When investors choose a mutual fund that claims to invest in companies with socially responsible policies, it would be reasonable to expect those funds to carry out that mission. But research conducted by Columbia Business School’s Professor Shivaram Rajgopal revealed that many funds labeled as ethical are actually more likely to invest in companies that have worse track records on major social and environmental issues than funds that are not explicitly marketed as socially responsible.

“The big finding is, these guys don’t necessarily walk the walk,” says Rajgopal, the Roy Bernard Kester and T.W. Byrnes Professor of Accounting and Auditing and chair of the Accounting Division at CBS.

Rajgopal and his co-author, Aneesh Raghunandan, an assistant professor of accounting at the London School of Economics, will publish their results in the paper, “Do ESG Funds Make Stakeholder-Friendly Investments,” in a forthcoming issue of The Review of Accounting Studies.

The researchers reviewed a sample of US mutual funds that were labeled environmental, social, and governance (ESG) investments by Morningstar, an investment advisory service, between 2010 and 2018. The ESG funds all proclaimed a focus on investing in portfolio companies devoted to overall environmental sustainability, particularly with regard to carbon emissions. The mutual funds also emphasized a focus on social issues, such as employee treatment and governance issues like executive compensation.

Rajgopal and Raghunandan identified 147 such individual mutual funds, managed by 74 different asset managers, and compared them to 2,428 non-ESG funds. Digging into the individual companies’ track records, they reviewed the firms’ emissions data as well as their history with state and federal regulators, including the Occupational Safety and Health Administration, the Environmental Protection Agency, and the Securities and Exchange Commission (SEC). Paradoxically, they found that while these ESG funds tended to hold companies that had high ESG ratings, they also had more violations of labor and environmental laws, reported higher carbon emissions, and had worse outcomes for a range of other objectives — including compliance with labor and environmental laws — than companies held by non-ESG funds that were managed by the same financial institutions in the same years, Rajgopal says.

This conflict between a stated investment goal and the actual holdings presents a thorny problem for consumers. They’ve typically chosen an ESG fund because it matches their personal goals, and they’re willing to pay above-average annual expenses for that reassurance, Rajgopal notes. 

Rajgopal considers transparency to be one of the fundamental problems the investment community and regulators should address. He believes advisers and regulators need to help investors better understand how a fund manager selects companies for the fund and defines their ESG track records. “ESG ratings are a black box and methodologies are not obvious,” he says. That opacity can be oversimplified when marketing ESG funds to consumers.

“It boils down to a bigger problem, which is labeling,” Rajgopal says. “If you go to a grocery store and you’re trying to buy eggs, we have the exact same labeling problem: What is cage free? What is natural? What is organic? What is free range? Who is checking these labels?  It’s the same issue if you’re a retail investor trying to buy funds.” Actually, some labels for eggs are regulated, while US mutual funds claiming an ESG focus are not — at least not yet. The SEC has just passed a truth in labeling rule stating that 80 percent of investments in a fund should reflect the label under which the fund is marketed.

“One of the big issues in the sustainability space is sometimes the talk and the labeling doesn’t match the actions,” Rajgopal says. “We try to get to the fundamentals: What does ESG actually mean?” That’s one of the reasons Rajgopal evaluated portfolio companies based on publicly available data that can be replicated by others. The open data, unlike opaque ESG ratings, allow others to join the discussion, perhaps leading to agreements and standards.

The need to define standards and labels for ESG investments will likely become a growing concern as this area of the market continues to expand. The US Sustainable Investment Forum estimates that more than $8 trillion in assets were under management in ESG-related investments at the end of 2022. And Morningstar reported the number of ESG funds in the United States increased fourfold from 2010 to 2020, with the largest jump of 71 new funds added in 2020, a 30 percent increase from the year before.

“The aware consumers are probably not fooled,” Rajgopal says. “Some people understand this is messy and noisy — they know they’re picking perhaps the best among the worst and are aware they’re probably paying a higher fee.” But overall, investors may not be getting the value they sought. 

“Investors are voting with their money and effectively buying what they think is a company that has a positive impact on society and the world,” Rajgopal says, adding they certainly don’t expect to be paying more to support companies doing worse.


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