We model competition among funds with diverse Environmental, Social, and Governance (ESG) mandates and conventional funds, when investors have heterogeneous sustainability preferences. We characterize an equilibrium with segmentation, in which ESG funds cater exclusively to sustainability-minded investors, while conventional funds target only ESG-neutral investors. The model predicts that conventional funds survive only if they are of high quality. In contrast, underperforming ESG funds can persist due to the presence of investors with heterogeneous ESG preferences. Moreover, we show that competition from conventional funds is essential to curb the potential for ESG funds to set high fees and reduce investors’ welfare. Our findings contribute to the ongoing debate on the consequences of asset managers’ sustainability mandates by showing how sustainable investing can weaken fund competition.
