The ‘tournament-like’ impact of environmental, social and governance ratings on mutual funds

In recent years, environmental, social and governance (ESG) investing has been gaining popularity, with institutional and individual investors choosing this approach to support global change. ESG investing evaluates companies based on their environmental impact, social contributions and governance standards, making it a tool for promoting responsible business practices.

The mutual fund industry, which pools investments from various individuals and institutions to create diversified portfolios, has increasingly embraced ESG. With significant revenue now flowing into ESG funds, mutual funds are becoming major players in the movement. However, there’s growing concern that some fund managers may be using ESG ratings to improve their fund’s appeal, rather than genuinely prioritizing these values.

To explore this dynamic, Professor Fabio Moneta has been awarded a Telfer SMRG Research Development Grant for his project “Mutual Fund Tournaments and ESG Rating.” Moneta will study whether mutual fund managers, particularly those with underperforming funds, strategically adjust their portfolios to boost ESG ratings at the end of the year. This manoeuvre is seen as a way to attract ESG-focused investors and minimize the negative consequences of poor performance.

Through a detailed analysis of funds’ Morningstar Sustainability Ratings, the study, to be co-authored with Xiaoyu Sun, a PhD finance student at Telfer, will examine how these ratings are influenced by performance incentives. Funds that are underperforming in the first half of the year (“losers”) are more likely to increase their ESG scores by year end to draw in fresh investment than those that are performing well (“winners”). This competitive, almost “tournament-like,” behaviour, casts doubt on whether fund managers are prioritizing ESG values or merely adjusting ratings to meet investor demand.

This research could lead to a call for greater accountability and transparency in ESG investments, to ensure that the movement leads to real, positive change, rather than boosting the profits of the asset management industry.