ESG Preference and Market Efficiency: Evidence from Mispricing and Institutional Trading

We explore how the trend towards socially responsible investing affects the informational efficiency of stock prices. The return predictability of mispricing signals is much stronger among firms held by more socially responsible institutions (SR_Is). The results are driven by the divergence of trading implications from ESG performance and mispricing signals. SR_Is are less likely to buy underpriced stocks with bad ESG performance or sell overpriced stocks with good ESG performance. We rule out alternatives, such as known limits to arbitrage. The inefficiency only emerges in recent years with the rise of ESG investing, and is not fully offset by ESG-neutral arbitrageurs due to funding liquidity constraints. † We thank Vikas Agrawal, Hendrik Bessembinder, Jennifer Carpenter, Tarun Chordia, Zhi Da, Amit Goyal, Daniel Giamouridis, Charlie Hadlock, Bing Han, Samuel Hartzmark, Michael Hertzel, Kewei Hou, Jason Hsu, Gang Hu, Zoran Ivk ovich, Hao Jiang, Kose John, Ralph Koijen, Dong Lou, Bradley Paye, Jeffrey Pontiff, Florian Scheuer, Alexi Savov, Esad Smajlbegovic, David Solomon, Boris Vallee, Patrick Verwijmeren, Neng Wang, Robert Whitelaw, Jeffery Wurgler, David Yermack, and seminar participants at China Institute of Finance and Capital Markets, Erasmus University Rotterdam, Hong Kong Polytechnic University, Korea University, NYU Stern, Michigan State University, Northeastern University, Shanghai Jiaotong University, Shanghai School of Finance and Economics, Sungkyunkwan University, and Tsinghua University for helpful discussions and useful suggestions. We have benefited from the comments of participants at the 2017 CQAsia-BoAML Conference, the 2018 Deutsche Bank Annual Global Quantitative Strategy Conference, 2018 INQUIRE Europe Autumn Seminar, 2018 Geneva Summit on Sustainable Finance, Guanghua International Symposium on Finance, 2018 Hong Kong-Shenzhen Greater Bay Area Finance Conference, 2018 Australasian Finance & Banking Conference, and 2018 Finance Down Under Conference. We also acknowledge the best paper award at the 26th Conference on the Theories and Practices of Securities and Financial Markets. The work described in this paper was partially supported by a grant from the Research Grant Council of the Hong Kong Special Administrative Region, China (Project No. CUHK 14501115). All errors are our own.