Do ESG funds make stakeholder-friendly investments?

Review of Accounting Studies https://doi.org/10.1007/s11142-022-09693-1 Do ESG funds make stakeholder-friendly investments? Aneesh Raghunandan 1 & Shiva Rajgopal 2 Accepted: 28 May 2022 # The Author(s) 2022 Abstract Investment funds that claim to focus on socially responsible stocks have proliferated in recent times. In this paper, we verify whether ESG mutual funds actually invest in firms that have stakeholder-friendly track records. Using a comprehensive sample of selflabelled ESG mutual funds (as identified by Morningstar) in the United States from 2010 to 2018, we find that these funds hold portfolio firms with worse track records for compliance with labor and environmental laws, relative to portfolio firms held by nonESG funds managed by the same financial institutions in the same years. Relative to other funds offered by the same asset managers in the same years, ESG funds hold stocks that are more likely to voluntarily disclose carbon emissions performance but also stocks with higher carbon emissions per unit of revenue. Despite these findings, ESG funds hold portfolio firms with higher average ESG scores. We show that ESG scores are correlated with the quantity of voluntary ESG-related disclosures but not with firms’ compliance records or actual levels of carbon emissions. Finally, ESG funds appear to underperform financially relative to other funds within the same asset manager and year, and to charge higher fees. Our findings suggest that socially responsible funds do not appear to follow through on proclamations of concerns for stakeholders. Keywords Social responsibility . ESG . SEC . Environmental and labor laws . Mutual fund . Violation tracker JEL classification M14 . G23 . G34 . M41 * Aneesh Raghunandan Shiva Rajgopal 1 London School of Economics, London, UK 2 Columbia Business School, New York, USA A. Raghunandan, S. Rajgopal 1 Introduction In March 2021, the Securities and Exchange Commission (SEC) created the Climate and ESG Task Force to proactively identify misconduct related to environmental, social, and governance (ESG) issues.1 The taskforce was created in response to a recent explosion of interest in incorporating ESG factors into investment decisions. The asset management industry has responded to the demand for ESG investing by launching numerous “socially responsible” funds that nominally account for factors considered important to a firm’s overall sustainability: the environment (e.g., carbon emissions), social issues (e.g., employee treatment), and governance (e.g., executive compensation). According to the U.S. Forum for Sustainable and Responsible Investing, more than $12 trillion of assets under management (AUM) is explicitly linked to ESG issues. The availability of ESG funds is growing rapidly; Morningstar documents a nearly 50% increase in the number of ESG funds available in the United States from 2019 to 2020 alone. However, the creation of the SEC’s new taskforce represents regulatory concern that ESG funds are not providing asset owners with products that actually reflect concern for stakeholder welfare. In April 2021, the SEC stated that it had identified several asset managers that were misleading investors by marketing funds as ESG-friendly but not making investment decisions consistent with such marketing or,2 in some cases, even having a mechanism to “reasonably track” or screen portfolio firms’ ESG performance.3 This concern is shared by many members of the asset management industry. For example, in a recent op-ed, BlackRock’s former Chief Investment Officer for Sustainable Investing, Tariq Fancy, states,4 “Our messaging helped mainstream the concept that pursuing social good was also good for the bottom line. Sadly, that’s all it is, a hopeful idea. In truth, sustainable investing boils down to little more than marketing hype, PR spin and disingenuous promises from the investment community.” In this paper, we therefore attempt to verify whether ESG-oriented funds’ claims of picking portfolio firms that exhibit superior treatment of all stakeholders (as opposed to shareholder primacy) are borne out by the evidence. Our empirical approach focuses on whether self-labeled ESG-oriented mutual funds, as identified by Morningstar, invest in firms that have better track records with consumers, employees, the environment, taxpayers, and shareholders. We assess firms’ track records with respect to these groups of stakeholders based on fundamental measures of their behavior – or misbehavior – toward each group. Our primary measure of stakeholder-centric behavior is portfolio firms’ compliance with social (e.g., labor or consumer protection) and environmental laws. We also consider several other measures of stakeholder-centric behavior: carbon emissions, CEO compensation, board composition, and managerial entrenchment. To ensure that our results are not driven by heterogeneity in asset managers, we limit our main analyses to funds issued by financial institutions that also issued at least one non-ESG fund in the same year; i.e., we compare ESG funds to non-ESG funds 1 https://thehill.com/policy/finance/541689-sec-creates-task-force-for-climate-esg-violations https://www.wsj.com/articles/sec-review-highlights-potentially-misleading-esg-practices-among-funds11618019507 3 https://www.reuters.com/article/us-usa-sec-esg-idUSKBN2BW2SZ 4 https://www.usatoday.com/story/opinion/2021/03/16/wall-street-esg-sustainable-investing-greenwashingcolumn/6948923002/ 2 Do ESG funds make stakeholder-friendly investments? managed by the same financial institutions in the same year.5 We begin with a comprehensive list, published by Morningstar, of mutual funds based in the United States that self-identify as ESG-oriented. We emphasize that although the list is compiled by Morningstar, it does not reflect Morningstar’s determination of which funds qualify as ESG-oriented. Rather, Morningstar is simply providing an aggregated list of self-identified ESG funds, primarily based on those funds’ prospectuses, fund reports, and websites. While there is substantial heterogeneity in how individual ESG funds claim to select stocks, our reading of several ESG funds’ prospectuses, summarized in Appendix A, suggests that the funds’ stock selection process can roughly be characterized as drawing on both ESG factors and valuation attributes (e.g., value or momentum). However, the funds largely characterize these two sets of criteria as distinct rather than interrelated, in many cases even cautioning that financial performance may suffer as a result of incorporating ESG factors into the investment process. After applying screens for data availability, we identify 147 distinct mutual funds, issued by 74 distinct asset managers, over the period 2010–2018 that claim to be ESGoriented. We track the stakeholder-related behavior of stocks included in and added to these funds, relative to stocks held by 2428 non-ESG funds run by the same financial institutio (...truncated)