The SFDR orphan – Fund of funds

The last days of 2022 are hectic for all working with SFDR, the deadline in the EU for having pre-contractual documents and websites compliant with SFDR RTS is in a little over a week, 1 January 2023. While SFDR unfortunately still has a large room for interpretation despite extensive exchanges between the ESAs and the EU Commission, some products are simply not thought of. The orphan of SFDR is the fund of funds.

We have some suggestions on how to deal with this and certainly also not to deal with this.

No SFDR mercy

First of all, there is no reason to believe that the SFDR will accept looser regulation for FOFs than for other financial products. What do we mean by this? Since the topic is to create transparency on sustainability characteristics for financial products to stop #greenwashing and at the same time protect the investor (the link in to the updated Mifid), no shortcuts will be accepted.

A short cut we see is pre-contractual documentation where the asset manager claims that since all underlying funds are regulated by Art 8 so is the FOF. The short cut is the misuse of SFDR as a “classification” regulation. It is not, it is a disclosure regulation, therefore all aspects of the SFDR RTS must be respected.

This means that for a fund where the asset manager wishes to promote E and/or S characteristics, these must be described and binding elements relevant for these must be specified. But also, Art 6 must be respected, how do the FOF integrate ESG risks in investment decisions? And how does the FOF ensure that all companies have “good governance”, etc.

The challenges for FOF in SFDR

If you have a FOF investing only in funds from the same asset manager, and they all have the same SFDR RTS approach, there are no challenges.

Where it becomes a problem is when the FOF invests in funds from several different other asset managers. The most severe case is when the FOF invests only in funds from other asset managers. How to address this? The minimum common elements.

The minimum common elements

Let us select to focus here on 3 elements, where challenges arise for a FOF investing in different asset managers’ products. (Considering PAI, using PAI as DNSH proxy, and Sustainable Investments are all too complex to really be considered for a FOF now as we see it, with potentially the kitchen door of the asset allocation as described below)

Art 6 – ESG risk integration in investment decisions.

Here a deep work must be done to understand the ESG risk integration process of the underlying funds. Most of these descriptions are very vague or potentially so complicated that few really understand them. This was also the conclusion in a recent audit done by the Swedish Finansinspektionen. But to be able to describe this the minimum common elements for all, this job have to be done to be able to make the text describing this process for the FOF. This is very challenging with many underlying funds!

Art 8 – The E and/or S characteristics.  

Here the same type of jo must be done. In reality, only binding elements relative to exclusions and selected PAIs will work? This work starts with the EET files, but not all of them are ready or complete yet! If 10 underlying funds exclude in total among them 14 different things, tobacco, coal, etc., maybe only 3 are common for them all. Only these 3 can then be selected as the E and/or S characteristics for the FOF. It is important to remind the marketing department that these will also be the only E and/or S characteristics allowed to be mentioned in the marketing material!

Art 8 – Good governance.

This is a harder nut, as we are likely to see a wide range of solutions and answers from asset managers here. The year is not yet over, and I am working on solutions for this as we speak, but the point here too is to find the minimum common elements for the underlying funds. This is very challenging with many underlying funds and few of them have published yet anything on this new requirement.

SFDR RTS asset allocation is the saviour?

Do not despair! We have a back door in the SFDR Art 8 template, the asset allocation part. Here we can inform that less than 100% of the fund will be allocated to the promoted E and/or S characteristics! Recent feedback from CSSF in Luxembourg indicate that less then 50% will not be accepted and lower levels will not look serious. For a normal fund anything below 80% seems weak to us.

How can we use this for a FOF? Well, if you have 60% of the investments of the FOF in funds with very similar answers to Art 6 and Art 8, this can form the SFDR RTS Template for the precontractual with a minimum allocation of 51% for instance. Remember to inform the marketing department so that this comes across in a clear manner in marketing documents. Do not forget that also for the remaining investments a minimum E and S safeguard must be explained.

Conclusion

Data is also important as the SFDR RTS Periodic Disclosure will follow for the annual fund reporting for 2022. Be sure to prepare the data flows from the asset managers as you likely cannot await the reporting for the underlying funds. You need look-through to all underlying holdings to ensure the binding elements are respected at any time, Investment compliance will require this. Unless you have a different delayed year end for the FOF, maybe not a bad idea.

The EU will never accept, and the FSAs never approve pre-contractual documentation for an FOF that only links referring to underlying funds without going in detail and this will not fit into EETs or MiFID’s requirement of mapping of the investor preference for sustainability. FOFs are the orphans of the SFDR, but this will be addressed by the EASs and the EU Commission. But when?

If you disagree, have other thoughts or suggestions let us know!