Asset managers trying to sell funds in Europe are finding it “increasingly difficult” to do so unless their products are registered as ESG, according to a study by analysts at Goldman Sachs Group Inc.

The research comes more than two years after the European Union enforced its Sustainable Finance Disclosure Regulation, a landmark ESG investing rulebook with global reach designed to stamp out greenwashing and direct capital into sustainable activities. Since 2019, the same year lawmakers first adopted SFDR, its two ESG categories — Articles 8 and 9 — have received 3.4 times as much in client flows as their non-ESG counterpart — Article 6, according to the Goldman analysis.

The new regulatory world order has had “significant impacts on capital flows,” Goldman analysts including Evan Tylenda and Grace Chen wrote in a note published on Monday. Conversations they’ve had with industry insiders show it’s “increasingly difficult to market Article 6 funds,” they said.

It’s a reality that’s putting ever more pressure on the fund industry to slap an ESG label on as much as possible, or risk losing client allocations. That’s leading some asset managers to test the limits of the EU’s weakest ESG fund designation — Article 8 — which has now been applied to roughly $6 trillion worth of portfolio assets, according to Bloomberg Intelligence. Recent examples include a Bitcoin exchange traded fund, which drew criticism from environmental experts.

At the same time, roughly a third of Article 8 funds don’t target any sustainable investments, while the rest peg their ESG claims to a wide array of hard-to-pin-down goals, according to research by Morningstar Inc. To register a fund as Article 8, an asset manager needs to promise to “promote” ESG, whereas an Article 9 fund must make ESG its “objective” and target 100% sustainable investments, according to SFDR’s definition.

$AUM and SFDR Share

The Goldman analysis also indicates that end investors are becoming more discerning, and targeting Article 8 funds with the highest sustainability claims. That’s creating an unofficial sub-category — Article 8+ — the analysts noted, referring to funds that are registered as Article 8 but live up to higher sustainability criteria than required.

Since 2019, so-called Article 8+ funds saw 3.2 times the level of cumulative flows of regular Article 8 funds with no sustainable investment targets, the Goldman study shows. SFDR was signed into law in November 2019, and published in the official Journal of the European Union a month later.

At the same time, funds registered as Article 9 — the EU’s highest ESG designation — are “seeing the most consistent inflows across equities and fixed income,” the Goldman analysts wrote.

For Article 8 funds, preferred sectors are water utilities, health-care technology and diversified consumer services, the Goldman analysts wrote. The funds tend to shun tobacco, aerospace and defense, fossil fuels and residential REITs, the analysts said.

For Article 9 funds, the preferred sectors are water utilities, mortgage REITs, and independent power and renewable electricity producers, the Goldman analysts said.

That compares with a second-quarter analysis by Bloomberg Intelligence, which shows that the most popular stocks among the top 50 in Article 9 funds are Schneider Electric SE, ASML Holding NV and Vestas Wind Systems A/S.

Article 9: Top 10 Most-Owned & Sector Breakdown

Investment firms trying to adapt to SFDR have been through a turbulent period culminating in mass downgrades from Article 9 to 8 late last year, as asset managers struggled to interpret guidance around EU regulations. The industry seems to have settled, with the pace of reclassifications much more moderate this year, the Goldman analysts said.

Meanwhile, the investment industry faces a long list of updates to existing EU ESG regulations, including a review of how well fund managers are adapting to a new requirement to disclose so-called principal adverse impact indicators, as well as new regulatory technical standards that will put more pressure on firms to back up their ESG claims.

At the same time, the demand for ESG products will lead fund managers to become increasingly ambitious in the sustainability targets they set, the Goldman analysts said.

“We expect a continued shift in ‘upgrading’ towards Article 8+ and eventually Article 9 as we continue to hear that end clients are demanding more differentiated and innovative products,” they said. “While the commercial preference for funds categorized as Article 8+ and 9 is quite clear, this guidance and flexibility will take time for local regulators and investors to get comfortable with, which could delay ‘upgrades’ of funds disclosing under Article 9.”

--With assistance from Frances Schwartzkopff.

(Adds reference to wave of fund reclassifications in fourth-to-last paragraph.)