Sustainability or Performance? Ratings and Fund Managers' Incentives

We explore how mutual funds react when the tradeoff between sustainability and performance becomes salient. Following the introduction of Morningstar’s sustainability ratings (the “globe” ratings), mutual funds increased their holdings of sustainable stocks in order to improve their globe ratings. This trading behavior created buying pressure, decreasing the returns of stocks with high sustainability ratings. Consequently, a tradeoff between sustainability and performance emerged. Since performance appears to be more important in attracting flows than sustainability, in the new equilibrium, funds do not trade to improve their globe ratings and the globe ratings do not affect investor flows.