Introduction

Screening portfolio firms based on their multi-dimensional ESG activities is complex and costly, therefore investors often resort to commercial ESG ratings offered by information intermediaries. This raises the fundamental question of whether investors end up relying on such ratings even when they fail to capture firms’ ESG performance. This study examines whether ESG mutual funds change their portfolio holdings in response to a mechanical change in the ESG ratings – i.e., a change independent of concurrent changes in firms’ actual ESG activities.

Data and research design

The researchers used data from the Centre for Research in Security Prices (CRSP) US Mutual Fund Holdings Database and firm-level ESG ratings from Refinitiv, KLD, and Sustainalytics. A difference-in-differences (DiD) analysis centred around the 2015 Refinitiv scores was conducted, involving 755,166 fund-firm-quarter observations.

Investor response to mechanical changes in ESG ratings

The study finds that ESG funds increase their holdings of firms experiencing a mechanical increase in ESG ratings. The probability of being selected by an ESG fund is higher for these firms compared to control firms, especially among passive ESG funds and resource-constrained active funds with fewer assets under management (AUM), larger portfolios, and lower expense ratios. The magnitude of the effect is approximately 20% compared to the unconditional mean of 0.015.

Active vs. passive ESG funds

Both ESG index funds and active ESG funds are more likely to select firms with mechanical rating increases. While the result for passive funds is expected, the result for active ESG funds is somewhat surprising, as those funds are supposed to conduct a careful examination of firms’ ESG activities.

Cross-sectional variation in active ESG funds’ resources

The propensity of active ESG funds to select firms with mechanical rating increases varies systematically with their resources. Active ESG funds with fewer resources (smaller AUM, lower expense ratios, larger portfolios) are significantly more likely to respond to mechanical increases in ESG ratings, relative to those with more resources.

Discussion of findings

The findings indicate that passive investing based on commercial ESG ratings, whether due to resource constraints or portfolio indexing, might result in portfolio allocations that do not reflect the actual ESG activities of firms. This behaviour is consistent with concerns expressed by the SEC and highlights the potential misalignment between ESG fund objectives and their actual portfolio compositions.

Conclusion

The study concludes that investors respond to mechanical changes in ESG ratings that are independent of concurrent changes in firms’ ESG activities. This behaviour is prevalent among both passive ESG index funds and resource-constrained active ESG funds, leading to portfolio allocations that do not truly reflect firms’ ESG performance​​.