We study how mutual funds respond to ESG scandals of portfolio companies. We find that, after experiencing an ESG scandal in their portfolio, active mutual fund managers (but not passive ones) are more likely to vote in favor of ESG proposals compared to other funds voting on the same proposal, and are more likely to reduce their stakes (and hence their voting power) in high-ESG risk stocks compared to other funds holding the same stock at the same time. Both results are pronounced (a) when the stake in the scandal stock is large, (b) when the scandal is less expected, and (c) when the scandal is accompanied by more negative stock returns. Our results suggest that scandal-shocked funds manage ESG risks in their portfolios, but do not try to maximize impact. As a result, divestments may undermine engagement efforts precisely for those firms that presumably have the biggest need for reform.

We measure hedge funds’ portfolio exposures to green sentiment as measured by the returns on green-minus-brown (GMB) portfolios that track the performance of green stocks compared to brown stocks. While the aggregate hedge fund GMB beta is negative (i.e., an overall brown portfolio tilt), we find heterogeneity in green sentiment exposures that strongly predicts fund returns. A portfolio of funds with GMB betas in the top decile (“green funds”) outperform those with GMB betas in the bottom decile (“brown funds”) by 5.89% per year. Data on portfolio holdings show that the superior performance of green funds can be attributed to stock selectivity skill. A copycat portfolio of green stocks held by hedge funds outperforms a benchmark portfolio of green stocks, and holdings of put options reliably anticipate declines in green stock market valuations.