When Investors Call for Climate Responsibility, How Do Mutual Funds Respond?

Research Retrieved: March 2019
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Issue

The action plan for sustainable finance, proposed by the European Commission, has the purpose of progressing towards the climate goals agreed to in Paris. It includes the introduction of a uniform eco-label for financial products across the European Union. This label is aimed at assisting climate-conscious individuals in aligning their investments with their social preferences. For this to be successful, it is important to know whether the existence of an informative label alters behavior of retail investors and financial professionals in a way that moves finances towards more sustainable companies. The authors investigate whether this is the case.
In April 2018, the investment platform and financial advisor Morningstar introduced a new eco-label for mutual funds, the Low Carbon Designation (LCD) label. This label is awarded to mutual funds that have low exposure to carbon risk and fossil fuel involvement. Hence, this label is distinct from the Morningstar “Globes”, which only provide a generic sustainability rating. The authors assess whether the unexpected introduction of this eco-label affects fund flows and investing behavior of fund managers.

Key Findings

  • The LCD label significantly increases monthly fund inflows. Funds that attained the label on average enjoyed a 38 basis points increase in their monthly net inflows, compared to funds without the label. The effect is economically important: when compounded over the 8 months from May through December 2018, this premium corresponds to a cumulative increase of 3.1% of assets under management, equaling around USD 5.3 million for the median-sized LCD fund in the sample. The effect is stronger for European funds, where labeled funds enjoyed an overall increase in assets under management of 3.7% compared to non-labeled funds. These findings hold controlling for many other factors, including the generic sustainability “Globes”.
  • Losing the LCD leads to similar-sized flow effects. Funds that received, or lost, the LCD in the quarterly updates that followed the initial publication also experienced similarly sized flow effects.
  • The effect of the LCD label affects behavior of fund managers. Funds that had barely missed receiving the label re-balanced their portfolios towards more climate-friendly companies compared to fund managers that barely got the LCD. For example, compared to managers of funds that just received the LCD, non-recipients at the threshold reduced their portfolio fossil fuel involvement by 0.56 percentage points during the two quarters after the label was introduced. The strategic response of fund managers is also influenced by within-fund-family considerations: fund managers are most inclined to improve on climate performance when they are part of small families in which many peers received the LCD. This is consistent with fund managers competing within a family, not only on performance, but also on the inflows of climate-conscious clients.
  • Funds exhibited this re-balancing behavior more where the expected rewards in terms of fund flows were greater. The re-balancing efforts of fund managers are proportional to the LCD rewards experienced by similar funds when the label was first released. Retail, poor-performance, conventional, and low-sustainability funds re-balanced their portfolios more aggressively to improve on climate performance than institutional, high-performance, socially conscious and high-sustainability funds.

Relevance for Practice

A preference for climate responsibility of individual investors drives mutual fund flows. This relation depends on whether information is easily available to individual investors. This provides evidence that the introduction of a uniform eco-label for financial products across the European Union may assist in meeting the climate goals agreed to in Paris.