ESG and Mutual Fund Competition

ESG and Mutual Fund Competition

How ESG disclosure affects market performance is becoming increasingly important as investors review companies’ ESG information to decide which to include or exclude from their portfolios. In recent years, capital flows into ESG investment products have grown substantially, driven by concerns for social responsibility, environmental sustainability, and long-term risks such as climate change. While many investors incorporate ESG preferences into their decisions, they also demand competitive financial returns. This dual focus on pecuniary and non-pecuniary motivations has created a new competitive landscape for mutual funds.

In this project, we aim to study both theoretically and empirically how investors’ welfare is affected by the rapid rise of ESG-focused mutual funds and the coexistence of these funds with conventional alternatives. By analyzing how do ESG funds compete with traditional funds for investors with pecuniary and non-pecuniary preferences, we will contribute to understanding investors’ preferences for sustainable investments, their determinants, their evolution over time, and how these preferences influence their financial decisions.

First, we develop a theoretical model which investors have heterogeneous preferences for sustainability and mutual funds compete to attract investors’ money. The model predicts that competition among ESG and conventional funds results in market segmentation: ESG investors allocate exclusively to ESG funds, while neutral investors choose only conventional funds. Importantly, the model also predicts that heterogeneous ESG preferences allow underperforming ESG funds to survive, and that ESG funds are able to charge higher fees (“greenium”) than conventional ones. A key implication is that competition from conventional funds benefits not only neutral investors but also ESG-minded investors, as it curbs the potential for excessive fees and performance under-delivery in the ESG segment.

Second, we aim to test the empirical implications of the model and understand whether these predictions hold in real-world data on mutual funds and investor allocations. We will quantify the welfare implications of ESG fund growth by analyzing investor returns, fee structures, and fund survival. Specifically, we will address the following research questions:
1. Do ESG funds charge systematically higher fees relative to conventional funds of similar quality and investment style?
2. Are ESG investors less sensitive to underperformance than conventional investors, as the model predicts?
3. Do conventional funds improve investor welfare by disciplining ESG funds in terms of fees and performance?
4. How have investor preferences for sustainability evolved over time, and what determinants (e.g., environmental concerns, social values, climate risk hedging) explain this evolution?
5. Is there variation in mutual fund fees or performance sensitivity depending on whether the investment objectives emphasizes one of the three pillars: Environmental, Social and Governance?
6. Are there significant differences in ESG mutual fund competition acrross Europe and the United States?

Working Plan

To achieve these objectives, the project will combine theoretical modeling with a rigorous empirical strategy:
Data Collection
— Assemble a comprehensive dataset of European and US mutual funds, distinguishing between ESG and conventional funds, including fees, flows, returns, ESG mandates, and fund attributes.
— Collect investor-level flow data to capture heterogeneous ESG preferences.
— Use ESG disclosure data to link firm-level ESG practices with fund holdings.

Empirical Analysis
— Test the prediction that ESG funds charge higher fees using cross-sectional and time-series regressions, controlling for fund characteristics and performance.
— Analyze investor flow-performance sensitivity to compare ESG versus conventional fund investors.
— Examine persistence in ESG fund performance and survival of underperforming ESG funds.
— Analyze whether there are significant differences across the three pillars regarding fee setting and flow-performance sensitivity.
— Investigate the disciplining role of conventional funds by analyzing market equilibria across periods of varying ESG fund entry and growth.

Welfare Implications
— Develop empirical measures of investor welfare combining net returns, fees paid, and alignment with ESG preferences.
— Assess whether the growth of ESG funds has improved or worsened welfare for different investor segments.
— Study whether neutral investors and ESG-oriented investors benefit more from a mixed market (ESG and conventional funds) compared to a hypothetical market dominated only by ESG funds.

This project will contribute both to the academic debate and to policy discussions on the financial and welfare consequences of ESG investing. By empirically validating the predictions of the theoretical model, it will shed light on the balance between doing well and doing good in financial markets and provide insights for investors, regulators, and asset managers.