Do institutional ESG investors suffer from negativity bias?

Research suggests tendency to fixate too much on ESG shocks, causing deeper-than-justified stock-price drops

Do institutional ESG investors suffer from negativity bias?

Institutional investors have been increasingly training their sights on ESG factors as they seek to manage risks associated with negative events. But is that mindset priming them to overreact to ESG controversies?

In a piece published by the CFA Institute, Bei Cui, PhD and Paul Docherty, PhD examined the possibility that “when institutional investors observe a negative shock to the ESG attributes of a stock, … they will tend to overestimate the probability of further shocks.” The upshot, they theorized, would be a “stronger tendency to sell and a larger fall in the stock price” than warranted by fundamental considerations.

Focusing on constituent stocks of the S&P Composite 1500 Index, Cui and Docherty looked at return data from Center for Research in Security Prices (CRSP), and took information concerning ESG news events from MarketWatch as well as a filtered search of RavenPack News Analytics’s Dow Jones Edition.

Using RavenPack’s news classification system and news sentiment methodology, they were able to product a sample of 82,435 firm-event observations, including both positive and negative events, which encompassed the period from January 2000 to December 2018.

To examine the impact of ESG news events on stock returns, Cui employed a statistical method that isolates the abnormal return attributable to the event, adjusting for returns rooted in market risk, size, value, and momentum. “To measure the returns around ESG announcements, we calculated the cumulative abnormal return (CAR) for 21 trading days centered on each news release day,” they said.

The analysis found that across all firms sampled, there was a statistically significant cumulative abnormal return of -0.773% at the 0.01 level for the 21-day window around bad news. In comparison, the average abnormal return observed around good news was insignificant, amounting to 0.0004%.

A more refined analysis that separated stocks according to size showed a clear negative abnormal return for firms subject to bad ESG news, with evidence of possible leakage of information ahead of the actual events “as cumulative abnormal returns begin occurring several days before news releases.”

Stock trading volumes also tended to increase significantly around bad ESG news, with a more marked effect observed for smaller stocks. And looking at stock price reactions across different categories of negative ESG news, Cui and Docherty found the largest negative abnormal returns for corporate governance, including force majeure, where a firm seeks to be exempted from honouring its part of a contract; discrimination defendant, when a company faces a lawsuit alleging discrimination; and antitrust suit, when the company is the subject of legal action against unfair business practices.

The study also found that in the 90-day period following announcements of bad ESG news, initial negative returns tended to give way to abnormally high returns.

“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,” Cui and Docherty explained, adding that post-decline returns were larger in magnitude for small-cap stocks.



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