Between 2019 and 2022, the share of index funds with an environmental, social, and governance (ESG) mandate nearly doubled, from 3 percent to 5 percent. ESG mandates instruct funds to consider the environmental and social consequences of potential investments in addition to their expected financial returns. Many financial intermediaries, boards of directors, and corporate executives are acting as if their investors value ESG, but without quantifying the premium households are willing to pay.
In (NBER Working Paper 30708), Malcolm Baker, Mark Egan, and Suproteem Sarkar find that investors are willing to pay a premium to invest in index funds with ESG mandates. These funds track rules-based indices that resemble their non-ESG index counterparts, but that have been constructed to underweight or exclude the stocks of firms with low ESG ratings. Firms with high ESG ratings will correspondingly receive higher portfolio weight in ESG-screened funds.
Mutual funds with environmental, social, and governance mandates are proliferating, and investors appear willing to pay a premium to invest in these funds.
The researchers compile data on fund assets, flows, and returns from the CRSP Mutual Fund database, and link this information with data on ESG mandates and ratings from Morningstar, Refinitiv, and fund prospectuses. They use these data to estimate investor demand for index funds, and in particular, whether an investor who has chosen to invest in a particular class of funds, such as US large-capitalization equities, opts for a fund with or without an ESG mandate.
The findings suggest that investors are willing to pay 20 basis points more per year in fees — 0.2 percent of their assets invested in the fund — to invest in an ESG rather than a non-ESG fund. This is likely to be an underestimate of their willingness to pay for ESG stocks, which are held in fund portfolios, since there is significant overlap between the stock holdings of ESG and non-ESG funds. On average, 68 percent of the stocks held by ESG funds are the same as the stocks held by matched non-ESG funds. Adjusting for this overlap, the researchers conclude that investors are willing to pay an extra 63 basis points to invest in ESG stocks. Willingness to pay is also higher in parts of the country and for employees in industries where concerns about climate are more salient. The fees charged by ESG funds, however, are only 5.9 basis points higher than those of non-ESG funds, suggesting that only a small proportion of investors’ willingness to pay for ESG investments is captured by intermediaries in the form of higher fees.
The researchers consider two potential explanations for investors’ higher willingness to pay for ESG funds. One is that this reflects a nonmonetary psychological or social preference for ESG investments; even if the financial returns are the same on ESG and non-ESG funds, or even lower on ESG funds, investors would still prefer to own them. The other explanation, one advanced by some institutional investors, is that investing in ESG funds is a win-win proposition in the sense that ESG funds can generate higher financial returns while also furthering social priorities. This second perspective could be justified if there is a shift over time toward sustainable business practices and preferences, and if the higher future payoffs associated with these practices are not currently reflected in the share prices of firms that score highly on ESG metrics. The researchers test whether ESG funds generate higher financial returns than their non-ESG counterparts, but the limited length of their historical sample prevents them from drawing firm conclusions.
— Shakked Noy