Losing money with a clear conscience

New research from the Monash Centre for Financial Studies exposes pitfalls for ethically-focused ‘ESG’ (environmental, social and governance) investors.

When bad news hits big companies, it’s not always just about business and the financial bottom line. As many companies have learned, there is also bad news of the ‘ESG’ variety – environmental, social and governance issues.

It wasn’t that long ago when ESG barely rated a mention in company boardrooms. These days, ethical issues are never far from the radar of big company managers and board members as they navigate the modern paradigm of having to combine social and environmental responsibility and with profitability.

The rise of the ESG phenomenon across the developed world raises many questions.  Do ESG scandals prompt companies to clean up their act? What typically happens to a company’s share price when it becomes the focus of bad ESG news? And what are the implications for share investors?

These last questions have been the focus of two recent ground-breaking studies by researchers at the Monash Centre for Financial Studies in Melbourne. The results raise significant issues about how professional investors deal with ESG events affecting listed companies.

The global ESG phenomenon

The studies are timely, coming after a period of rapid growth in the ESG phenomenon globally. Between 2016 and 2018, the total value of sustainable and responsible investment assets across Europe, the United States, Japan, Canada, and Australia/New Zealand surged 34% to $30.7 trillion.

In the first of the two studies, researchers Dr Bei Cui and Paul Docherty focused on the USA, which has led the world in the trend towards ethical investment.

Overreaction to ESG news

The researchers began with a prediction that investor bias towards ESG considerations might result in overreaction to ESG-related news.  ‘’If investors overestimate ESG risk for a stock after a bad news event, it follows that the reaction of the market will be out of step with the change in fundamentals associated with the news – and abnormal returns will result,’’ they write.

The researchers sourced information from a vast US media database to identify ESG news events affecting major listed corporations between January 2000 and December 2018. The information was then matched to share price data from the relevant period.

The results showed:

• Investors tend to collectively overreact when companies are the subject of negative ESG news, resulting in share price falls greater than justified by fundamental value considerations.

• Market overreaction is more pronounced for bad ESG news than for good ESG news.

• Investors or fund managers wishing to reduce exposure following bad ESG news can sometimes be better off waiting – in some cases up to 90 days – to execute the necessary trades.


Researchers sourced information to identify ESG news events affecting major listed corporations

The study is believed to be the first major global research project to test the extent of market reaction to ESG controversies up to 90 days after the event. Previous studies have focused on shorter timeframes.

The Monash findings largely aligned with predictions. ‘’Our prediction was grounded in salience theory, which holds that when the attention of decision-makers is disproportionately directed to one or a few factors – in this case, environmental, social, and governance issues – those factors will receive disproportionate weighting in subsequent judgements,’’ they write.

‘’Thus, when institutional investors observe a negative shock to the ESG attributes of a stock, it is expected that they will overestimate the probability of further shocks, resulting in a stronger tendency to sell, and a larger fall in the stock price than might be justified by fundamental considerations.

‘’Consistent with this proposition, our study found a negative effect on returns when negative ESG news was released, but that these returns mean reverted over the subsequent 90 days.’’

Benefits of a calm, measured approach

The findings point to the benefits for institutional investors in taking a calm and measured approach to trade around bad ESG news, rather than reacting to their initial instincts. The results also suggest that, due to market overreaction, contrarian investors may be able to profit from buying stocks after the release of negative ESG news.

But would these findings hold true for markets other than the United States?

To investigate this question, Dr Cui launched a separate study to examine the extent of ESG culture globally and to test and compare the impacts on stock prices when listed companies in various countries become the subject of environmental, social or governance news events.

She collected stock market and news data from 23 countries, including all the major economies of Western Europe and North America, as well as Australia, New Zealand, Japan and Israel, and applied the same analytical parameters as she did for the US study.  The findings were broadly similar, showing:

• Over-emphasis on ESG considerations by investors can lead to markets overreacting when companies are the subject of negative ESG news.

• Patterns of market overreaction were similar across most countries, with a few exceptions.

• Negative returns surrounding ESG events tend to ‘mean revert’ over the following 90 days.

Published on 19 Aug 2020