The report examines the challenges of ESG fund classification, highlighting inconsistencies in existing frameworks. It proposes a system based on observable features rather than subjective terminology to improve investor decision-making, regulatory clarity, and research quality.

The problem with “ESG funds”

ESG funds are interpreted in three ways: those investing in ESG-related assets, those perceived as benefiting society, and those incorporating ESG factors into investment processes. The third definition is most practical but requires further segmentation due to significant variation in ESG implementation.

Product classification basics

A structured classification system should be exclusive, comprehensive, and based on clear boundaries. Current frameworks rely on subjective labels rather than distinct investment features, leading to inconsistencies in fund categorisation.

Design objectives for an “ESG fund” classification system

The system should meet investor, regulatory, and research needs. It must enable investors to align choices with financial and ethical considerations, support regulators in disclosure requirements, and assist researchers in performance analysis.

Analysis of relevant classification systems

The EU’s SFDR, US SEC’s Enhanced Disclosures Rule, and UK SDR frameworks are reviewed. SFDR lacks clear fund boundaries, leading to market confusion. The SEC’s classification is criticised for vague definitions like “significant consideration,” while the UK’s SDR applies only to sustainability-labelled funds. These frameworks fail to categorise all ESG funds effectively.

Classification system design: Feature specification

Three features define ESG funds:

• Feature 1 – Using ESG information for risk-adjusted returns.
• Feature 2 – Implementing policies that control exposure to systemic ESG issues.
• Feature 3 – Seeking measurable environmental or social outcomes.

This approach ensures categorisation is based on tangible fund characteristics rather than self-declared ESG intent.

Classification system design: Group specification

Funds are classified into three groups:

• Group A – Funds with Feature 1 only, using ESG data purely for financial analysis.
• Group B – Funds with Feature 2, controlling ESG exposure but without specific impact objectives.
• Group C – Funds with Feature 3, explicitly targeting ESG outcomes.

This structure provides clear distinctions without misleading ESG labels.

Classification system design: Evaluation and comparison

The proposed system improves on SFDR by introducing defined criteria rather than vague fund labels. It refines the SEC’s approach by using observable features instead of ambiguous terminology. The broad nature of Feature 2 may require further segmentation, distinguishing between exclusionary screens, thematic allocations, and stewardship activities.

Implementation: Determining the existence of features

The report outlines a process to determine fund features using investment policies, voting records, and engagement strategies. Challenges include fragmented information and inconsistent disclosures.

Three case studies demonstrate practical application:

• ClearBridge International Growth Fund – Features 1 and 2, using ESG integration and exclusionary screening.
• PGIM Total Return Bond Fund – Feature 1 only, incorporating ESG risk analysis but lacking specific ESG policies.
• Incofin Water Access Acceleration Fund – Feature 3, explicitly targeting improved water access for 30 million people.

Findings highlight the need for standardised ESG disclosures to improve classification accuracy.

Conclusions and next steps

A structured ESG fund classification system is crucial for investor decision-making and regulatory transparency. Regulators should refine existing frameworks to focus on investment features rather than sustainability claims. Further research may explore Feature 2 segmentation and extend classification to other investment products. Automation and standardised reporting could improve ESG fund classification efficiency.