This paper analyzes the drivers and consequences of active stock trading decisions made by ESG and conventional mutual funds using a global sample of holdings from 2014 to 2022. By decomposing trades into discretionary and expected components, we examine how fund managers incorporate both backward-looking ESG ratings and forward-looking ES incidents into their portfolio allocations. We find that while both fund types deem ESG information financially material, ESG funds exhibit a significantly stronger propensity to trade on ESG
ratings. However, we identify a critical ”ESG constraint”: relative to conventional funds, ESG funds appear less flexible in trading away from stocks with negative ES incidents when those firms maintain high aggregate ESG scores. Interestingly, we find that this lack of flexibility is costly; a greater propensity to trade on high ESG scores is associated with reduced risk adjusted performance for ESG funds compared to conventional funds. Nevertheless, investors reward ESG funds for preempting future ES incidents and maintaining high-ESG profiles, even when these trades do not generate risk-adjusted returns. Our results suggest that ESG fund
managers face a trade-off between maximizing discretionary trading returns and meeting the non-pecuniary mandates of their investor base.
