Sustainability or Performance? Ratings and Fund Managers’ Incentives

Do managers prioritise sustainability or financial performance when both are at stake?

Nickolay Gantchev, Mariassunta Giannetti, and Rachel Li explore this tension in Sustainability or Performance? Ratings and Fund Managers' Incentives.

They analyse how U.S. mutual fund managers responded to the introduction of Morningstar's sustainability ratings in 2016. Using data from 1,959 equity funds (2015–2017), they examine shifts in portfolio strategies, fund flows, and performance through econometric analysis of fund trading behaviours.

They conclude:

• Funds actively tilted portfolios towards sustainable stocks post-rating introduction, showing an initial ESG enthusiasm boosting inflows but harming returns.
• Aggressive ESG traders underperformed, with an annualised return drag of -2.37% for funds near rating cutoffs.
• Fund flows shifted back towards performance-driven metrics like star ratings, which overshadowed sustainability ratings in investors priorities within a year.
• The globe ratings' influence on investor decisions only had a short-lived ESG impact. It decreased quickly to reveal performance back as the dominant driver.
• Some funds manipulated portfolios for better ESG ratings without genuine integration, which led to the development of greenwashing practices.
• Few managers effectively leveraged ESG data to generate alpha, highlighting a skill deficit in sustainable investing and an expertise gap between responsible investors.

Investors should critically evaluate ESG claims rather than relying on external ESG assessments to align with long-term performance goals and curb greenwashing. It involves leveraging robust data and expertise rather than chasing superficial ratings.

The study focuses on U.S. equity funds, limiting global generalisability. It also covers a short post-introduction period, with potential shifts in investor behaviour beyond 2017 remaining unexplored.