Low-carbon Mutual Funds

Abstract

Climate change poses new challenges for portfolio management. Investors face a trade-off between minimizing climate risk exposure and maximizing the risk benefits of portfolio diversification in a not-yet-low-carbon world. This paper investigates investors' and financial intermediaries' responses to this risk-risk trade-off. We analyze the fund flows and position changes of a large sample of European and US mutual funds after the release of Morningstar's carbon risk metrics in April 2018, a shock to the availability of information on climate transition risks. Funds labeled as "low carbon" experienced a significant increase in investor demand, especially those compensating for their under-diversification with high risk-adjusted returns. Fund managers actively reduced their exposure to high-carbon risk firms, especially when less costly for portfolio diversification. These findings shed light on whether and how climate-related information can re orient capital flows in a low-carbon direction.

Keywords: Behavioral finance, climate change, eco-labels, investor preferences, mutual funds, sustainable finance

JEL Classification: D03, G02, G12, G23