(Bloomberg) -- Fund managers peddling ESG products in Europe may want to take another look to ensure that what they’re selling actually lives up to their marketing promises.

The European Securities and Markets Authority said Friday in a report that it has observed a “mismatch” between what fund managers are telling ESG clients, and their actual allocation strategies. That’s as Morningstar Inc. removes the ESG label from over $1 trillion in investment funds it says don’t meet adequate environmental, social and governance standards. 

The development suggests that Europe’s anti-greenwash rulebook known as the Sustainable Finance Disclosure Regulation is far from watertight. According to Morningstar’s global head of sustainability research, Hortense Bioy, the “vast majority” of funds making unsubstantiated ESG claims at the end of last year carried a label created under SFDR called Article 8. 

It’s a category that’s sometimes also dubbed light green, and that gives investment managers considerable freedom to decide what to include in a fund. That’s made it a popular ESG category within SFDR, and asset managers are currently allocating more than seven times as much money to Article 8 as they are to SFDR’s stricter green category, Article 9. But industry interpretations of the two articles differ.

ESMA said it now sees evidence of an “unequal understanding” among investment firms of how to apply SFDR articles, which “may lead fund managers to disclose inconsistently under these articles and effectively cause greenwashing in some cases.” It’s “observed” cases in which exclusion policies were misleading and where ESG integration strategies resulted in “no commitment” made to ESG considerations. The upshot is a heightened risk of “misinformation, mis-pricing and mis-selling,” it said.

The European Commission is considering introducing minimum standards for Article 8, in an apparent acknowledgment that the current framework invites greenwashing. Meanwhile, ESMA has published a strategy update in which it lays out its plans to rigorously monitor the ESG market.

ESG fund managers have tended to prefer Article 8 because it lets them choose from a bigger investment universe, enabling better diversification and stabler returns. But those going the extra mile and opting for Article 9 face a much smaller risk of greenwashing allegations, according to Bioy.

“Article 9 funds tend to have clearly articulated investment objectives and policies,” Bioy said an interview. A comparison of risks and exposure to “controversial activities” found that Article 9 funds “in aggregate exhibit higher ESG characteristics,” she said.

The notion that a fund’s returns will be sacrificed to achieve its ESG goals is off the mark, said Bjarne Graven Larsen, chief executive of quant fund and Article 9 pioneer Qblue Balanced. He said the stricter ESG category doesn’t have to mean lower returns.

“There are a lot of people who don’t have the same experience investing sustainably who do think that they might be sacrificing returns, but I find in my career it has been the exact opposite,” he said in an interview. “You actually take out substantial tail risk in your portfolio by not investing in non-sustainable companies.” 

The world’s biggest Article 9 fund, according to Morningstar rankings, is run by the investment arm of Nordea Bank Abp. Its Nordea 1 - Global Climate and Environment fund oversees 11.4 billion euros ($12.9 billion) in actively managed Article 9 products spanning small and midcap equities. 

Snorre Storset, the head of asset and wealth management at Nordea, said it can be financially risky basing an ESG strategy on a very narrow definition of sustainability. That’s particularly true in an environment in which central banks are striking a more hawkish tone and risk appetite is receding.

“If you have more narrow-scope funds that are typically Article 9 funds with a very high exposure” to the cleanest ESG assets, “those funds are a little bit more at risk in this type of situation, obviously,” Storset said in an interview.

©2022 Bloomberg L.P.