Oversight of sustainable funds: current challenges and the path forward
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Purpose and core objectives of investment fund oversight
Investors chose to invest in pooled funds to access the financial expertise of investment professionals. Correspondingly, asset managers are tasked with acting in the best interests of the end investors, including meeting the stated objectives of the fund. The fund governance structures ensure appropriate level of oversight over investment activity, with the ultimate accountability residing with the governance body called a ‘fund board’ in the context of this article.
Legal and organisational structures of investment funds vary across jurisdictions – for example, ‘investment company’ corporate structures are more common in Western Europe, while contract-based unit trusts are popular in Hong Kong, Japan and Australia. Despite the resulting differences in fund board responsibilities across jurisdictions, the research conducted by the Fund Boards Council (FBC) was able to highlight some generally applicable core objectives of fund oversight:
- delivery of the fund’s commitments to investors
- compliance with laws and regulations
- risk management
- board composition.
These objectives did not change with the rapid growth of sustainable investment in the past three to five years; however their achievement became more complex. The developing regulatory frameworks, which introduced varying definitions of sustainability and related disclosure obligations added another host of concerns to the board’s attention. FBC conducted in-depth interviews with fund board directors and other fund board professionals across 21 organisations in order to uncover the challenges that arose as a result of these developments.
The sections below will draw on the results of the FBC’s research (available as a full report here) to highlight the sustainability considerations relevant to the core fund oversight objectives, as well as the resulting challenges for the boards and the potential path forward.
Delivery of the fund’s commitments to investors
What is required from the fund board? - The board generally must ensure that the investment fund has clearly articulated objectives, the chosen investment manager can adequately fulfil these objectives, and monitor whether the objectives are being continually met. In the context of sustainable investment, sustainable fund features should form part of the stated objectives, be included in the consideration of investment manager, and monitored effectively.
Challenges - The role of the fund boards in ensuring delivery on sustainability commitments is currently unclear. The interview results indicate that only a minority of fund boards are involved in setting policies or guidance regarding how sustainability is incorporated in the investment process or receive information on sustainability-related fund features. The majority stated that the sustainability policy is being set by the fund’s mandate and the investment manager approach to sustainable investing (a ‘bottom-up’ set-up). In addition, while the directors acknowledged the ultimate responsibility of the board, the executive teams were considered best placed to understand, implement and monitor the fund’s sustainable objectives. Most participants also reported low involvement in monitoring the fund performance against sustainability objectives.
Proposed action - to ensure that the fund’s sustainable objectives are met, the board should be satisfied that:
- clearly articulated sustainable investing policies are in place
- the directors understand and have confidence in the investment managers’ approach to assessing sustainability
- fund performance monitoring incorporates the relevant sustainability features.
Compliance with laws and regulations
What is required from the fund board? - The board must ensure that the funds are created and managed according to the relevant regulatory requirements, including the ones covering product design, documentation and mandatory reporting. Sustainability-related regulatory developments are increasingly addressing these areas, with some jurisdictions issuing specific guidance on sustainable fund naming, classification and disclosure. In absence of sustainability-related guidance, most jurisdictions have general requirements for the fund name, objective and investment strategy to be clear and not misleading, which would similarly apply to a sustainable fund.
Challenges - Some fund boards are relatively remote from the activities impacted by the sustainability-related guidance, such as product development, production and publication of fund documentation and other mandatory disclosure.
Proposed action - To ensure that the fund is compliant with all relevant rules and regulations, the fund boards should be satisfied that:
- sustainability requirements are incorporated into product governance frameworks
- controls around fund documentation and mandatory reporting remain effective
- the product approval proposals are adequate (especially when existing funds are reviewed for conformity with new sustainable fund labelling or classification regulations)
- the directors are aware of data used, it’s potential limitations and the data integrity controls.
What is required from the fund board? - The board must ensure that the key risks applicable to an investment fund are identified, monitored and managed within the agreed risk appetite limitations and effective internal controls are in place. Sustainability can impact the risk-related fund board responsibilities in connection to sustainability-related investment risk or ‘greenwashing’ risk. Several jurisdictions introduced disclosure requirements on the integration of sustainability (and/or climate) risks into the investment process (e.g. UCITS amendments, SFDR, Hong Kong SFC requirements). Addressing greenwashing has been a key concern in many jurisdictions, with FCA and ESMA identifying it as a priority in their strategic roadmaps.
Challenges - Some fund boards may not have considered how sustainability risk is integrated in the fund risk management frameworks. In addition, internal processes may struggle to keep pace with the evolving regulatory requirements.
Interviewees demonstrated a strong reliance on the ‘three lines of defence’ model for managing regulatory risks. However, it was also noted that controls and competencies are generally most developed in the first line of defence (portfolio managers and responsible investment specialists) while second (compliance and risk review teams) and third (internal audit) may have relatively less expertise.
Proposed action - Fund board directors should satisfy themselves that:
- sustainability risk is appropriately incorporated into portfolio management and enterprise risk management frameworks and governance
- all relevant risk management functions can effectively address sustainability-related risks
- true to label controls can effectively address greenwashing risk.
What is required from the fund board? - Board members must possess appropriate skills, knowledge and experience to discharge their duties. In the sustainable investment context, this would mean an adequate understanding of the nature of sustainable funds, related risks and relevant regulatory responsibilities.
Challenges - Some fund boards have not yet developed an appropriate level of knowledge and understanding of key sustainable investing regulations, investment approaches, tools and metrics. During the interviews, less than a third of participants evaluated the level of knowledge of the boards they serve on as ‘high’. The research also revealed that executive directors generally had a higher level of knowledge compared to non-executive directors, often with at least one executive director being a subject-matter expert. While most interviewees reported a high to medium awareness of the fund-related sustainability regulations, there was a clear desire to see consistent fund governance guidance at the local level as well as international harmonisation.
Proposed action - Fund boards should:
- undertake board assessments to identify gaps in sustainable investment knowledge, skills and experience
- address any identified gaps as appropriate (e.g. training, ‘deep dive’ board sessions, appointment of subject matter experts).
How would you rate the fund board's knowledge of sustainability-related regulation on a scale of high, medium or low?