Study suggests US funds used ‘window-dressing’ to boost Morningstar ESG ratings

Fund managers increased exposure to ESG stocks before making mandatory disclosures, say researchers.

New research suggests that US asset managers may be timing the sale and purchase of sustainable stocks to inflate ESG fund ratings provided by Morningstar.

According to a paper by the Centre of Economic Policy Research (CEPR), just over half of US sustainability-themed mutual funds assessed in a study increased their exposure to ESG stocks immediately before they were required to make mandatory portfolio disclosures and subsequently reallocated towards higher-paying assets.

Researchers found that the funds exhibited 31 percent higher exposure to ESG assets prior to making portfolio disclosures, compared to afterwards. It is estimated that the practice was common among 100 to 120 US ESG funds.

The paper looked at a total of 197 US mutual equity funds which either had a clear reference to an ESG mandate in their name or were listed as sustainable by the US Forum for Sustainable and Responsible Investment (US SIF). It excluded passive ETFs and index funds, and assessed the period between the introduction of Morningstar Sustainability Ratings in 2016 to 2021.

In the US, portfolio disclosures made in the third month of every quarter are released publicly via the Securities and Exchange Commission. The filings are used by Morningstar to calculate its Sustainability Ratings.

The ratings product was chosen by researchers as it is “arguably the most followed”.

The paper found that daily returns reported by ESG funds reflected that of major ESG benchmarks during periods of public disclosures, and began diverging immediately following disclosures. Funds reported higher daily returns when they were not required to make public disclosures.

Funds which engaged in the behaviour, which the researchers dubbed “green window-dressing”, showed improvements in their Morningstar ratings in line with the degree of their increased exposure to ESG stocks during disclosure periods.

The same funds also received investment flows that were 80 percent higher compared to the average three-month flows reported by other ESG funds.

In further support of the findings, class-leading ESG stocks were found to generate abnormal returns in a three-day window before fund disclosures, attributed to “price pressure from a surge in demand rather than fundamental news”. This reverted to zero shortly after disclosures.

In contrast, share prices of controversial stocks – those in the bottom 20 percent of ESG ratings – showed significant negative price pressure during the disclosure periods, which also reversed subsequently.

“The results suggest that funds switch from controversial to responsible stocks shortly before disclosing their positions, only to revert back to controversial stocks immediately afterwards,” said researchers.

No evidence of window-dressing was found prior to the introduction of the Morningstar ratings.

Morningstar staff working on ratings methodologies said that it would take a significant amount of time to determine if the claims were accurate, in comments made to Responsible Investor.

“There appears to be potential for several other factors to be captured in the results, some of which could be operational and specific to asset managers,” they said.

This includes operational processes caused by additional requirements to hit ESG target scores by funds, the use of front running tactics to generate returns from stocks which could be added to passive ETFs or last-minute rebalancing to address “natural drift” in their ESG scores.

Rebalancing within a small universe of stocks could also create a magnified effect on prices, they added.

The research was co-authored by EDHEC Business School academics Gianpaolo Parise, a former BIS economist, and Mirco Rubin.

“The only remedy, as far as I see it, is more transparency,” Parise told RI. “Funds should disclose more information and more frequently.”

When asked to name specific funds or managers, Parise said that the study was designed to assess overall market performance and was not capable of identifying specific instances of greenwashing.

“We can say that funds engage in window-dressing on average, but we cannot say for an individual fund with certainty whether it is doing this or not, and we would not want to speculate.”

Commenting on the study, University College Dublin academic Andreas Hoepner said: “While the study is not able to conclusively prove intentional window dressing by ESG funds, it does a pretty good job of showing that the risk of it happening is there and it certainly should not be ignored.

“Investors should particularly scrutinise funds which report high average turnover, more frequent disclosures are also desirable.”

US SIF was unable to provide comment.