Do Investors Respond to Mechanical Changes in ESG Ratings?

60 Pages Posted: 22 May 2024 Last revised: 31 May 2024

See all articles by Seungju Choi

Seungju Choi

University of Miami Herbert Business School

Fabrizio Ferri

University of Miami - Miami Business School; European Corporate Governance Institute

Daniele Macciocchi

University of Miami Herbert Business School

Date Written: May 21, 2024

Abstract

Using a quasi-experimental setting, we study whether investors respond to a purely mechanical change in ESG ratings––i.e., a change independent of concurrent changes in firms’ actual ESG activities. We find that when a firm experiences a mechanical increase in ESG ratings, the probability of being selected by an ESG fund increases (extensive margin). In contrast, if the firm is already in the fund’s portfolio, its holdings do not change (intensive margin), consistent with portfolio weighting being based on market capitalization. The selection effect is observable not only among funds that follow an ESG index but also among active ESG funds, which presumably should have the incentives and ability to identify and filter out the mechanical increase in ESG ratings. Among active ESG funds, the selection effect is stronger for funds with less assets under management (AUM), larger portfolios of firms, and lower expense ratios, consistent with the notion that resource constraints may impede a fund’s screening ability. Our findings imply that passive investing based on commercial ESG ratings––whether due to resource constraints or portfolio indexing––might result in portfolio allocations that do not reflect the actual ESG activities of firms.

Keywords: ESG, Ratings, Information Intermediaries, Mutual Funds, Portfolio Selection

Suggested Citation

Choi, Seungju and Ferri, Fabrizio and Macciocchi, Daniele, Do Investors Respond to Mechanical Changes in ESG Ratings? (May 21, 2024). European Corporate Governance Institute – Finance Working Paper No. 981/2024, University of Miami Business School Research Paper No. 4836697, Available at SSRN: https://ssrn.com/abstract=4836697 or http://dx.doi.org/10.2139/ssrn.4836697

Seungju Choi

University of Miami Herbert Business School ( email )

P.O. Box 248126
Florida
Coral Gables, FL 33124
United States

Fabrizio Ferri

University of Miami - Miami Business School ( email )

Coral Gables, FL 33146-6531
United States

European Corporate Governance Institute ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Daniele Macciocchi (Contact Author)

University of Miami Herbert Business School ( email )

P.O. Box 248126
Florida
Coral Gables, FL 33124
United States

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