What are ESG fund labels?

‘Responsible’ funds look beyond purely financial considerations when it comes to their investment strategy. These additional considerations typically relate to social or environmental concerns, or both.

What might be considered a responsible investment can be both subjective and personal. Investors should therefore consider whether a fund's responsible investment approach fits with their own ethics and values.

If you’re an ESG investor, you’ll know it can be hard to choose a fund that meets your environmental and ethical preferences. Often, it involves wading through an alphabet soup of acronyms and buzzwords that shed little light on how the fund actually handles ESG criteria in its investment portfolio.

What are the new ESG fund labels, and what do they mean?

In a bid to improve consumer communications, the Financial Conduct Authority (FCA) introduced a series of reforms over the course of 2024, known as the Sustainability Disclosure Requirements (SDR).

One of these is an ‘anti-greenwashing rule’. This stops fund providers making claims about the ESG characteristics of their fund that don’t actually match up with what’s going on in the portfolio.

To help investors make more informed decisions, the FCA also introduced four new investment labels that you might see on fund literature. Each label corresponds to one of four different approaches to ESG investing set out by the FCA. To use the labels, a fund needs to have an explicitly stated sustainability objective, with at least 70% of its assets invested in that way.

The four new labels are as detailed below.

Sustainability Focus

Funds in this category need to invest more than 70% of their portfolio into assets that are environmentally or socially sustainable.

Sustainability Improvers

Funds which can show at least 70% of their portfolio is invested in assets which have potential to improve environmental or social sustainability over time. Fund providers need to identify when the improvement is expected to happen, and engage with companies they’ve invested in to keep this on track.

Sustainability Impact

To qualify for this category, funds must ensure they aim to achieve a pre-defined, measurable and positive impact on environmental or social outcomes.

Sustainability Mixed Goals

These funds need to invest at least 70% into assets that meet a combination of the above three approaches. Many funds employ a combination of approaches to ESG investing – this category provides a label for funds that might not qualify for any of the other categories in isolation.

What else do I need to know?

The FCA says the sustainability characteristics of a fund must conform to a robust, evidence-based standard that is an absolute measure of environmental and/or social sustainability. In some cases, fund providers themselves may develop their own standards, but it seems likely many will defer to existing frameworks to define the standard for their funds. In either case, the intention is to get funds to show they’re actually delivering on ESG promises, rather than simply having good intentions.

Fund providers need to monitor their funds to ensure they comply with these labels, as well as to undergo an independent assessment to judge if they’re meeting the right standard. They’ll also need to keep investors informed of their ESG activities.

Passive funds aren’t exempt from these rules. They’re included in the labelling regime, even though they don’t normally control the composition of the index they’re tracking. While the FCA seems to afford them some leeway here, it says they’re still expected to take reasonable steps to make sure their fund maintains the ESG standards laid out to investors. This would include communicating with index providers if it looks like there’s a mismatch between the components of the index and the sustainability objective of the fund.

Keep in mind that ESG funds labels won't cover every fund with ESG leanings. Some funds that apply an ESG lens to their portfolio won’t qualify for any of these labels – and won’t be able to use one. They also won’t be able to use the words ‘sustainable’, ‘sustainability’, and ‘impact’ in their names. But that still leaves other, related names they could use, such as ‘responsible’, ‘ethical’ or ‘stewardship’. The FCA has also issued rules on how these funds are marketed to investors and the disclosures they need to make – again, as a barrier to funds talking the ESG talk but not walking the walk.

What are some other responsible funds?

Beyond the four labels, there are a number of other approaches to responsible investment. While these do not necessarily fit the FCA’s four categories, these funds still need to disclose their own approach to responsible investing under the new SDR regulations where the fund name indicates a responsible approach. These funds include:

ESG tilting

This is when a fund uses the consideration of ESG (environmental, social or governance) factors to ‘tilt’ the portfolio away from companies with poor ESG credentials, and towards companies with better ESG credentials. Within this type of fund, companies and industries that score poorly on ESG considerations will still feature, but to a lesser extent than the wider market. Tilting therefore seeks to strike a balance between ethics and pragmatism.

ESG leaders/best-in-class

Similar to ESG tilting, an ESG leaders strategy allows investment across a range of industries, even carbon intensive ones. However, in this approach, a portfolio of companies is picked that leads its sector in terms of ESG credentials. As with ESG tilting, the benefit of this approach is that it’s easier to produce a balanced portfolio.

Thematic

Here, a fund focuses on one particular area within responsible investment such as green energy transition, sustainable agriculture, or sustainable water and waste. These funds invest in companies that are either contributing to sustainable shifts within an industry, or those that align with broader societal shifts relating to the fund’s focus.

Ethical/exclusions-based

Within ethical or exclusions-based funds, specific industries or companies are excluded from a fund’s investable universe. Typical examples of excluded sectors include tobacco, oil and gas, gambling, and defence companies. Whilst considered a very light-touch approach to responsible investing, exclusions-based funds do benefit from being easy to understand and manage.

Stewardship

The stewardship approach to responsible investing focuses on an asset manager’s engagement with the underlying companies in their portfolio. This typically stretches from voting on proposals made by the company, to lobbying the company – either in private or in public – for change. Stewardship is typically incorporated within most responsible investment strategies and is rarely the sole focus of a responsible fund.

Will the new rules work?

Whether these rules help consumers make more informed choices remains to be seen. There’s likely to be a bedding in period, as firms adjust to the labels and their quite onerous requirements. Beyond that, as the FCA itself states, there is no single definition of ‘sustainability’. These labels are really an attempt to provide some standardisation to a landscape that is varied and extremely nuanced.

At some point, we’re expecting the UK Green Taxonomy to be published by the government, a common framework to set clear definitions of which economic activities and investments can be defined as environmentally sustainable. That the regulator is pushing ahead with rules to govern the large ESG fund industry before this framework has been published tells us that they’re rushing to erect some regulatory scaffolding around a haphazard building that has popped up very quickly.

When will I see these changes?

While some funds have already completed the application process for labels, we expect most labels to be formalised by April 2025. Offshore funds are not currently subject to this regulatory regime.

What are the risks of responsible investment funds?

Investors should note that some responsible funds, whether sustainably labelled or not, can be riskier than funds that are not managed to a responsible mandate. This is because the funds may have a reduced investment universe, which can lead to a more concentrated profile of companies, both by number and by economic factors that drive their underlying share prices. This is often particularly true for funds with a sustainability label, given the more stringent disclosure requirements applied to their investments.

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