Mitigating Contagion Risk by ESG Investing

Abstract

We study whether ESG investing may mitigate the risk of contagion among equity mutual funds. More precisely, we measure the impact of fire-sale spillover, propagating throughout the financial system, on funds ranked on ESG aspects. We compare the relative loss of capitalization experienced by high- and low-ranked funds. Contagion, which is indirect since funds are not exposed to counterparty risk, is modeled using a network structure. In cases of deleveraging from funds, fire-sale spillover propagates throughout the network because of common asset holdings among funds. We find that funds’ vulnerability to contagion decreases when the level of ESG compliance increases. Moreover, the average relative loss is lower for the high-ranked funds than for the low-ranked ones. The small-size funds mainly drive the result. Our findings indicate that contagion is less effective for high-ranked funds. From a macroeconomic perspective, ESG investing represents a new opportunity for diversification that makes the system more resilient to contagion.