Sustainability or performance? Ratings and fund managers’ incentives

To achieve a more sustainable economy, it is crucial to increase capital flows to sustainable investments. It is unclear, however, whether achieving such a goal requires regulation or whether it can simply be attained by increasing transparency about the sustainability of investments. To answer this question, it is necessary to understand the extent to which various investors value sustainability.

While institutional investors around the world declare that they value environmental and social sustainability (e.g., McCahery, Sautner, and Starks, 2016; Bauer, Ruof and Smets, 2021), they are often unaware of the trade-off between sustainability and performance. Industry publications appear to suggest that sustainability generates alpha, even though academic research provides mixed evidence at best.^[1] Recent news coverage suggests that investors stop pursuing sustainable investments once they realise that this may lead to lower performance.^[2] There is, however, no systematic evidence that this may be the case.

In our new working paper, we evaluate how US mutual fund managers and investors resolve the trade-off between sustainability and performance once it becomes salient. To achieve this, we use Morningstar’s introduction of the globe ratings, which rank mutual funds based on how their portfolio companies meet environmental, social, and governance (ESG) standards.

These new sustainability ratings were introduced in March 2016 alongside the well-established Morningstar star ratings, which rank mutual funds on their risk-adjusted performance, and have been widely shown to be an important determinant of fund flows beyond historical performance (Ben-David, Li, Rossi, and Song, 2019; Del Guercio and Tkac, 2008).

In the aftermath of their introduction, the new sustainability ratings increased inflows to the funds that ranked highest, and increased outflows from the funds that ranked lowest (Hartzmark and Sussman, 2019).

We show that the introduction of the globe ratings affected the incentives of mutual fund managers, with demand for stocks with high sustainability ratings increasing as funds attempted to improve their globe ratings. As a result, sustainable stocks became overvalued, and subsequently experienced negative abnormal returns. At the same time, funds with strong incentives to improve their globe ratings sold stocks that negatively affected the sustainability ratings of their portfolios. These became undervalued and experienced positive abnormal returns in the months ahead.

The trading behaviour of funds trying to push up their globe ratings created a trade-off between sustainability and performance. We explore how fund managers and their investors resolve this trade-off in the following months.

We find that funds with stronger incentives to improve their star ratings started purchasing undervalued low-sustainability stocks and selling overvalued high-sustainability stocks. Consequently, the performance of funds with less sustainable portfolios improved, and they ended up attracting larger flows than other funds. Just as importantly, after only a few quarters, fund managers stopped selecting stocks in order to improve their globe ratings, and the globe ratings stopped having any effect on fund flows.

This trading behaviour is consistent with recent evidence (He, Kahraman, and Lowry, 2020) showing that the majority of ESG proposals are not supported by shareholders, particularly institutional investors, suggesting that most investors care predominantly about performance.

Our paper implies that the proportion of US mutual fund investors that care about sustainability over performance may be too small for transparency to be the only tool to increase the flow of capital to sustainable investments. Outside the world of impact investors and other institutions with explicit sustainability preferences, regulation may be necessary to direct capital to more sustainable investments.

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