ESG building blocks / Maxxa_Satori

This article appears in the April 2023 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.

New rules, lousy markets and strategic imperatives are pushing ESG products into a new phase, with manufacturers looking to specific themes and favouring products focused on risk reduction and returns.

After a bonanza of ESG product releases over the past few years, launches slowed at the end of 2022. According to Chicago-based Morningstar Inc., only one sustainable fund entered the Canadian market in the fourth quarter, the lowest total in nearly four years.

That slowdown contrasted with a record-setting first quarter of 2022, when 28 sustainable funds launched.

Fate Saghir, senior vice-president, sustainable investing with Mackenzie Investments, said the boom and bust that bookended last year were reflective of markets generally, as rising rates and the war in Ukraine hurt returns.

“Many of us were trying to take a step back and figure out if we had the right strategies in place,” Saghir said. “I think that’s reflective of the broader market and not just the sustainable investment market.”

Still, the decline in growth stocks and the re-emergence of the energy sector as a market leader made the environment even more complicated for ESG fund manufacturers.

Ian Tam, director of investment research for Canada with Morningstar, said the timing for sustainable product releases was less than ideal. “As a fund provider, you have to be kind of strategic when you launch these types of products,” he said.

New rules for fund managers may also have contributed to the slowdown, Tam said. In January 2022, the Canadian Securities Administrators (CSA) introduced guidance for fund managers on ESG-related disclosures in an attempt to combat “greenwashing” in the industry.

“There really was no regulatory guidance in Canada before this year on what needs to be said in a prospectus document, but now there is,” Tam said. “That immediately sets the bar higher.”

Tam added that the reporting requirements likely affected the types of sustainable funds released last year too. Using the six categories in the Canadian Investment Funds Standards Committee’s (CIFSC) responsible investing framework, Tam noted far more new funds were released last year using ESG exclusions (64), ESG integration and evaluation (55) and ESG best in class (52) than launches for ESG engagement and stewardship (41), ESG thematic investing (33) and impact investing (32). (Sixty-eight sustainable funds launched last year, but funds can fall into more than one category.)

The first three categories focus on reducing risk or enhancing returns, Tam said. The remaining three are meant to make an impact on the planet or society, and require more stringent reporting.

Best-in-class funds typically rely on an index, Tam said, while exclusion funds can use data from independent providers in their disclosures. This makes them slightly easier to implement.

ESG engagement fund providers, on the other hand, are required to report their proxy voting and engagement with issuers, Tam said. Impact funds must demonstrate the impact they’re making — by reducing their carbon footprint, for example, and explaining how the reduction came about.

“That is a lot of work for the portfolio manager to put together,” he said. “I think we’re seeing less of them because it is a higher bar.”

After so many new funds were released in the past few years, the industry may also have reached a saturation point — at least in terms of existing types of ESG funds.

“Most of us now have the broad-based, best-in-class type of fund on our shelves,” Saghir said. “What will be really interesting is, as taxonomies and disclosure standards emerge, what we’re able to do with that data in terms of more thematic investments.”

The CSA is reconsidering its proposed climate disclosure standards for issuers after the U.S. Securities and Exchange Commission and the International Sustainability Standards Board issued their own proposals. Whenever definitive rules emerge, Saghir said, fund companies will be watching to see how the disclosures can be used in products.

“‘What does that do for the data that we have and what can we create under the theme of climate’ is probably top of mind for many of us,” she said.

Add it all up, and we may be entering a new phase of ESG products.

Tiffany Zhang, an ETF analyst with National Bank Financial Ltd., said many ESG products traditionally resembled broad index products, with low active share. But now, she said, “the concept of ESG is becoming more concrete and more tangible.” This means investors now can select themes such as renewable energy, all-female fund-management teams or responsibly sourced gold.

“Investors can really pick and choose what they believe is ESG,” Zhang said.

The only ESG ETFs to launch in Canada this year as of press time were a suite of dividend products from Invesco Canada Ltd. (See “New ESG funds pay dividends”.)

Saghir said she expects to see more products released with a specific focus.

“I don’t know if we have the building blocks to build a truly diversified [ESG] portfolio today,” she said. “I imagine there’s going to be launches that fill some of those gaps.”

Meanwhile, the CIFSC classification may help advisors sort through the hundreds of products available, but conversations with your clients about what ESG means to them will remain important.

Charles Provost, wealth advisor with the Vo-Dignard Provost Wealth Management Group at National Bank Financial Wealth Management in Montreal, said his team doesn’t limit itself to funds marketed as ESG when constructing sustainable portfolios for clients.

“What we’ve found is that some funds are marketed as ESG but when you dig deep, you see that it’s maybe not perfect,” he said. “On the opposite side, there are funds not marketed as ESG funds but they fit into our criteria. We don’t exclude the rest and we don’t only focus on ESG-marketed products.”