This paper examines how mutual funds’ portfolio holdings respond to environmental regulations. Using county-level ozone nonattainment designations induced by discrete policy changes in the National Ambient Air Quality Standards as a source of exogenous variation in environmental regulation, we find that funds underweight (overweight) those polluting stocks whose cash flows covary negatively (positively) with the regulatory shock. Our results are consistent with hedging adjustments in response to expected changes in firm fundamentals due to negative cash flow shocks stemming from the costs of nonattainment regulation. Further analysis in the post-nonattainment period shows that heavy ozone-polluting firms exposed to nonattainment designations experience worse profitability. The most underweighted of such firms also exhibit worse abnormal stock return performance and are subject to more regulatory compliance costs. Such underweighting translates into better fund portfolio performance.
