Do Investors Respond to Mechanical Changes in ESG Ratings?

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.