DP15945 Sustainability or Performance? Ratings and Fund Managers' Incentives

Author(s): Nick Gantchev, Mariassunta Giannetti, Rachel Li
Publication Date: March 2021
Keyword(s): ESG, Fund flows, Mutual funds, Ratings, sustainability
JEL(s): G11, G12, G23, G24
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15945

We show that following the introduction of Morningstar's sustainability ratings (the "globe" ratings), mutual funds attempt to improve their globe ratings by increasing their demand for sustainable stocks. This trading behavior creates buying pressure, making stocks with high sustainability ratings overvalued. As a consequence, a tradeoff between sustainability and performance arises and the performance of funds improving their globe ratings deteriorates. As performance appears to be more important in attracting flows than sustainability, a new equilibrium emerges in which the globe ratings stop affecting investor flows and funds no longer trade to improve their globe ratings. Our results highlight the issues arising when funds are evaluated along two different dimensions that create conflicting incentives for fund managers competing for flows.