Retail investors are paying greater attention to value-driven investment funds, but are also at risk of falling for potentially misleading ratings, a study by the Ontario Securities Commission (OSC) suggests.

Research by the provincial financial regulator found the environmental, social and governance (ESG) rating of a hypothetical fund was second in importance only to past performance. Higher ESG ratings correlated with a higher chance of selection by the subjects, hinting it is influencing investors.

But a “fairly arbitrary” distinction between assigning a letter grade or number of stars to indicate the quality of the ranking was notable, Meera Paleja, the program head of research at Toronto-based OSC, told Sustainable Biz Canada. Stars caught the attention of investors more than letters.

It suggests arbitrary factors have “disproportionate impact on investing behaviour all the time,” she said. “This is a really subtle difference that nevertheless has a downstream impact.”

The findings highlight the risk of misrepresenting a business or fund by emphasizing sustainability in marketing and disclosure but taking little to no action, also called greenwashing.

What motivated the investors

For its experiment, OSC presented 961 retail investor participants with two hypothetical investment funds carrying eight attributes including management fee and operating expenses, risk profile and name. The degree of the attributes were randomized per subject, varying how well the fund performed.

Two funds were randomly generated and presented to each participant, who would choose one in which to invest. This process was repeated 11 times. The influence an attribute had on impacting the probability of a selection was analyzed as a point of comparison.

A roughly even amount of investors were split between being driven by financial returns or values. The value-driven investors were willing to trade some fiscal gains to prioritize causes such as the climate or ethical labour practices.

Both investor types were similarly interested in factors like historical performance, the fund’s objective and risk profile. The largest divergences occurred with ESG.

Not surprisingly, value-driven investors placed more emphasis on ESG compared to their financially driven counterparts, showing more interest in funds that have an ESG rating of four stars and less demand for those with no ESG rating.

Including a plain-language explanation of the ESG rating did not influence value-driven investors as much as financially driven investors. The inclusion of a rating breakdown led to increases in interest for both types of investors, with a notable increase among financially driven investors.

The OSC believes financially driven investors could have found the ESG rating more valuable after better understanding the concept.

Opening the risk of greenwashing

Investors were not sensitive to certain ESG gaps, showing vulnerability to greenwashing, OSC said.

Respondents tended to believe the ESG rating reflected effectiveness of sustainability outcomes such as the environmental performance, when it actually measured the ESG risks to the fund – the impact ESG issues have on the organization. If a fund reported a high ESG rating but had no ESG-oriented investment strategy, the ranking still had more influence on value-driven investors. 

Using stars as opposed to letter grades made a notable difference. An ESG rating of four stars was the strongest booster of interest in a fund, performing seven per cent better than three stars. A comparative B-grade did not motivate respondents by as much, doing three per cent worse than four stars.

A three-star rating resulted in a small bump in fund interest, but a C-rating had negative influence. It's one of the few factors that had such impact.

Paleja suggested a rating lets investors “look at something and have a quick idea of what this might be,” to explain its effectiveness. But, “if it’s misrepresented, if it doesn’t actually reflect what’s in the fund, then that can have downstream negative consequences.”

By randomizing the fund attributes, some were effectively greenwashed, with mismatches between a fund that had “ESG” in the name but no sustainability strategy.

When a fund had no ESG rating, having “sustainable” in the name made it 14 per cent less likely to be chosen by participants compared to the alternative. But this effect did not carry over for fund names that contain “ESG” and “SRI” (socially responsible investing).

How to prepare for greenwashing

Research like the report is part of public education, Paleja said, so retail investors can be motivated to reflect on factors that drive investment decisions and guard against being misled. Though the study is limited to hypotheticals, raising the question of whether investors would behave in such fashion outside of an experiment, she said it contributes to the field of ESG investing to inform policies and educational outreach.

The OSC is aiming to clarify ESG definitions and ratings, she said. Standardization could help eliminate confusion, such as differentiating between ESG risk and impact, ensuring ESG ratings are consistent and comparable, and identifying greenwashing.

Finally, financial advisors can be trained on ESG investing so they can better guide clients in the sector, Paleja added.