Do Sustainability Ratings Induce ESG Window-Dressing by Mutual Funds?

We find that after the initiation of Morningstar’s mutual fund ESG ratings, the implied returns from funds’ quarter-end holdings exhibit significantly higher ESG β than their actual returns. The increase in the ESG β gap between the two is greater for funds surrounding rating thresholds. ESG window dressing also leads to predictable returns. Stocks with the best (worst) ESG ratings earn significantly positive (negative) returns before quarter-ends, which reverse shortly thereafter. This pattern strengthens for stocks with higher ownership by high ESG β-gap funds. Our findings suggest that assessing funds’ ESG performance with holdings-based ESG scores brings unintended consequences.