SFDR – Still not a lot of fun…

So, the implementation of SFDR has been delayed again. Even if you were not paying attention, it was fairly clear that few were in a fit state to start compiling their taxonomy alignment, and those that claimed they were, required considerable creative effort. Not necessarily a wise move when reporting to the regulators.
What has not gone away however is the regulatory focus on all things ESG. In the past month missives have gone forth from the CBI, FSA and the CSSF guiding everyone to take greater and more substantive care of their ESG credentials. Intentional or not there is a definite feel of regulatory one-upmanship occurring. The end result however is that being an Article 8 fund now seems considerably more strenuous that it appeared to be a year ago. The FCA are greatly concerned re the naming of the fund and anyone who has an ESG tinge to their name had better have a significant body of evidence detailing substantive ESG credentials. The CBI have generously given funds until the 14^th December to file their ESG credentials in an accelerated process. Irrespective of the actual fund management perspective, having an ESG type fund, or even an ESG type term in the name of the fund effectively requires the ESG tail to wag the investment dog irrespective of relative sizes.
So, what does this mean from a risk management perspective. I have long been an advocate that ESG risk management is both separate from, and potentially more complicated than much of standard risk management. What we are seeing is that regulators are getting in on the act and so that funds claiming to have a particular bias will have to evidence that fact on an on-going basis. Claiming an Environmental bias will require filtering to determine an in-scope universe of assets. The filtering will be done on less than 100% reliable data and that data is liable to evolve over time requiring on-going re-balancing. In addition, you will have to illustrate, again on an on-going basis that your portfolio is more “E” than some benchmark, and but a material amount. I do not know if there is a definition of materiality in ESG land, but I am guessing it is significantly more than a 10% shift. And there is no backsliding. If, due to market moves, your bias is decreasing, you will need to re-balance again to maintain your “E” credibility. This will require monitoring of your “E-Ness” and all the standard risk management that accompanies monitored estimates.
This gets materially more complicated if you are considering yourself to be an “ES” type of fund. The dimensions have doubled, but the risk management issues have increased by a considerably greater amount. Your set of in-scope assets is more complicated to define. In addition, what is your target? Clearly an investment target, but also an “E” and “S” and an “ES” target and to what extent do these dominate the portfolio construction. On that level the sensitivity of your portfolio to “E” factors is sadly not going to be anything like that of your “S” factors or the investment factors for that matter. As such trying to balance the portfolio so that it is continually biased in those two directions is significantly non-trivial. But that is what you will be required to do. And evidence the fact. And the more things that you are trying to target, the more care needs to be taken to ensure that the portfolio is not drifting away from its multi-dimensional target.
So let us not start on the risk characteristics of an ESG aligned portfolio. That being said, I have always thought that the Governance crowd did a great job of lobbying to get company organisation the same status as saving the planet and redeeming its inhabitants. However, governance type issues are well represented in the principal adverse impacts table, so that too needs to be taken most seriously.
At the end of the day, SFDR may have been delayed but its potential impact is casting a longer and heavier shadow on the investment industry. You can run in the short term, but you cannot hide in the medium to long term.