Financing Nature: Investment Funds and Biodiversity Risks

How do international investors adjust portfolios in response to biodiversity risk? Using monthly data on investment fund portfolios from the commercial data provider EPFR Global and a difference-in-differences identification strategy, we show that the 2021 Kunming Declaration led fund managers to reallocate portfolios from high-biodiversity risk countries to less risky ones, while ultimate fund investors remained unresponsive. Fund managers reduced exposures to extremely high biodiversity risk without seizing low biodiversity risk as an opportunity for profit, characterizing biodiversity as downside risk factor. In economic terms, our estimates imply a decrease in portfolio capital flows into high-risk countries of up to 0.46 billion USD, or 0.45% of the median country-level annual GDP in the sample. Actively managed funds’ portfolio allocations are more sensitive to biodiversity risk shocks, as allowed by a higher tracking error relative to benchmark-bound ETFs. Moreover, funds are more likely to tilt portfolios in favor of less risky countries if the pre-KD country-specific position was underweight relative to a fund’s historic allocation. Funds with a larger fraction of share classes marketed to retail instead of institutional investors also reallocate portfolios more significantly. This is consistent with the notion that institutional investors pursue long-term investments, resulting in lower sensitivities to biodiversity risk materialization. We further show that investment funds drive cross-country spillovers as the reallocation triggers significant capital flows benefiting low-biodiversity risk countries in the same geographic region, but outside of a fund’s hitherto established portfolio. Using a novel measure of legal action to protect nature, we demonstrate that countries taking more legal acts are partially shielded from funds reducing their exposure to high-biodiversity risk countries. Policies only indirectly related to nature conservation, such as mitigating climate change and strengthening macroeconomic fundamentals, are not effective in modulating portfolio reallocations. The results are robust to a wide range of sensitivity checks.