Research based on Morningstar’s “globe” ratings, which measure a fund’s adherence to environmental, social and governance (ESG) standards, shows that most conventional funds indeed prioritize sustainability in their mandates, and that highly rated, five-globe funds don’t perform any better than one-globe funds.
Over the past decade, and particularly over the last several years, there has been a dramatic increase in ESG investing strategies. In fact, ESG investing (also known as sustainable investing or socially responsible [SR] investing) now accounts for more than one-fourth of total assets under management (AUM) in the U.S., with AUM growing to $12 trillion, up 38% from the start of 2016 to the start of 2018. Total assets in sustainable investing exceeded $30 trillion globally at the start of 2018, with institutions accounting for 75% of the total.
Increased investor interest has not only led to cash inflows but to heightened interest in research on ESG investment strategies. Harshini Shanker contributes to the literature with her December 2019 study, Social Preferences of Investors and Sustainable Investing. Shanker sought answers to questions such as: “Are sustainable investments the exclusive territory of a small set of so-called socially responsible mutual funds, or do conventional funds also prioritize sustainability? Are socially responsible fund portfolios more sustainable than conventional fund portfolios? Does the conventional investor in the market have social preferences? Are his preferences of a different nature than those of his socially responsible counterparts?”
To answer the questions, Shanker used Morningstar sustainability ratings, which are available on more than 20,000 mutual funds. Morningstar assigns each fund a “globe” rating ranging from one to five, with five being the most sustainable. The worst 10% and best 10% of funds receive one and five globes, respectively. Morningstar categorizes a fund as socially conscious if the fund declares a non-economic investment objective in its prospectus.
Following is a summary of her findings, some of which are quite surprising:
- A large fraction of conventional funds systematically prioritize sustainable investments, even without an explicit ESG mandate.
- The sustainability ratings of conventional funds are highly persistent over time, suggesting they did not end up with a high globe rating by accident – they consciously choose sustainability for its own sake.
- Conventional funds with above-average globe ratings outnumber the entire population of sustainable funds and manage assets roughly 3.5 times the collective value of sustainable fund assets – sustainable investing is therefore not restricted to ESG funds.
- Only 27% of five-globe funds have a self-declared SR mandate. Thus, almost three-fourths of five-globe funds deliver sustainability, even without an explicit SR objective.
- Conventional funds with four or five globe ratings collectively have 3.5 times the assets under management (AUM) of the whole universe of SR funds.
- Half the ESG fund universe is rated three globes or fewer, making their portfolios no better than an average conventional fund portfolio. And only one-fourth of them manage a five-globe Morningstar rating.
- The average globe rating of a conventional fund is 2.8, while that of an SR fund is 3.5. Thus, the one-fourth of conventional funds that are rated four or five globes are more sustainable than the average SR fund.
- There is no evidence that five-globe funds outperform one-globe funds. The result is consistent across conventional and SR fund categories.
Because Shanker found that the poor globe ratings are highly persistent over time, she ruled out that ratings are temporary and accidental. She concluded that, “these poorly rated SR funds are only pretending to be SR but systematically making unsustainable investments, i.e., they are greenwashing.” (“Greenwashing” is the process of conveying a false impression or providing misleading information about how a company's products are more environmentally sound.) Thus, in a large percentage of cases, SR investors were not receiving what they signed up for.
Interestingly, on the other hand, Shanker noted that, “conventional funds with high globe ratings are giving investors more than they signed up for.” She also found: “Conventional investors have strong social preferences. A low-globe conventional fund would need to offer roughly twice the excess return of a high-globe fund to enjoy the same level of capital flow.” She added: “While conventional investors reward high-globe funds handsomely for their social attribute, they do not proportionately penalize low-globe funds.”
Turning now to how SR investors react to the financial performance, Shanker noted: “In the category of SR funds whose financial performance is below the peer median, SR investors reward high-globe funds, indicating a willingness to sacrifice financial return for social good. However, when SR funds perform well financially, the globe rating appears to lose its relevance. The evidence is consistent with a propensity to trust an SR fund to deliver on its promise, causing the investor to fail to monitor globe ratings in general until the fund performs poorly financially. Poor financial performance elicits scrutiny and accords a salience to the globe rating, consequently allowing high-globe funds to be rewarded. However, irrespective of financial performance, low-globe funds are not punished to the same extent that high-globe funds are rewarded, and greenwashing behavior remains largely unpunished.”
These findings led Shanker to conclude: “Both types of investors value sustainability, and both react to good and bad social performance asymmetrically” – weak social performance is not punished to the same extent that strong social performance is rewarded. Her finding that there is no evidence that five-globe funds outperform one-globe funds led her to rule out that investors value sustainability due to a rational belief that sustainability predicts financial performance. They invest, she found, for “non-economic reasons (warm glow, reputation, etc.)” She also concluded: “The demand for sustainability among investors drives even conventional funds to systematically and persistently invest sustainably, with the number and size of such ‘sustainable’ conventional funds dominating the entire population of SR funds.”
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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Research based on Morningstar’s “globe” ratings, which measure a fund’s adherence to environmental, social and governance (ESG) standards, shows that most conventional funds indeed prioritize sustainability in their mandates, and that highly rated, five-globe funds don’t perform any better than one-globe funds.
