Morningstar Sustainability Ratings Deliver Inferior Performance but Drive Asset Flows

Research shows that funds with positive Morningstar sustainability ratings deliver inferior performance. Nonetheless, funds have sought to increase their holdings of “green” stocks to improve those ratings and have benefited from additional asset flows.

In March 2016, Morningstar initiated sustainability ratings for more than 20,000 mutual funds, ranked on a percentile basis and given a “globe” rating based on their holdings. The worst 10% of funds were rated one globe (low sustainability), while the best 10% were rated five globes (high sustainability). Before that time, there was not an easy way for investors to judge the sustainability of most mutual funds without considerable effort. The globe ratings also provided a way to test investors’ preferences and their impact.

In their study, “Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows” published in the August 2019 issue of The Journal of Finance, Samuel Hartzmark and Abigail Sussman found that mutual fund investors, both individual and institutional, collectively treated sustainability as a positive fund attribute, allocating more money to funds ranked five globes and less money to funds ranked one globe. Moderate ratings of either two, three or four globes did not significantly affect fund flows. They also found that investors focused on the simple globe rating and largely ignored the more detailed sustainability information. And despite the significant increase in cash flows, which impacted valuations, they did not find any evidence of higher returns to the funds with higher sustainability ratings.

Hartzmark and Sussman also ran an experiment using MBA students and MTurk participants in which they elicited expectations about future performance, risk and investment decisions as a function of globe ratings. They found that there was a strong positive relation between globe ratings and expected future performance and a strong negative relation between globe ratings and expected riskiness – a pattern inconsistent with the positive relationship we should expect between risk and expected return. They also found evidence of nonpecuniary motives across both populations.