“The major problem that I have is that even if they’re [ESG funds] marketed correctly, they actually have no demonstrable impact.”1
Tariq Fancy, the former head of BlackRock’s sustainable investing
Flows into ESG mutual funds have increased markedly over recent years, raising the question of whether these capital flows lead to improved ESG policies in the underlying firms. Recent evidence is not encouraging; findings cast doubt on whether ESG funds exert material impacts on firms’ cost of capital or improve corporate conduct. We argue that this lack of evidence stems in part from the fact that all ESG funds are not equal – only a subset of funds has incentives to pressure portfolio firms toward better ESG policies.
Which Mutual Funds Have the Strongest Incentives to Influence Firms’ ESG Policies?
Mutual funds have the capacity to pressure firms into improving their ESG policies. But are they incentivized to devote resources to such activities? Mutual funds vary in their incentives to engage with underlying firms.
Our estimate of funds’ incentives to engage is based on the fundamental point that mutual fund managers benefit when the net asset value of the fund is greater. Following this intuition, we estimate funds’ incentives to engage as a function of two components.2 First, the direct component is based on a fund’s dollar investment in each firm; it captures the extent to which greater engagement increases the value of the portfolio firm, thereby contributing to higher fund value and higher management fees. Second, the indirect component is based on the fund’s holdings in the firm relative to the holdings of peer funds; it captures the ways in which the mutual fund’s relative performance affects subsequent fund flows. To capture funds’ incentives to engage on their ESG holdings, we estimate each component across the high ESG stocks in each fund’s portfolio. We categorize ESG funds with above-median incentives to engage as Committed ESG funds and all other ESG funds as Nominal ESG funds.
We validate our measure of committed ESG funds using two different approaches. First, we compare it to the Morningstar ESG Commitment Level measure, which was introduced in 2020 and is based on funds’ investment process and extent of active engagement on ESG issues. Second, we perform a textual analysis of the Principal Investment Strategies (PIS section) of each fund prospectus. Both these approaches provide independent validation that our classification of ESG funds into committed versus nominal captures fundamental differences in funds’ ESG investment strategies. Moreover, by construction, committed funds and nominal funds have the same dollar investment in high ESG firms.
Descriptive statistics provide further evidence that our measure captures significant differences across funds and across types of portfolio holdings. First, both the direct component and the flow component (of our incentive to engage measure) is significantly higher for committed funds than nominal funds. Second, for comparison purposes, we separately calculate the incentive to engage measure across each fund’s non-ESG stocks. We find that, among committed funds, the incentive to engage measure is significantly higher among high ESG stocks than among other stocks. We do not find a similar difference among nominal ESG funds.
Investment Strategies: Committed ESG funds v. Nominal ESG Funds
We begin by contrasting the investment strategies of committed ESG funds with those of nominal ESG funds. We evaluate both the research conducted by the funds and the trading behavior of the funds.
First, we find that committed ESG funds pay more attention than nominal funds to portfolio firms’ ESG risks, consistent with their efforts to engage with firms on these issues. Committed funds are significantly more likely to view firm filings (i.e., filings posted on the SEC website) in the days surrounding firms’ negative ESG news announcements.
Second, armed with this greater research, we find that committed funds implement a more long-term investment strategy. Rather than simply employing negative screening, for example, by selling after negative ESG-related incidents, we find that funds with higher incentives to engage are more patient toward management. Committed ESG funds’ tendency to maintain their investment positions (following negative ESG incidents) is consistent with them both having a greater understanding of the incident, for example, as a result of their greater research, and with them holding for longer periods as they engage with management on the underlying issues. In contrast, nominal ESG funds are significantly more likely to sell following announcements of severe negative ESG events.
Third, we find that committed funds’ more patient investment strategy toward ESG stocks extends more broadly to periods of poor financial performance. While mutual funds have a general tendency to sell stocks following periods of negative abnormal returns or poor earnings, we find significant heterogeneity in this tendency. Among nominal ESG funds, the tendency to sell following poor performance is similar across both ESG and non-ESG stocks. In contrast, among committed ESG funds, the tendency to sell following poor performance is concentrated solely within non-ESG stocks.
The lower tendency of committed ESG funds to sell high ESG stocks following negative events, e.g., negative ESG incidents or poor financial performance, is reflected in the duration of their holdings. We find that committed funds tend to hold high ESG stocks significantly longer than their other stocks. In stark contrast, nominal ESG funds tend to trade ESG stocks and other stocks similarly.
The contrast between committed versus nominal ESG funds’ investment strategies is consistent with committed funds’ advantages in understanding ESG risks, due to their significant investments in high ESG firms and their greater incentives to both research the firms and to engage with firm management.
Impact on Underlying Firms
Committed funds’ greater incentives to engage should contribute to more ESG-related improvements at portfolio firms. This is exactly what we find. Firms intensely bought by committed funds following severe ESG incidents subsequently experience a 36% reduction in their risk index, relative to the base case in which funds neither intensely buy nor intensely sell. Additional tests indicate that at least a portion of this relation reflects causality: Consistent with committed funds actively engaging with portfolio firms, greater investment by committed ESG funds causes the ESG risks of the underlying firms to subsequently decrease.
Our tests of causality rely on the initiation of Morningstar Sustainability Ratings in early 2016 as a shock to flows into high ESG funds. This shock, on average, caused funds to increase the dollars invested within existing portfolio firms (in addition to any investments in new firms), thereby increasing funds’ incentives to engage with these firms. Under the premise that the Morningstar shock is exogenous to funds’ pre-shock investment choices, this channel enables us to shut down the selection effect (i.e., the choice of which firms to invest in) and focus on the engagement channel (i.e., the effects of funds’ engagement on the underlying portfolio firms).
Using this setting, we examine two dimensions along which funds’ engagement potentially influences firms’ ESG-related risks: the RepRisk Risk index and firms’ on-site toxic emissions that are reported to the U.S. Environmental Protection Agency (EPA). The former represents a broad measure of a firm’s ESG profile, and the latter more precisely captures a firm’s environmental practices. Results are consistent across both measures: Firms overweighted by committed funds prior to the shock experience a significant decrease in ESG risk and a significant decrease in their carbon footprint after the shock. We find that these effects are concentrated within high ESG firms, suggesting that committed funds focus their engagement on firms that have an established reputation for being responsible and would thus wish to avoid an ESG ratings downgrade.
Can Funds Do Well By Doing Good?
In the next part of the paper, we investigate the relation between ESG funds’ incentives to engage and fund performance. We find that committed ESG funds have outperformed both the market and their nominal counterparts on their ESG investments. This is consistent with committed funds’ engagement contributing not only to better ESG-related outcomes but also to better firm performance.
Are Committed Funds Rewarded for Their Efforts?
In the last part of the paper, we pose two questions related to whether committed funds are rewarded for their ESG-related efforts. First, are investors aware of these differences among ESG funds? Second, are committed funds rewarded for their more sophisticated ESG integration? We address these questions through an examination of fund flows.
We find no evidence that committed funds are rewarded with additional flows beyond those that can be explained by differences in fund performance. This finding is consistent with one of two scenarios. On the one hand, it may be that investors are not willing to pay more for sustainable investments that have larger impacts. Alternatively, despite preferences for sustainable investments, average mutual fund investors may not be sophisticated enough to differentiate between sustainable investments that are better positioned to have social impacts and opportunistic window dressing behavior that aims to attract investor flows. Our findings call for greater investor awareness on the heterogeneity across different types of ESG funds.
Michelle Lowry is the TD Bank Endowed Professor at the LeBow College of Business of Drexel University.
Pingle Wang is an Assistant Professor of Finance at the Naveen Jindal School of Management of the University of Texas, Dallas.
Kelsey Wei is an Associate Professor of Finance and Managerial Economics at the Naveen Jindal School of Management of the University of Texas, Dallas.
This post is adapted from their paper, “Are All ESG Funds Created Equal? Only Some Funds Are Committed,” available on SSRN.
The views expressed in this post are those of the authors and do not represent the views of the Global Financial Markets Center or Duke Law.
