labels are only available to UK-domiciled funds, meaning ETFs are excluded, even those listed on the London stock exchange.

Given that “most [of the 1,960] passive funds available for sale in the UK are overseas ETFs . . . the limited number of labelled passive funds will reduce the choice offered to sustainability oriented investors in the UK”, said Hortense Bioy, global director of sustainability research at Morningstar.

Morningstar forecast that “practically all the UK funds carrying the words ‘sustainable’, ‘sustainability’, or ‘impact’ in their names [will] opt for a label,” due to “commercial interest and the risk of being accused of greenwashing, among other factors”.

However, of the 300 funds with combined assets of £110bn Morningstar forecasts will have adopted the new labels by the end of this year, as few as 20 are likely to be passively managed, largely due to the absence of ETFs.

“I have counted 50 [UK-domiciled] passive funds with ESG related to their names: 20-23 can potentially use the labels but a lot of these would need to make some changes,” said Bioy. The labels are not available to funds that merely employ exclusions or negative screening to filter out unsuitable stocks.

“It’s a real problem both for asset managers and investors because that constrains the choice that they have. It’s clear that investors really like the passive approach when it comes to ESG,” Bioy added.

Overall, Morningstar calculated that about 1,370 of the 1,780 funds available in the UK with sustainability related terms in the names are domiciled overseas.

Under the SDR regime, fund sponsors will be able to choose from four sustainability labels to apply to each fund: Sustainability Focus, Sustainability Improvers, Sustainability Impact and Sustainability Mixed Goals.

The categories are based on whether a fund mainly invests in assets that focus on sustainability; invests in assets that are not sustainable now with the aim of improving their sustainability; holds underlying holdings that endeavour to provide solutions to sustainability problems; or is a mixture of these three.

The regulations do at least allow fund distributors to apply the labels themselves to offshore funds that are otherwise excluded from the regime.

“When we first saw this I thought this doesn’t work. Half of the funds that we use are offshore,” said Jack Turner, head of ESG portfolio management at Seven Investment Management, which uses many passive ETFs to construct its investment portfolios.

However, Turner said the FCA had clarified that 7im can “look through to the assets that are held in these funds or ETFs and make a decision ourselves as to whether these funds are sustainable”.

As a result, its Sustainable Balance Fund may be able to adopt the Sustainability Mixed Goals label, even though some of its holdings are ETFs that cannot apply for this label.

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Distributors such as 7im will have to apply a “robust evidence-based standard” to determine whether an asset is sustainable, something that is likely to be beyond ESG-minded DIY retail investors looking to build their own portfolios.

“In a perfect world it would be easier if all our investments had an underlying label,” said Turner.

“It’s investors who are penalised for this [omission],” said Bioy. “They still have access to these ETFs, [but] it reduces the attractiveness of the label.”

The FCA has said that, in order to support a level playing field “we want all firms marketing their products in the UK to be subject to the same broad requirements”, but that the extension of SDR to overseas funds “is a matter for” the UK Treasury.  

The Treasury pointed the Financial Times to a written statement by Bim Afolami, the City minister, who said that the UK government “intends to consult on whether to broaden the scope of SDR to include funds recognised under the OFR [Overseas Funds Regime]”.

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