Hao Liang is Associate Professor of Finance at Singapore Management University; Lin Sun is Assistant Professor at the Fanhai International School of Finance and School of Economics at Fudan University; and Melvyn Teo is Lee Kong Chian Professor of Finance at Singapore Management University. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Max M. Schanzenbach and Robert H. Sitkoff (discussed on the Forum here); and Companies Should Maximize Shareholder Welfare Not Market Value by Oliver Hart and Luigi Zingales (discussed on the Forum here).

Responsible investment is an approach to managing assets that sees investors include environmental, social, and governance (ESG) factors in their decisions about what to invest and the role they play as owners and creditors. For investment managers, a popular way to publicly signal one’s commitment to responsible investment is to endorse the United Nations Principles for Responsible Investment (henceforth PRI). Attesting to the spectacular growth in investor interest in responsible investment, the assets under management of PRI signatories have ballooned from US$6.5 trillion in 2006 to US$86.3 trillion in 2019.

Given the unprecedented interest in responsible investment by asset owners, one concern is that some fund managers may deceptively endorse the PRI to attract flows from responsible investors while not honoring their promise of incorporating ESG into their investment decisions. According to a recent KPMG report, hedge fund managers may greenwash due to inadequate expertise, shortage of data, or skepticism about the value of ESG. Such managers could subsequently underperform given their focus on asset gathering as opposed to generating alpha. In that case, greenwashing could be symptomatic of agency problems since such fund managers clearly fall short on their dual mandate of delivering both investment performance and ESG exposure, thereby failing to maximize investor welfare. Despite the concerns voiced by practitioners and regulators about greenwashing, and its potential implications for investor welfare and asset prices, we know little about greenwashing. In this study, we fill this gap by studying greenwashing among hedge fund management companies that endorse the PRI.

To test for evidence of greenwashing, we first compute the value-weighted portfolio level ESG scores for hedge fund management companies by leveraging on Refinitiv (formerly Thomson Reuters ASSET4) stock ESG scores and long-only stock holdings data. We find that while on average hedge fund signatories feature greater ESG exposures than do nonsignatories, there is significant overlap in the distributions of their ESG exposures. Based on our estimates, a non-trivial 20.79% of hedge fund signatories or US$149 billion of hedge fund assets have ESG exposures below that of the median hedge fund firm. These results call into question the view that signatories are exemplars of responsible investment.

Next, we investigate the investment implications of greenwashing. We show first that on average hedge funds managed by investment management firms that endorse the PRI underperform other hedge funds by 2.45 percent per annum after adjusting for co-variation with the Fung and Hsieh (2004) seven factors. The results are not driven by the usual suspects that affect hedge fund performance including fund age, fund manager incentive fee, fund size, past fund performance, serial correlation, incubation bias and backfill bias.

The underperformance of hedge fund signatories can be traced to signatories that greenwash, i.e., those with low ESG scores, defined as those with bottom-tercile ESG scores and define high-ESG signatories as those with top-tercile ESG scores. Specifically, low-ESG signatory hedge funds underperform low-ESG nonsignatory hedge funds by an economically significant 7.72% per annum after adjusting for risk. In contrast, the difference in risk-adjusted performance between high-ESG signatory and nonsignatory funds is an economically modest 0.54% per annum. Moreover, signatories with low ESG exposures underperform signatories with high ESG exposures by a risk-adjusted 5.94% per year. Therefore, funds that greenwash underperform both genuinely green and nongreen funds. The findings are robust to alternative ways of evaluating investment management firm exposure to responsible companies, and are also robust to augmenting the performance evaluation model with factor-mimicking stock portfolios for ESG, CO2 emissions, and toxic emissions.

To test whether the underperformance of signatories that greenwash is related to agency problems, we redo the baseline and double sorts on hedge funds partitioned by fund incentive alignment metrics that include manager total delta, the ratio of fund management fee to performance fee, and fund governance score. Prior work suggests that funds with low manager total deltas, high management fees to performance fees, and low governance scores are more susceptible to agency problems. Consonant with the agency view, we find that the underperformance of hedge fund signatories with low ESG exposures is larger for precisely such funds.

To address endogeneity concerns, such as unskilled hedge funds endorsing the PRI to compensate for their inability to outperform and subsequently mismanage ESG implementation, we exploit the staggered adoption of stewardship codes in the different countries where hedge funds are based. The stewardship codes, either mandated by regulators or proposed by industry associations, ratchet up the pressure on fund managers to improve engagement and transparency, thereby making it harder for them to engage in greenwashing. In line with this view, we find that the ESG exposures of low-ESG signatories increase in the year post stewardship code adoption relative to the prior year. If greenwashing leads to fund underperformance via the agency channel, insofar as the codes help align incentives at such funds with those of socially responsible investors, we expect that the adoption of the stewardship codes will ameliorate the underperformance of funds that heretofore indulged in greenwashing. This is precisely what we find: low-ESG signatories underperform less in the year following the adoption of such codes.

Do investors discriminate between signatories that greenwash and those that are genuinely green? We find that after adjusting for past fund performance and other usual suspects, signatories attract an economically and statistically meaningful 20.20% more flows per annum than do nonsignatories. These results suggest that PRI endorsement facilitates asset gathering. More interestingly, low-ESG signatories attract as much fund flows as do high-ESG signatories after controlling for past performance and other factors that affect flows. Moreover, there is also no discernible difference in the sensitivity of flows to past performance for low- versus high-ESG signatories.

Does greenwashing provide insight into other aspects of managerial opportunism? We show that signatories with low ESG exposures exhibit greater operational risk. Specifically, low-ESG signatories are more likely to disclose new regulatory actions as well as investment and severe violations on their Form ADVs, suggesting that they deviate from expected standards of business conduct or cut corners when it comes to compliance and record keeping. Moreover, they are more likely to report fund returns that feature a discontinuity around zero, a paucity of negative returns, and an extremely low correlation with style factors, transgressions that may be indicative of return misreporting and fraud. These results are broadly consistent with the agency view.

Collectively, our results shed light on the investment performance, asset gathering, and operational risk implications of greenwashing in the asset management context. The findings provide novel insights relative to research that shows that socially responsible mutual funds, venture capital funds, and university endowments underperform due to their greater exposure to socially responsible firms. By showing that managers who indulge in greenwashing underperform, we uncover a different channel, i.e., agency, which can engender underperformance in socially responsible managers. Our results suggest that financial intermediation introduces agency-induced leakages or frictions which could impede the process, by which investors’ tastes for green assets are impounded into asset prices. Given the inherent subjectivity and substantial information acquisition costs associated with ESG assessment as well as the significant heterogeneity in sophistication levels among hedge fund investors, greenwashing is likely to persist.

The full paper is available from download here.

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