Low Carbon Mutual Funds
Marco Ceccarelli, Stefano Ramelli, Alexander F Wagner
Review of Finance, Volume 28, Issue 1, January 2024, Pages 45–74, https://doi.org/10.1093/rof/rfad015
Climate change poses new challenges for portfolio management. In our not-yet-low carbon world, investors face a trade-off between minimizing their exposure to climate risks and maximizing the benefits of portfolio diversification.
On the one hand, low carbon funds hold, on average, firms that are less exposed to climate-related risks than the average firm hold by conventional funds. As a result, as Panel A in Figure 1 shows, mutual funds with lower carbon risk scores hold, on average, less risky firms. However, mutual funds with low levels of carbon risk are not less risky — and can even be riskier — than those with median carbon risk. Thus, in Panel B of Figure 1, the line is flat on the left, not downward-sloping. – Why does this happen? The source of this result is the high degree of industry concentration of low carbon funds. These funds overweight IT, retail, and healthcare firms, while they underweight energy, materials, and utility firms. Overall, low carbon funds hold assets that, although individually less risky, have a high degree of covariance, limiting risk–sharing.
Investors take into account climate risks when choosing where to allocate their funds. To show this, we exploit the release of Morningstar’s novel carbon risk metrics and the new eco-label “Low Carbon Designation” (LCD) in April 2018. Funds receiving the “Low Carbon Designation” (LCD) of Morningstar enjoyed a substantial increase in their monthly flows relative to other funds. The economic impact of the LCD label corresponds to an average increase in flows of approximately 36 basis points each month through the end of 2018; this increase is equal to about two–thirds of the effect on flows caused by a one–standard–deviation stronger monthly financial performance. This differential inflow was much more pronounced for funds with higher perceived risk-adjusted returns (as proxied by Morningstar “stars”), consistent with investors taking both the benefits and the costs into account when investing in low carbon funds.
Fund managers also aim to reduce their exposure to climate risks. After April 2018, they actively rebalanced their portfolios to reduce their holdings of firms with high carbon risk scores. However, they are mindful of the under-diversification problem potentially embedded in this investment strategy. Importantly, we find that when managers reduced their positions in stocks with a score of medium or high carbon risk, they did so more aggressively for those with a higher return covariance with the remainder of the portfolio, consistent with an attempt to preserve diversification.
Overall, these findings shed light on whether and how climate-related information can re-orient capital flows in a low carbon direction.