How ESG Funds Will Be Impacted By The SEC's Expansion Of The 80 Percent Names Rule

The Securities and Exchange Commission has been considering expanding the 80% rule for fund names to include strategies, a change that will have sweeping impacts on the mutual fund industry. The 80% rule states that managers cannot use misleading names for their funds and that 80% of the fund must be invested in the types of investments by the name.

Expanding the names rule would likely lead to a crackdown on funds with ESG-related names that don’t invest most of their assets into the types of themes their names suggest. In a recent interview about upcoming changes to the rules for fund names, attorney Clair Pagnano of K&L Gates
explained the changes that are coming specifically to ESG funds.

Expanding the names rule

Currently, the rule states that managers may not use a fund name that the SEC finds “materially deceptive or misleading” but limits the stipulations to the type of investment, an industry or a geographic area.

The proposed change would add strategies to the list of stipulations that trigger the 80% name rule. For example, a fund that uses the word “growth” in its name would have to invest 80% of its assets into growth stocks.

“From an industry perspective, it is a significant step away from how fund names have been regulated up to this point,” Pagnano said. “I think the challenge for the industry will be to figure out what a fund name is. Is it falling within that rubric of a characteristic that’s an investment focus, or is it a pure strategy that’s not focused, so the lane is not clear at all.”

One of the key problems is that when the amendment goes into effect, the use of words like “growth” will be open for interpretation because definitions for growth stocks can vary widely by fund manager. The SEC will allow fund managers to give their definitions of such terms alongside the names of their funds that use those terms.

Similarly, ESG-related fund names will be open for interpretation if the SEC passes the proposed amendment. Pagnano warns that in some cases, the SEC may decide that a word in a fund name is a characteristic with an investment focus, although the fund manager might not think that when establishing the fund’s name. As a result, she doesn’t think the agency is adding significant clarity to the rule.

SEC already pushing ESG funds to adopt 80% policy

Most already-established funds will likely choose to comply with the 80% rule rather than change their names, especially those with ESG-related terms in their names. In fact, she said the SEC has already been pushing ESG funds to comply with the 80% rule even though the amendment about strategy-related words hasn’t gone into effect yet.

“A number of fund clients have been filing for funds with ESG components to them, and SEC staff are already pushing or requiring for them to go effective that they have an 80% test coming into the ESG space,” Pagnano states. “That said, ESG is still a strategy. You have a process or a way that you’re implementing this, and it’s through that ESG lens, so I think that it is, in some cases, going to be difficult to craft an 80% policy.”

Integration ESG funds

There will be three categories of ESG funds under the new rule. She explained that the SEC staff created three new categories of ESG funds and codified them into the rules. The three categories are: focus, impact and integration. The requirements and limitations for each type of ESG fund are quite different.

“So if you’re an integration ESG fund, you’re not allowed to use ‘ESG’ in your fund name at all,” he explains. “They recognize that integration funds use ESG as a strategy or process because they’re saying when you’re an integration fund, you consider ESG factors when making choices about which company to buy.”

Integration funds assign the same weight to companies’ balance sheets or their history of dividend payments. Thus, ESG is only one component of perhaps 10 to 15 factors in the investment-making process for funds in this category. These fund managers don’t give ESG any additional weight compared to the other factors.

Focus funds and impact funds

While integration ESG funds can’t use “ESG” in their names at all, focus funds are allowed to do so — as long as they pass the 80% test with their investments.

“Focus funds are going to have an investment process or focus on an ESG-type of component,” Pagnano states. “In other words, an example the SEC gave was a green energy fund. It’s going to invest 80% of its assets in clean energy technology, which is broadly defined as wind power, solar power, electric batteries, whatever it is that’s a sort of a ESG component or focus.”

The third type, impact funds, are those with a sustainable goal in mind when selecting investments. They can also use ESG terms in their names if they follow the 80% rule.

“I think it’s interesting that the SEC staff has created these three categories of new ESG funds, and I think that the difficulty for managers is going to be what happens if your fund is going between those categories,” Pagnano opines. “What’s your obligation if you are a focus fund, and maybe you’re more of an impact fund? I think the difficulty is going to be what happens between those categories.”

She noted that the categories don’t allow for much flexibility for fund managers to move their portfolio in different ways. Pagnano is interested in seeing how the final rules come out and hearing discussions about transitions between the categories.

Leveling the playing field among ESG funds

She finds it particularly interesting that, in some respects, the 80% rule could even the playing field with some of the earlier ESG funds launched before the 80% test. All focus and impact ESG funds will have to follow the 80% test, which will probably align all industry participants.

“One of the things that may be different for managers and an opportunity to comment is the transition period,” she added. “There’s only a one-year transition period, which could be quick for a number of these managers if they have to adopt 80% policies to move and reposition their portfolios to come into compliance with those requirements. Depending on what the market conditions are during that transition period, if we’re in a significant recession or other volatility, the war in Ukraine or any number of things could affect the market.”

As a result, one year might not be enough time for fund managers to transition their portfolios into compliance in such a way that’s not harmful to shareholders. Clair drew attention to one industry comment made to the SEC, which argued that the transition period isn’t long enough to allow for an orderly transition to those new requirements.

Restraining fund managers

Overall, Pagnano is concerned that the new 80% rule will constrain fund managers, preventing them from using the proprietary strategies they have built their reputations on. The SEC appears to be expanding the 80% rule to strategies with the assumption of standard, industrywide definitions for such terms.

“As much as the commission thinks there are standard definitions out there, they aren’t,” Claire says. “There are nuances in how these terms are interpreted and used by managers to invest in their own proprietary process, and so I think the risk is that we’re going to get to the point where there’s a homogenization of these terms.”

She warned that establishing standardized definitions for fund strategies could limit fund managers’ flexibility to use their own proprietary investment processes. Pagnano is unsure about whether that benefits or furthers competition in the fund industry.

However, she does believe that it risks limiting investor choice in terms of evaluating managers if all of them use the same definitions. Ultimately, she expects some shifts in performance due to such external constraints or limitations on how fund managers can execute their portfolio management strategies. Of course, it’s unclear whether the results will be negative.

Concerns about antithetical investments

The attorney also wants to see more clarification on how managers can invest the other 20% of the fund’s assets. The SEC requires fund managers to avoid antithetical investments in that 20% basket, which she noted puts a significant burden on the fund’s chief compliance officer to determine what that 20% can hold.

One clear example of antithetical investments would be to invest 20% of the portfolio in oil companies while investing 80% of it into green energy stocks due to the use of an ESG-related word or phase in the fund’s name.

However, it’s unclear what should be considered antithetical to many other types of investment strategies. For example, it’s not always clear what would be antithetical to growth or value stocks, especially because the definitions for these two strategies vary among fund managers.

Warnings about greenwashing

Experts are concerned about how expanding the 80% rule will impact ESG funds, The Corporate Citizenship Project remains concerned about greenwashing. The independent think tank’s chief analyst, Bryan Junus, said applying the 80% rule to ESG funds will not prevent greenwashing.

“The so-called ‘80% rule’ will not stop fund managers from greenwashing because the definition of ‘ESG’ itself is far too vague for even the SEC to define accurately,” he said in an email. “All the rule does is require funds with ESG-related names to invest 80% of their assets in investments that are aligned with the fund name. But determining what investments are aligned with the fund name is subjective and near impossible to define without massive government overreach.”

For example, Bryan believes nothing will stop a fund focused on climate change from investing in a video game company with the logic that when people stay inside playing video games, they’re not using their cars. He questioned whether that logic is acceptable to the SEC. If it isn’t, he wonders how regulators can make those determinations and enforce them fairly and impartially while giving fund managers reasonable discretion.

“The reality is that this rule will make little to no impact in ending greenwashing,” Junus declares. “There is too much incentive to greenwash and too many loopholes preventing effective regulation.”

The nature of standard ESG definitions

As stated earlier, the 80% rule could lead to a single definition for ESG-related terms. However, Junus is concerned about whether it will be a quantitative or qualitative standard. He pointed out that qualitative measures are “open to abuse, especially when trillions of investment dollars are involved.” On the other hand, it would be extremely difficult to develop a quantitative standard.

“The challenge in developing a uniform ESG standard is that it will either be too vague and therefore unenforceable,” Junus states. “Alternatively, a more qualitative-driven standard will be too open to interpretation and, consequently, open to selective enforcement. Do we really want the SEC deciding which companies are acceptable ESG investments and which ones are not?”

Junus also called on the SEC to regulate proxy advisors like Institutional Shareholder Services (ISS) in their use of ESG-related terms and how they apply them to companies.

“If the SEC is interested in ensuring that ESG profiteers do not mislead socially conscious investors, they should place reasonable regulations upon proxy advisors,” Bryan states. “This proposed regulation would ensure their proxy advisors’ ESG ratings are not motivated by conflicts of interest between their consulting and ESG rating businesses.”

Michelle Jones contributed to this report.

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