Why we need to redefine greenwashing in the asset management industry

Sustainable finance and ESG investments have received significant attention in recent years as investors have invested heavily in portfolios with an ESG focus. According to Global Sustainable Investment Alliance, in 2020, an estimated USD 35.3 trillion, accounting for more than one third of worldwide assets under management, were invested according to Environmental, Social and Governance (ESG) criteria. 

Despite this growing interest in sustainable investing, the investment industry lacks clear standards for what constitutes a sustainable investment. This lack of clarity creates a concern that asset managers could label their products as Environmental, Social and Governance (ESG) investments without truly aligning with ESG principles. This practice, known as greenwashing, aims to attract investors’ money, but without actually committing to sustainable investing. 

The drawbacks of current standardization 

Greenwashing by mutual funds has significant implications. It means that investors’ money is not managed according to their values. Also, it affects the allocation of capital and thus, hampers the advancement of social, environmental and governance causes. 
 
Some industry experts consider that the solution to this problem is the development of a standardized framework for sustainable investing that considers the unique characteristics of each investment. Accordingly, regulators have created a framework through which they aim to provide transparency to investors about the sustainability of their investments. Thus, the European Union’s Sustainable Finance Disclosure Regulation (SFDR), effective since March 2021, mandates asset managers to classify investment products as sustainable or non-sustainable and to justify their choices.  

Divesting from companies with poor ESG practices may be ineffective to address environmental issues

In November 2022, the European Securities and Markets Authority (ESMA) released a Consultation Paper on Guidelines on funds’ names using ESG or sustainability-related terms. ESMA proposes that any fund with ESG-related words in its name should have a minimum of 80% of its assets used to meet the environmental or social characteristics or sustainable investment objectives.  
 
A similar proposal is underway in the US (Amendment to the Fund “Names Rules”) requiring funds with ESG names to invest at least 80% of their assets in line with the name’s suggested investments. The new rule would apply to any fund names with "particular characteristics," including environmental, social and governance investing factors.  
 
The recent regulatory proposals are consistent with the idea that a fund’s commitment to sustainable investing can been measured by the ESG scores of the securities it holds in its portfolio. According to this view, asset managers who claim to invest based on ESG principles but invest in firms with low ESG scores are greenwashers.  

ESG activist investors often hold securities issued by firms with poor ratings in order to improve them

However, this view oversimplifies matters, since a mutual fund’s portfolio is more than just a collection of securities. Imposing negative screens on companies with poor ESG scores is not the sole method of exercising a fund manager’s commitment to sustainable investing. Moreover, divesting from companies with poor ESG practices may not be the most effective means to address environmental and social issues.  

Indeed, the empirical evidence on the efficacy of divesting is mixed. Furthermore, divesting from “brown” companies may be counterproductive in addressing the climate crisis, as sold assets often end up in the hands of private-equity firms, sometimes with opaque practices. Also, if divestment results in the liquidation of a company, layoffs and a decrease in supply of energy and other goods could have harmful social consequences.  

Instead of excluding securities from their portfolios, mutual funds can act as activist investors and attempt to improve firms’ practices. For example, they can vote in favor of proposals related to firms’ ESG policies. Naturally, ESG activist investors often hold securities issued by firms with poor ESG ratings because improving those ratings is their objective. Labeling such activists as greenwashers would be wrong. 

A new definition for greenwashing 

To investigate greenwashing in asset management, in a recent article “Defining Greenwashing,” joint work with Javier Gil-Bazo and Feng Zhou, we propose a new definition of greenwashing in asset management industry that combines ESG disclosures, ESG ratings and voting record on shareholders’ proposals.  

Thus, we define as greenwashers those funds that self-label as ESG funds (either in their name or in their investment strategy), receive poor sustainability ratings and do not vote in support of at least 70% of ESG initiatives proposed by shareholders in one year. 

Armed with this definition, we studied the prevalence of greenwashers in the US mutual funds industry during the period 2016-2020 and showed that 23.8% of the self-labeled ESG funds are greenwashers, down from about 40% when one considers only the self-labeled ESG funds that have poor ratings.  

Through an analysis of fund and asset management companies’ characteristics, we show that:  

• Funds in larger and older assets management companies are more prone to greenwashing.  
• Mutual funds within fund families that are signatories of the United Nations Principles for Responsible Investment (UNPRI) are 33% less likely to engage in greenwashing.  
• Funds that had lower recent fund flows are also more likely to greenwash.  

These results provide the investors and market supervisors with cues on identifying greenwashing. 

Investors are able to spot greewashers and reward genuine ESG funds 

Are the investors able to spot the greenwashers? By examining the fund flows in the self-labeled ESG funds, we find that investors, on the whole, can distinguish between genuine ESG funds and greenwashers, and reward genuine ESG funds with an average 3.1% higher asset annual growth, equivalent to $16.5 million. However, institutional investors are entirely responsible for this higher growth, as they are able to identify which funds honor their commitment towards sustainable finance and which funds do not. In contrast, retail investors are not able to differentiate between greenwashers and genuine ESG funds. This finding suggests that retail investors and institutional investors differ significantly in their assessments of mutual funds’ ESG quality. While retail investors tend to rely on funds’ ESG claims and ratings, institutional investors also pay close attention to voting behavior. 

Taken together, our results imply that in a mutual fund market where sustainability reporting lacks specific regulations, such as the US, asset management firms must deliver on their promise to invest based on ESG principles if they wish to attract institutional investors. This external governance appears to act as a deterrent against greenwashing.

However, to protect retail investors an enhanced ESG disclosure regulation may be necessary. The current regulation and proposals are not sufficient in helping retail investors identifying the greenwashers because they mainly focus on the ESG ratings and do not account for the possibility of funds to engage with the company and influence the corporate behavior.