The goal of this master's thesis is to investigate whether the ambiguous relationship between the sustainability of an ESG mutual fund and its performance is due to the fact that ESG mutual funds are subject to behavioral biases. The structure of this master's thesis is divided into three parts. First, it will be investigated if global ESG equity mutual funds domiciled in Europe are subject to the home bias, that is that a too large fraction of the equity investments is invested in domestic stocks. Furthermore, it will be investigated whether ESG mutual funds are subject to a Europe bias (whether a disproportionately large fraction of the equity investments is allocated to stocks from Europe) and finally whether ESG mutual funds are subject to the industry bias (their holdings are heavily allocated to individual industry sectors).
Secondly, the financial performance of ESG mutual funds in the period from August 2017 to August 2021 was examined using the Capital Asset Pricing model (CAPM) and the Carhart four-factor model like in the most important works on ESG mutual fund performance. Furthermore, it will be investigated whether the ESG mutual funds perform worse than their unsustainable counterparts (i.e. conventional investment funds via a matched-pair sample). Thirdly, it will be investigated whether behavioral biases have an impact on the performance of ESG mutual funds and lead to possible under-diversification.
Table of Contents
1 Introduction
2 Theoretical background
2.1 ESG investing as a special form of investment
2.1.1 Fundamentals of investing, mutual Funds and fund managers in general
2.1.2 Conceptual delimitation and special features of ESG investing
2.2 Behavioral biases and their influence on investment decisions
2.2.1 Traditional finance vs Behavioral finance
2.2.2 Behavioral biases
3 Literature review
3.1 ESG investing
3.1.1 Sustainable investing and financial performance
3.1.2 Behavior of ESG investors
3.2 Behavioral biases and their potential role in ESG investing
3.2.1 Home bias and Europe bias
3.2.2 Industry bias
4 Hypothesis development
4.1 Behavioral biases of ESG mutual funds
4.2 Performance of ESG mutual funds
5 Data and methodology
5.1 Data and descriptive statistics
5.1.1 Data
5.1.2 Descriptive statisics
5.2 Methodology of measuring behavioral biases
5.2.1 Home bias
5.2.2 Europe bias
5.2.3 Industry bias
5.3 Performance measures
5.3.1 Capital-asset-pricing model
5.3.2 Carhart four-factor model
5.3.3 Characteristic based performance measure
5.3.4 Regression model
6 Results
6.1 Main results of behavioral biases in ESG mutual funds
6.1.1 Evidence of home Bias
6.1.2 Evidence of Europe Bias
6.1.3 Evidence of industry Bias
6.2 Main results of the performance analysis of ESG mutual funds
6.2.1 Performance measures
6.2.2 Impact of behavioral biases on ESG mutual fund performance
6.3 Robustness
6.3.1 Alternative measurement approaches
6.3.2 Sub-period performance
6.3.3 Performance before and after expenses
6.3.4 Robustness home bias
6.3.5 Robustness Europe bias
6.3.6 Robustness industry bias
7 Limitations
8 Conclusion
Research Objective and Topics
This master's thesis investigates whether the ambiguous performance relationship of ESG mutual funds is rooted in behavioral biases. The research explores if these funds, domiciled in Europe, exhibit specific home, European, and industry biases, and analyzes the impact of these deviations on fund performance and diversification, using asset pricing models (CAPM and Carhart four-factor) over the period from 2017 to 2021.
- ESG investing and its definition
- Behavioral finance theories vs. traditional finance
- Identification of home, Europe, and industry biases in ESG funds
- Performance analysis using CAPM and Carhart four-factor models
- Impact of behavioral biases on ESG portfolio diversification
Excerpt from the Book
2.2 Behavioral biases and their influence on investment decisions
Starting from the Prospect Theory of Kahnemann and Tversky a number of other deviations from rational investment behavior were discovered. Those systematic deviations from rationality, which let people make seemingly irrational decisions, are designated as behavioral biases. Investors which are biased often make poor decisions about timing, trading frequency and fund style and expenses which can lead to poor portfolio performance. In the course of BF research a whole range of behavioral biases have been discovered over the years. However, there is much heterogeneity in the current literature concerning the definition of behavioral biases. Some authors treat behavioral biases as equivalent to heuristics (i.e. simple rules of thumb in information processing to simplify decision problems of people) whilst others refer to them as beliefs, judgements or preferences. Pompian (2012) defines behavioral biases as "perceptual distortions of individuals that lead to irrational behaviors and flawed decisions." Even if biased individuals could process information perfectly, they would not make fully rational decisions. The biases relate to how people process information and reach decisions according to their preferences. Baker et al. (2019) on the other hand define a behavioral bias as "the inclination of people to think or feel in a certain way that deviates systematically from rationality or a standard."
Summary of Chapters
1 Introduction: Provides an overview of the growth of sustainable investing and defines the research scope regarding behavioral biases in ESG mutual funds.
2 Theoretical background: Explains the foundations of ESG investing, mutual fund mechanics, and the shift from traditional finance to behavioral finance.
3 Literature review: Reviews existing empirical studies on the performance of ESG investments and the behavioral patterns of both individual and institutional investors.
4 Hypothesis development: Derives nine hypotheses regarding the susceptibility of ESG funds to home, Europe, and industry biases and their resulting impact on fund performance.
5 Data and methodology: Describes the dataset of 340 ESG mutual funds, matching procedures with conventional peers, and the quantitative models used to identify biases and measure performance.
6 Results: Presents the empirical findings confirming that ESG mutual funds exhibit specific behavioral biases and analyzes the resulting effects on their risk-adjusted returns.
7 Limitations: Discusses factors affecting the results, such as the quality of ESG data, lack of standardized reporting, and the impact of the regulatory environment.
8 Conclusion: Synthesizes the main findings, confirming that while ESG funds show specific biases, their impact on performance varies and provides suggestions for future research.
Keywords
ESG investing, Behavioral Finance, Home Bias, Europe Bias, Industry Bias, Mutual Funds, Portfolio Performance, CAPM, Carhart four-factor model, Rationality, Market Efficiency, Sustainable Finance, Diversification, Idiosyncratic Risk, Asset Allocation.
Frequently Asked Questions
What is the core focus of this research?
The research examines whether ESG-focused mutual funds are subject to specific behavioral biases—namely home bias, Europe bias, and industry bias—and how these biases affect their financial performance.
What are the primary thematic areas covered?
The work covers ESG fund characteristics, behavioral finance theories, performance measurement through factor models, and the comparison between ESG and conventional "twin" funds.
What is the primary research question?
The thesis seeks to determine if the mixed empirical findings regarding ESG fund performance can be explained by their susceptibility to systematic behavioral biases leading to under-diversification.
Which scientific methods are employed?
The study employs a quantitative approach using the Capital Asset Pricing Model (CAPM) and the Carhart four-factor model to calculate abnormal returns (alpha), alongside multivariate regression analyses to test the impact of identified biases.
What is discussed in the main body of the work?
The main body systematically reviews literature, defines the hypotheses, outlines the methodology for data collection (using Refinitiv Eikon), and details the results of bias and performance analyses for the period 2017–2021.
Which keywords define this study?
Key terms include ESG investing, Behavioral Finance, Home Bias, Industry Bias, Portfolio Performance, and Mutual Funds.
Does the study find that ESG funds underperform?
Results are mixed depending on the model; however, the study finds that ESG funds significantly outperform their matched conventional counterparts when directly compared, though this performance is not always statistically significant when using standard benchmark models.
How does the Europe bias affect ESG funds?
The findings show that ESG funds often over-allocate to European stocks. While this increases idiosyncratic risk, it does not necessarily negatively impact performance, suggesting potential informational advantages for managers in this region.
- Quote paper
- Stefan Briehl (Author), 2022, Behavioral Biases in ESG Investing, Munich, GRIN Verlag, https://www.grin.com/document/1189888
