Despite the huge momentum in the ESG market, integrating ESG considerations into the business will not be easy for mutual funds or other large players in financial services. The lack of generally accepted reporting standards is one challenge. It’s difficult for peers to compare their ESG efforts or progress toward ESG goals without common metrics, which are still a few years away. For ratings and data, multiple agencies use different scoring methodologies, causing further confusion.
Based on its engagement with the industry, EY has identified 10 major challenges for mutual fund directors related to ESG issues to work through:
1. Reputational risk associated with proxy voting
Not so long ago, shareholder proposals on environmental and social issues attracted only minority support; in 2016, only 29% of proposals gained the support of more than 30% of shareholders; in 2019, 48% of proposals had more than 30% support. When polled, directors participating in our session cited racial diversity, gender diversity and climate change as the voting issues with the highest reputational risk.
As directors are well aware, proxy voting may be a fiduciary responsibility, but it carries significant reputational risk if it is not informed by a deliberate voting policy. Beyond policy, funds — particularly smaller funds — face challenges in managing voting policies and processes, especially when they rely on third-party proxy-voting firms. Of course, reputational threats can stem from other risks, especially in social media within which negative issues can arise and be amplified quickly.
2. Lack of rigor in incorporating ESG factors into the investment process
Building ESG matters into the investment process is not easy; the topics are complex and inevitably more qualitative than financial matters. Directors have to be confident the fund’s investment procedures perform as disclosed to investors (for example, that the proportion of investments that should be influenced by ESG factors is, in fact, determined that way).
They have to validate that the portfolio managers use ESG data consistently in the investment decision-making process and that the fund builds ESG into the due diligence for major investments as necessary. In other words, the governance of ESG investing needs to be well defined and rigorously managed.
3. Lack of quality ESG data to use in developing products and services
Though more ESG data is available, there are concerns about how useful or insightful it is. Fund directors should seek assurances from fund advisors that investment professionals are using an appropriate level of judgement and healthy skepticism when using ESG in their decision-making or in the development of ESG-related services (e.g., data or portfolio management) for clients.
Using a single provider often leaves data gaps, which has led many firms to consolidate multiple data sources and, in some cases, build their own scoring methodologies and algorithms. However, having multiple providers can lead to higher costs and increased need for coordination, while home-grown scores present new risks.
4. Mis-marketing of ESG products
Regulators are increasingly focused on so-called “greenwashing,” whereby financial services firms knowingly or accidentally misrepresent products and services as ESG friendly in nature in their marketing programs. Some growth in the number of ESG funds during COVID-19 appears to have come from funds simply rebranding themselves. The lack of industry standards makes it more difficult for investors and customers to assess the quality of the products and services. Still, directors should validate that ESG products are marketed appropriately.
Increasingly, issuers are turning to third parties to confirm that ESG offerings are in line with public disclosures and other communications, with the goal of boosting investor confidence and mitigating reputational and compliance risks. The options include agreed-upon procedures, other kinds of attestations, more detailed assurance statements and certifications. In some markets (e.g., green bonds), such assurance is almost a prerequisite for issuance.
5. Lack of compliance with evolving ESG-related laws and regulations
Mutual fund directors take their compliance responsibilities very seriously and rely heavily on chief compliance officers (CCO) to assess whether and how processes, procedures and disclosures meet legal and regulatory requirements. Fund directors know the regulatory picture for ESG products and services is evolving. Not surprisingly, when polled, 42% of fund directors identified compliance as their largest concern in terms of ESG. It is important that fund boards get routine updates on regulatory trends and seek assurance from the CCO that the fund’s practices are keeping pace.
6. Third-party ESG-related risk
Mutual funds rely on a host of third parties, affiliated subadvisors and service providers and increasingly expect more of them to meet ESG standards and requirements. Fund boards must discuss ESG with relevant advisors and seek assurance that the fund’s standards and requirements are being met fully and can accommodate future changes. Almost a fifth of fund directors view this as one of their main concerns about ESG.
7. Inability to capitalize on ESG growth
Directors may feel bullish about the growth opportunities associated with ESG. However, without a clear strategy to attract and retain ESG-seeking investors, and a plan to distinguish their ESG funds in an increasingly crowded marketplace, those opportunities might not be realized. A trusted brand and differentiation are key success factors. Directors should ensure that effective strategies are in place to launch and grow products and to remain competitive and visible in the market.
8. Lack of board reporting and oversight
Fund boards must be engaged on ESG matters. Not only is it part of their fiduciary responsibilities, but also a critical competitive issue going forward. Yet, about 20% of fund directors view this as a top concern about ESG. Specifically, they worry that they do not receive sufficient information on their fund’s ESG strategy, performance and proxy-voting record, and that they do not apportion sufficient time to ESG issues when evaluating investment managers and other service providers. Fund boards will need to rectify these governance shortfalls.
9. Misalignment between sponsors and funds
Though fund boards operate independently of their fund managers, it would be naive to believe fund directors are not aware of the full range of risks. That’s especially true when it comes to the potential misalignment between ESG strategies, the fund sponsor’s public statements and the ESG policies and proxy-voting practices of fund managers. In a world where social media quickly amplifies perceived discrepancies between statements and practices, it is important to know where and how those misalignments could create reputational risks.
10. Substandard ESG disclosures
Fund managers are increasingly committed to new voluntary standards and more demanding mandatory disclosures. Directors should understand which disclosure frameworks or requirements fund advisors have committed to or might be subject to and then validate that the fund has processes to assess the accuracy and consistency of these disclosures on an ongoing basis. It is especially important that the fund has accurate and timely disclosures about ESG fund strategies and performance.