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.
Extending Hartzman and Sussman’s work, Nickolay Gantchev, Mariassunta Giannetti and Rachel Li, authors of the June 2021 study, “Sustainability or Performance? Ratings and Fund Managers’ Incentives,” analyzed whether portfolio sustainability ratings can have long-lasting effects on the allocation of capital in a world in which funds compete for flows based not only on their portfolio’s sustainability but also on performance. Their hypothesis was that in order “to improve their globe ratings, mutual funds may increase their demand for stocks with high sustainability ratings above and beyond what would be warranted by the stocks’ expected returns. This behavior is likely to increase the valuation of stocks with high sustainability ratings and negatively affect their future returns.” They added: “The relative weight that investors put on performance versus sustainability is likely to affect fund managers’ incentives to pursue different objectives. As a consequence, an equilibrium may arise in which some funds pursue high sustainability ratings, while others aim for better performance. However, if most investors primarily value performance, the tradeoff between sustainability and performance may motivate all funds to pursue performance as their main objective. In this case, the globe ratings may have limited effects on the funds’ portfolio allocation.” Their paper was the first to highlight the tensions arising when funds are rated along two different dimensions that may create opposing incentives for fund managers aiming to improve their funds’ ratings.
Their data sample covered the period March 2016-December 2017 and included 1,953 unique funds. Following is a summary of their findings:
- Following the introduction of Morningstar’s sustainability (globe) ratings, mutual funds increased their holdings of sustainable stocks to improve their globe ratings.
- As a consequence of their trading behavior, a tradeoff between sustainability and performance emerged and the performance of funds improving their globe ratings deteriorated. In contrast, funds purchasing (selling) stocks with low (high) sustainability ratings, which were sold (bought) by the funds attempting to improve their globe ratings, achieved better performance and improved their star ratings.
- The trading behavior was more pronounced for funds with stronger incentives to improve their star ratings because, for instance, they were closer to the cutoff for a higher rating and competed with fewer peers to be upgraded.
- Since performance appears to be more important in attracting flows than sustainability, in the new equilibrium the globe ratings do not affect investor flows and funds do not trade to improve their globe ratings. More importantly, they found that the effect of the globe ratings on flows was not persistent – starting nine months after the introduction of the globe ratings, they no longer observed any effects of the ratings, and their changes, on flows. Consistent with a new equilibrium in which globe ratings no longer affect flows, funds nearly stopped trading to improve their globe ratings.
Their findings led Gantchev, Giannetti and Li to conclude that “in the long run, only ratings on the dimension that is followed by a larger proportion of investors [the star rating] contribute to higher flows.” They added: “The behavior of mutual funds and their investors is consistent with evidence showing that a majority of ESG proposals is not supported by shareholders, and in particular by institutional investors, suggesting that ultimately investors care predominantly about performance. Our findings indicate that regulation may be necessary to direct capital to more sustainable investments.”
Gantchev, Gianneti and Li provided evidence demonstrating that investor preferences impact cash flows and future performance. While they did find that a majority of today’s investors place greater weight on performance ratings than on sustainability ratings, it seems likely that the increasing concern over climate change, and sustainability issues in general, will alter that ratio as a greater percentage of investors seek to express their values through their investments.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
Important Disclosure: The information presented here is for educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured author are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. LSR-21-123
Read more articles by Larry Swedroe
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.
