On the role of sustainability in European fund pricing using morningstar ratings

Abstract

This paper tests whether introducing the sustainable investment effect may be considered an additional variable for both Fama & French’s three-factor model and Carhart’s four-factor model so that the performance of asset pricing models can be improved. The sustainable investment effect is captured by a newly created sustainability factor, which is constructed using European open-ended mutual funds data from October 2018 to January 2022, rated by the Morningstar Sustainability Rating (MSR). The results indicate that (1) Green labelled funds outperform the returns of red labelled (unsustainable) funds on average. (2) Socially responsible mutual funds outperform regular funds during market decline, but underperform traditional funds during economic booms. (3) Investing is transitioning away from red-labelled funds toward green-labelled ones. (4) The Fama & French’s three-factor model acquires a higher explanatory power than the CAPM. (5) Carhart’s model does not suppose a major increase in performance over the Fama & French’s three-factor model results. (6) Sustainable investment effect introduction in both Fama and French’s three-factor model and Carhart’s four-factor model merely increases the efficacy of expected returns estimation. However, its major impact on expected fund returns must be underlined. (7) Its significance, loading and sing vary among MSR fund groups. Red labelled funds are the ones with a negative, highest in absolute value and significant sustainability beta, whereas green labelled funds are the ones with a positive, lowest in absolute value and insignificant sustainability beta.