The impact of the Morningstar Sustainability Rating on mutual fund flows

Date01 June 2019
DOIhttp://doi.org/10.1111/eufm.12181
Published date01 June 2019
A
520 © 2018 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/eufm Eur Financ Manag. 2019;25:520–553.
DOI: 10.1111/eufm.12181
ORIGINAL ARTICLE
The impact of the Morningstar Sustainability Rating
on mutual fund flows
Manuel Ammann1Christopher Bauer2Sebastian Fischer1
Philipp Müller2
1Swiss Institute of Banking and Finance,
University of St. Gallen, St. Gallen,
Switzerland
Emails: manuel.ammann@unisg.ch;
sebastian.fischer@unisg.ch
2University of St. Gallen, St. Gallen,
Switzerland
Emails:
christopher.bauer@student.unisg.ch;
philipp.mueller2@student.unisg.ch
Abstract
We examine the effect of the introduction of Morningstar’s
Sustainability Rating in March 2016 on mutual fund flows.
Exploiting this shock to the availability of sustainability in-
formation, we find strong evidence that retail investors shift
money away from low-rated and into high-rated funds. An
average high-rated retail fund receives between $4.1 million
and $10.1 million higher net flows and an average low-rated
retail fund suffers from $1.0 million to $5.0 million lower
net flows than an average-rated fund during the first year af-
ter the publication of the Rating. Institutional investors react
much more weakly to the publication of the Rating.
KEYWORDS
mutual fund, sustainability, investment decisions, information
JEL CLASSIFICATIONS
G11 , G14 , G23
1INTRODUCTION
Academic research has shed light on the empirical relation between fund flows and various perfor-
mance measures,1on the divergence of this performance--flow relationship in different investor clien-
teles,2and on the marginal impact of reduced search costs through increased marketing efforts.3Much
We thank John Doukas (the editor) and an anonymous referee for their helpful comments. We also thank Daniel Höchle, Se-
bastian Utz and Florian Weigert as well as the participants of the 2017 TiF Seminar at the University of St. Gallen and the
participants of the SGF Conference 2018for their helpful remarks. We are grateful to Morningstar Switzerland GmbH for pro-
viding access to Morningstar Direct as well as a unique dataset on the entire history of the Morningstar Sustainability Rating.
1See, for example, Chevalier and Ellison (1997), Sirri and Tufano (1998), and Ivković and Weisbenner (2009).
2Del Guercio and Tkac (2002) show that institutional investors, in contrast to retail investors, punish poorly performing man-
agers by withdrawing assets under management but do not invest in recent winners proportionally.
3Sirri and Tufano (1998) show that funds which receive greater media attention and belong to larger complexes grow more
rapidly than other funds. Moreover, they document that the performance--flow relationship is most pronounced for funds with
greater marketing efforts.
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less notice has been taken of the increasing attention of investors to sustainable investments and its
impact on fund flows. While assets under professional management utilizing sustainable investment
criteria grew by 33% from 2014 to 2016, more than one in every five dollars under professional manage-
ment in the United States (approximately $8.72 trillion) is invested according to sustainable investment
strategies.4Despite this already substantial market share of sustainable investments, a recent market
survey suggests this sector may grow even further, as 75% of investors have expressed interest in
sustainable investments.5Thus, a new variable is added to the decision-making process of investors.
The role of sustainability in investments is discussed by literature linking stock and fund perfor-
mance to environmental, social and governance (ESG) criteria.6There exists, however, little empirical
evidence on the impact of sustainability on fund flows and on the use of sustainability information in in-
vestment decisions. Massa (2003) suggests that investors select funds based on performance-related as
well as non-performance-related characteristics. Statman (2008) interviews social investors and finds
that ethical, societal and religious values influence their investment decisions. He observes that this
investor clientele evaluates an investment by combining its social responsibility and return charac-
teristics. Riedl and Smeets (2017) link individual investor data to survey responses and find that the
decision to invest in socially responsible mutual funds can be explained by social preferences and so-
cial signaling rather than financial motives. Bollen (2007) argues that investors have a multi-attribute
utility function and therefore profit from owning socially responsible investments. His findings, espe-
cially a lower volatility of fund flows and a lower (higher) sensitivity of flows to negative (positive)
past performance for socially responsible investment (SRI) funds compared to convenient funds, sup-
port this framework.7Benson and Humphrey (2008) and El Ghoul and Karoui (2017) find a weaker
performance--flowrelationship for sustainable funds. Renneboog et al. (2011) agree with this result for
all SRI funds but funds with environmental screens, for which the fund flows react more sensitively to
past performance. Whereas those prior results provide indirect evidence that investors appreciate sus-
tainability, a causal relationship between sustainability and fund flows has not been established so far.
To test for such a relationship, we make use of an exogenous shock to the availability of sustainability
information: the launch of Morningstar’s Sustainability Rating in March 2016.
Economists widely recognize the complexity of consumers’ purchasing decisions in the mutual
fund marketplace by means of costly search. Retail investors face thousands of choices and often lack
access to up-to-date information on potential fund investments or are unable to process sophisticated
information. Del Guercio and Tkac (2002), Evans and Fahlenbrach (2012) and Salganik-Shoshan
(2016) all show that retail investors react to simple return measures like past raw returns, whereas
institutional investors pay attention to more sophisticated performance measures such as multi-factor
alphas. As a result, the academic literature has documented the substantial impact of information inter-
mediaries who provide free access to clearly displayed information.8Due to the ongoing debate about
the definition of sustainability and the fact that information on sustainability has been available at
4The US SIF Foundation’s ‘‘2016 Report on US Sustainable, Responsible and Impact Investing Trends’’ reports $40.3 trillion
of total assets under professional management in the USA, of which $8.72 trillion have been invested according to sustainable
investment strategies.
5The study can be found in Morgan Stanley’s 2017 edition of the Sustainable Signals series, ‘‘New Data from the Individual
Investor.’’
6Filbeck et al. (2009) provide an overview of empirical research investigating the stock performance of sustainable companies.
A comprehensive literature overview on the performance of socially responsible funds can be found in Renneboog et al. (2008)
and Capelle-Blancard and Monjon (2014).
7As pointed out by Barnett and Salomon (2006), there is a heterogeneity within SRI funds concerning their type of social
screening. Throughout this paper we will refer to SRI funds and other funds complying with ESG criteria as sustainable funds.
8Del Guercio and Tkac (2002) provide robust empirical evidence that a package of fund quality information embodied in the
Morningstar Star Rating affects investor flow independently of the influence of other common measures of fund performance.
2AMMANN ET AL.
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FIGURE 1 Google search interest in Morningstar Ratings. This graph shows the four-week moving average of the
relative Google search interest in the search terms ‘‘Morningstar Sustainability Rating’’ and ‘‘Morningstar Star Rating.’’
The dashed vertical line indicates the initial publication date of the Sustainability Rating
company level only, we expect a freely accessible rating on sustainability to have such an impact, too.
If investors have a multi-attribute utility function, as proposed by Bollen (2007), but cannot assess a
fund’s level of sustainability, they will rely on a third-party judgment in order to align their investments
to their preferences. Prior to March 2016 there was no such freely accessible and reliable information.
With the publication of its Sustainability Rating, Morningstar, one of the leading information
providers in the mutual fund industry, has transformed sustainability from a difficult-to-grasp char-
acteristic into an easy-to-understand figure. Morningstar’s Sustainability Rating measures a fund’s
conformity to ESG criteria and assigns each mutual fund share class to a rating category between 1
(low sustainability) and 5 (high sustainability). Specifically, funds among the top 10% are assigned a
Sustainability Rating of 5, whereas the bottom 10% of funds receive a rating of 1. An analysis of the
relative Google search interest, displayed in Figure 1, reveals great attention to the Morningstar Sus-
tainability Rating, not only upon its public launch but also in subsequent months. In spring 2016, the
term ‘‘Morningstar Sustainability Rating’’ was about as popular as the well-established ‘‘Morningstar
Star Rating’’ and remained so during the next year.
The introduction of the Sustainability Rating in March 2016 constitutes a shock to investors’ in-
vestment decisions as it provides them with freely accessible information on the sustainability of a
majority of US equity mutual funds. We expect investors to adjust their investments in response to
the additional information in order to align them to their preference for sustainable investments. We
particularly expect the Rating to be informative to retail investors due to their limited informational
resources and stronger interest in sustainable investments.9Whereas institutional investors already had
access to databases providing both fund holding data and company-level information on sustainability
prior to the launch of Morningstar’s Sustainability Rating, it is unlikely that retail investors had access
to this data.
To examine our hypotheses we would ideally compare funds with a published Sustainability Rating
to comparable funds with the same but unpublished rating. Morningstar, however, simultaneously
launched its Sustainability Rating for the vast majority of mutual funds on February 29, 2016 (available
for Morningstar Direct users only) and March 17, 2016 (publicly available without cost). Funds that did
not receive a rating during those months cannot serve as a valid control group as Morningstar selected
funds that received a Sustainability Rating in early 2016 based on size and the availability of holding
9A compilation of survey evidence indicates that retail investors display a substantially stronger interest in sustainable in-
vestment strategies than institutional investors. The December/January 2016 issue of the Morningstar magazine provides an
overview of existing studies.
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