Greenwashing Under Pressure as Regulators Turn to Passive ESG Funds | Morningstar

WisdomTree settles with the SEC on its ESG process for three ETFs.

The vise is closing on greenwashing—the phenomenon of funds making deceptive claims about their sustainability. This month, WisdomTree Asset Management, the exchange-traded fund and passive investment manager, settled with the SEC for allegedly misrepresenting its environmental, social, and governance investment process for three ETFs. Separately, expect new anti-greenwashing regulations in the coming months, including Europe’s fund-naming rule.

The anti-greenwashing efforts come at a time that net purchases of sustainable funds have slowed, except for passive funds. Passive funds have taken the lion’s share of flows. Now, analysts say, some regulators are taking aim at passive sustainable funds, which typically use screens to exclude certain industries, controversial stocks, or companies that fail to pass certain ESG hurdles. Sometimes, these funds fail to police their own investments.

In 2020, WisdomTree converted three ETFs to use an investment process that would exclude companies involved in fossil fuels, tobacco, and other “controversial products.” But in the following two-plus years, the funds invested in companies involved in coal mining, natural gas extraction, and tobacco sales. The funds were closed in December. WisdomTree agreed to pay the fine without admitting or denying the allegations and said in a statement that it takes its regulatory responsibilities “very seriously.”

Adam Bernstein, ESG/Impact analyst for Gitterman Wealth Management, believes that more and more enforcement actions will focus on passive index products, which usually use exclusions to remove certain stocks and make the funds more sustainable. (For more on exclusions, read this.)

That happened in Australia, for example, when Australia’s federal court fined Vanguard Investments Australia A$12.9 million (USD $8.6 million) for misrepresenting the “ethical” characteristics of its Ethically Conscious Global Aggregate Bond Index Fund. The court said Vanguard hadn’t “researched or screened against applicable ESG criteria” for 74% of the fund’s securities. Vanguard said it had cooperated with the Australian Securities & Investments Commission since informing it of the issue in 2021, and that “there were no findings of financial loss to investors.”

“These are lazy mistakes,” says Bernstein.

How big of a problem is greenwashing in the investment industry? Generally, investors are well protected, says Hortense Bioy, head of sustainable investing research at Morningstar Sustainalytics, a division that provides sustainability research. In the funds industry, greenwashing is “about process: Your portfolio doesn’t match what you say your process is,” Bioy says. More regulation—and enforcement actions—will narrow the avenues for greenwashers. “It’s becoming less of a problem,” says Bioy.

A handful of high-profile settlements preceded WisdomTree:

- In September 2023, money manager DWS Investments agreed to pay $25 million for overstating how it used ESG factors in its funds and settled SEC allegations that it violated anti-money-laundering rules for its mutual funds. DWS is controlled by Deutsche Bank DB. It did not admit or deny the SEC’s findings.

- In November 2022, Goldman Sachs Asset Management agreed to pay $4 million to the SEC to settle charges of “policies and procedures failures involving the ESG research its investment teams used to select and monitor securities,” according to the SEC. The firm said it was pleased to have resolved the matter.

- In May 2022 Bank of New York Mellon’s BK investment advisory division agreed to pay $1.5 million to the SEC to settle charges of making misstatements about its sustainable practices in six mutual funds. The firm said it was pleased to resolve the matter.

- Australian regulators have been exceptionally active. In August, the Australian Securities & Investments Commission said it “made 47 regulatory interventions to address greenwashing misconduct during the 15-month period up to 30 June 2024.” In addition to the Vanguard fine, Australia fined A$11.3 million for Mercer Superannuation (Australia) for making misleading statements about the sustainable nature of some of its investment options in what was described as Australia’s “first greenwashing case brought before the Federal Court.” Mercer said it had undertaken a comprehensive review of its internal marketing processes and procedures.

Indeed, Morningstar also paid Australia a penalty after finding it was exposed to “controversial weapons investments” in one of its funds. Morningstar said the relevant securities were held for short periods and had revised its processes to ensure the error didn’t occur again.

Regulators will insist on more clarity. Last year, the SEC amended its Names Rule. The fund’s name is the first thing that investors encounter, and according to the Names Rule, which was originally adopted in 2001, funds must invest 80% of their assets in the investments the name suggests. The amendments now expand that requirement to fund names with “particular characteristics,” such as “growth” and “value,” or names that say it incorporates ESG. These are broad new requirements that will also require greater disclosures in the prospectus.

In the European Union, asset managers marketing funds in the EU must comply with the European Securities and Markets Authority’s guidelines on ESG funds’ names by May 2025, says Bioy. The guidelines aim to protect investors against greenwashing risk and provide minimum standards for funds available for sale in the EU that use specific ESG terms in their names. In May, Morningstar identified around 4,300 EU funds with ESG or sustainability-related terms in their names that may fall within the scope of the guidelines.

In the UK, managers of sustainable funds must comply with the naming and marketing rules of the UK Sustainability Disclosure Requirements by April 2025. Last January, Morningstar identified more than 400 UK funds with ESG-related terms in their names, about half of which contained the key terms “sustainable/sustainability” or “impact.” Keeping these terms would require the funds to apply for one of the four sustainability labels.

Fund managers will need to guard against more lazy mistakes as exclusions stay important, particularly in Europe. Other investors that use exclusions include faith-based investors, custom and direct indexers, and fossil-fuel-free investors.

To be sure, flows into sustainable funds have moderated, Bernstein notes. Still, if they lift again, expect more enforcement actions down the road.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.