* Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows Hartzmark, Samuel M. and Abigail B. Sussman, 2019

Question 1

BACKGROUND

Answer 1

Morningstar Sustainability Ratings: In March 2016 Morningstar, a leading financial research firm,
introduced sustainability ratings (based on their Environmental, Social, and Governance (ESG)
activities). Individual stocks have a fixed supply in the short run and therefore do not provide such
a direct measure of investor responses. Investors mostly look at globe ratings rather than pure
measure of percentile or sustainability score (discrete rather than continuous measures, also extremes
(1 or 5)).
Do investors value sustainability?
If a fund is generally viewed as more desirable after its rating becomes public, money will flow in to
it and it will grow = fund flows are likely to explain the sustainability preferences of investors.
Prior to the rating publication, funds received similar levels of flows, so there were no fundamental
differences. Over the 11 months after the publication $12-15 billion in assets left one-globe funds
and $24-32 billion in assets entered five-globe funds as a result of their globe rating.

Question 2

WHY DO INVESTORS VALUE SUSTAINABILITY?

Answer 2

1. Institutional constraints = Institutional investors are often obliged to hold high sustainability
   stocks or constrained not to hold low sustainability stocks (university endowment funds). Possible
   explanations for no difference between institutional and noninstitutional investors: 1.
   Institutional share classes face constraints that force them to behave like other investors. 2. Their
   preferences are similar to those of other investors.
2. Rational performance expectations: Investors might rationally believe that sustainability is a
   positive predictor of future fund performance. If investors believe sustainable funds will
   outperform the market, funds will flow to high sustainable funds. Actual evidence: inverse relation
   or no relation between globe ratings and returns.
3. Irrational Expectations and Nonpecuniary Motives. Investors might have naively assumed that
   a high sustainability rating would lead to high future fund returns OR they simply had nonmonetary preference for holding more sustainable mutual funds (e.g., altruism, warm glow,
   social motives). The authors run an experiment using high-level professionals and find that despite
   no significant differences in fund performance, risk, etc. high-globe ratings are associated with
   better future performance = the authors find evidence on irrational expectations and non-monetary motives

Question 3

REMARKS

Answer 3

The sustainability ratings of stocks do not prove to represent the financial performance of the
company, however, many investors still choose to invest in them. In the situation of an economic
downturn, stocks with a good ESG rating experience less volatility.
The reasons for choosing stocks with a good ESG standing is most likely explained by irrational
behavior and non-monetary motives.
«People were given highest morning star rated stocks in terms of ESG and asked what benefits it
could provide. Answer? High return and low risk.»