All authorized fund managers in the European Union (EU), beginning on August 1 2022, will be required to integrate sustainability risks in their portfolio and risk management processes for UCITS and AIFM funds, a development that may present a big challenge for Asian fund managers who are seeking to tap the European market.

The new requirements are part of a European Securities and Markets Authority (ESMA) supervisory briefing issued on May 31 2022, and are contained in Article 6 of the Sustainable Finance Disclosure Regulation (SFDR), the EU’s set of rather stringent disclosure rules for sustainable funds which took effect on March 2021.

Article 6 of the SFDR covers funds that do not integrate any kind of sustainability into the investment process and could include stocks currently excluded by environmental, social and governance (ESG) funds, such as those of tobacco companies or thermal coal producers.

Although the ESMA guidelines are designed for EU fund managers, strong long-term demand from EU investors for Asian, particularly Chinese, equities and fixed-income funds have resulted in a growing number of Asian asset managers seeking to package such Asian assets into UCITS (undertakings for collective investments in transferable securities) and AIFM (alternative investment fund managers) funds for sale to European investors.

Under the ESMA guidelines even fund managers who do not offer sustainable funds will be required to comply with the new rules, a requirement that may be onerous for such fund managers at this point.

The ESMA guidelines note that while large fund managers often already have tools in place to assess portfolio sustainability risk, they also acknowledge that smaller and mid-sized managers may struggle to comply with the new rules. In Asia, unfortunately the majority of asset managers will fall in the latter category.

In fact, recent surveys indicate that EU investors consider the Chinese market as being of strategic importance in their global asset allocation despite the current headwinds facing this market.

In any case, the ESMA guidelines encourage regulators to ensure that asset managers perform periodic reviews of their internal policies, and that supervisors perform “desk-based or on-site reviews” of the implementation of the policies and procedures.

Under the ESMA guidelines, it is imperative for local regulators to implement the sustainability requirements that cover the relevant policies and procedures relating to investment due diligence, risk management, remuneration, recruitments and human resources, organisational structure and decision-making of the management companies and UCITs/AIFs, internal reporting and recording keeping, conflict of interest, delegation monitoring, accounting and valuation, costs and fees, reporting, and internal control functions and regular controls by senior management.