ESG and Mutual Fund Competition

Abstract

We model competition among conventional funds and funds with diverse Environmental, Social, and Governance (ESG) mandates when investors have heterogeneous sustainability preferences. We characterize an equilibrium with segmentation, in which ESG funds cater exclusively to sustainability-minded investors, while conventional funds target only ESG-neutral investors. The model predicts that conventional funds survive only if they are of high quality. In contrast, underperforming ESG funds can persist due to the presence of investors with heterogeneous ESG preferences. Moreover, we show that competition from conventional funds is essential to curb the potential for ESG funds to set high fees and reduce investors' welfare. Our findings have implications for understanding ESG investor behavior, ESG fund performance, and the ongoing debate on the consequences of asset managers' sustainability mandates.