Why Asset Managers are Reclassifying Funds From Article 9 to Article 8

More than a year after the initial implementation of the Sustainable Finance Disclosure Regulation (SFDR), many major asset managers have moved to reclassify funds from Article 9 to Article 8. According to data from Trackinsight, as many as 70% of Article 9 ETFs have been reclassified in this trend.

To understand this movement, first, we need to understand the difference between the two specific fund categories stipulated in the SFDR.

What is Article 8 and 9 of the SFDR? 

The definition of Article 9 (dark green) requires that the fund must explicitly articulate a sustainable objective: 

“A Fund that has sustainable investment as its objective or a reduction in carbon emissions as its objective.”

Article 8 (light green) funds, on the other hand, must contain some element of ESG:

“A Fund which promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices.”

So what is the driving force behind this mass reclassification from Article 9 to Article 8? The SFDR, like many other ESG reporting and regulatory frameworks, continues to evolve meaning that adjustments will be necessary over time to ensure it remains fit for purpose in achieving its goals of greater transparency and enhanced comparability across sustainable investment products.

Consider that ESG regulations only really came into effect when the EU conceived of the Sustainable Finance Action Plan in 2018, with the SFDR introduced a year later in 2019. At the outset, the original definitions for SFDR left room for interpretation – and therefore, misclassification. The term ‘sustainable investments’ in itself – used loosely in investment rhetoric – meant that any fund with even just one constituent considered to be sustainable could qualify as a sustainable investment. And even then, the definition of ‘sustainable’ was open to interpretation, adding another layer of grey area to the classification process. 

Challenges with classifying Article 8 and 9 funds

On July 2022, the European Commission issued further guidance on Article 9 funds under the SFDR framework, with the key takeaway that only funds deemed to be 100% sustainable could qualify as Article 9under these new guidelines. However, the definition of and criteria for ‘sustainable investments’ remain unclear.

This confusion is quite characteristic of the broader regulatory landscape concerning ESG investing. For Article 8 and 9 funds, however, such loose definitions can result in significant discrepancies in fund classification with much dependent on how respective issuers interpret the guidelines – a situation further compounded by a lack of available, and consistent, data across the industry.

At best, incorrect fund classification may mean that, inadvertently, many funds are marketed as being more sustainable than they actually are. At worst, it perpetuates the risk of greenwashing.

For the most part, Article 8 funds have sufficient scope under the current definition to issue sustainability claims regardless of whether ESG considerations truly are a fundamental element of the fund strategy or not. 

What’s next for SFDR?

On a positive note, however, the recent trend of voluntary reclassifications highlights the ongoing commitment on the part of fund issuers to take a proactive approach to ensure compliance with the guiding principles of the SFDR. Following the European Commission’s recent clarification of Article 9 definition, many asset managers recognized adjustments were necessary to accurately classify their products and, as we have seen, have taken steps to address this. 

However, with the spotlight now pivoting to Article 8 funds – with the industry under pressure to actively demonstrate a fund’s sustainability credentials – it can be expected that more reclassifications will follow as fund managers adjust their labels to comply with the latest announcement. 

Stakeholder groups and investors have voiced their concerns, proposing a redefinition or an overhaul of SFDR guidelines for improved clarity and more stringent classification criteria. Proposals put forth so far include reserving green classification exclusively for Article 9 funds, while Article 8 funds should be able to prove that at least 80% of their sustainable investment holdings explicitly articulate ESG goals. In other words, incidental impact may no longer qualify for classification under both categories. 

As the Commission undertakes consultations to improve the SFDR guidelines, we can expect more details to emerge. In the meantime, many fund managers are playing it safe by employing the precautionary principle – when in doubt, reclassify to Article 8.

*IMPORTANT: The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Trackinsight. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A FINANCIAL PROFESSIONAL IS STRONGLY ADVISED.