Do mutual fund managers believe in ESG?

In the wake of greenwashing scandals and a period of relatively weaker performance, many investors are viewing “sustainable” investment strategies a bit more sober-mindedly than before. Although it has become widely recognized that one doesn’t necessarily have to sacrifice returns with ESG-compliant investments, conversely there is also mounting evidence that “green” doesn’t automatically generate an outperformance. US Mutual fund managers likewise appear to realize this.

Preferably not ESG when one’s own money is at stake

Do mutual fund managers believe in ESG? Not all that long ago, that acronym used to get uttered in the same breath with “outperformance” and/or “lower risk”, or in any case with “a better risk-adjusted return” compared to conventional investment strategies. In the meantime, though, the green investment universe is no longer unconditionally being viewed through rose-tinted glasses. Nevertheless, it would be interesting to find out how it is really seen by those professionals who handle billions each day and are ultimately responsible for the investment decisions in the portfolios of institutional or wealthy private clients. A study published in February by the University of St. Gallen¹ investigated precisely this question using a sample of 1,273 broadly diversified, actively managed mutual funds in the USA.

The study specifically examined whether mutual fund managers who invest their own money in the strategy or product that they manage bet more or less on stocks that have good sustainability ratings. The design of the study was based on an underlying understanding that managers who have skin in the game invest in line with their own utility function and, in so doing, disclose their own belief systems, thus also in relation to sustainability investing. Similarly structured studies in the past have already shown that portfolio managers who have their own money at stake in their funds bet less frequently on lottery-like (highly speculative) stocks, take fewer risks, and tend to deliver a better risk-adjusted performance compared to other managers. The findings of the latest investigation may astonish you: the portfolios run by mutual fund managers who have skin in the game exhibit lower ESG scores – the higher the amount of a managers’ own capital invested, the poorer the ESG performance. When managerial ownership in funds was increased, holdings of ESG-oriented companies in portfolios were further reduced. Moreover, co-investing managers tended to overweight stocks with problematic ESG issues and to underweight stocks with no ESG controversies or risks.

Demand (and higher fees) drives supply

The negative correlation between a manager committing his own money to the investment strategy he runs and the sustainability attributes of the stocks selected gives reason to suspect that US mutual fund managers do not believe that ESG criteria produce a performance-boosting effect. Why, then, are sustainability funds enjoying constant net capital inflows, and why are new ESG investment products continually coming onto the market? The trend appears to be driven from two sides. On the one hand, investors have been exhibiting a steadily growing interest in the sustainability theme for years now. Many would like to use their investment capital to make a contribution to a more sustainable future. The fact that their earnest desire is being exploited by a number of black sheep in the mutual fund industry to promise investors a green pie in the sky is an adverse side effect of the ESG megatrend. In any event, the vibrant demand on the part of investors is a principal cause of the growing supply of ESG investment products. On the other hand, investment products in a sustainability wrapper are also attractive for the financial industry because they can be sold to the public at significantly higher prices in some cases. It’s a poorly kept secret in the industry that ESG perhaps does less good for mankind and our environment than predominantly gets promised, but is above all lucrative. The study by the University of St. Gallen confirms that incentives ultimately have a co-determining influence for or against an ESG tilt because although US mutual fund managers do not appear to be great believers in ESG, they nevertheless invest comparatively more in stocks with high ESG ratings if their compensation depends on the size of the assets under management in their respective investment products. They thus are well aware of the marketing impact of ESG. On the other hand, if a mutual fund manager’s compensation depends solely on the performance of the investment product (versus a defined benchmark, for example), the manager invests less in stocks with good ESG scores.

Sustainability without conflicts of interests

What does this analysis – which refers exclusively to the US market, mind you – imply for investors? It suggests that whoever wishes to invest sustainably must be aware of the risk that his or her needs may not be adequately met by some fund managers if they pursue their own interests due to corresponding incentive structures. The study also makes it clear yet again that investors should definitely be conscious about the costs of ESG products. In our view, sustainability-oriented portfolios should not be significantly more expensive than conventional strategies. Moreover, one can avoid the fund industry’s conflicts of interests by choosing providers that preclude misincentives right from the outset. Kaiser Partner Privatbank belongs to this category of independent asset managers. We differ from the fund industry not just with regard to potential conflicts of interests, but unlike the mutual fund managers described above, we also firmly believe that a resolute ESG strategy can reduce investment risks and enables investors to earn a superior risk-adjusted return.

*1) V. Orlov, S. Ramelli, A.F. Wagner: Revealed Beliefs about Responsible Investing: Evidence from Mutual Fund Managers