Analyze market reactions to ESG news
FactSet recently hosted its fourth annual (virtual) ESG Academic Network Roundtable, where leading scholars from world-class universities presented findings from environmental, social and governance (ESG) research leveraging data from Truvalue Labs’ FactSet alongside other datasets. This is the first of two articles highlighting some of the papers presented, extracting actionable implications for investors and companies where relevant.
Stock Price Responses to ESG News: The Role of ESG Ratings and Disagreements
Harvard’s George Serafeim and Northwestern’s Aaron Yoon’s article, “Stock Price Reactions to ESG News: The Role of ESG Ratings and Disagreements,” showcases an innovative use of FactSet’s Truvalue Labs data. The authors present a somewhat counterintuitive argument suggesting that ESG news coverage, as measured by data from Truvalue Labs, predicts ESG ratings and, in turn, has an effect on stock prices.
The argument begins by acknowledging and confirming the widely held understanding that various ESG ratings (eg, MSCI, Sustainalytics, Refinitiv, Truvalue Labs and others) have very low correlations. Low correlations lead to widespread confusion in the market about what a “realistic” rating is for a company and how to dispel the fog of rating confusion. By focusing on how media coverage rates company behaviors, as measured by data from Truvalue Labs, they can partially see through this fog to better judge rating quality and predict (within specified parameters ) the impact on the share price.
The caveat is that the prediction effect is significantly altered for ratings that align across all vendors for a given company. Thus, the dispersion of ratings is critical for the likely impact on stock prices. Serafeim and Yoon found that the dispersed impact of rating actions is greatest when isolating the ESG categories deemed important by the Sustainability Accounting Standards Board (SASB) for the company’s respective sector.
Yoon and Serafeim construct a hypothetical long/short portfolio (using a five-factor risk adjustment) based on the dispersion results for companies with strong disagreement between evaluators. They then use data from Truvalue Labs to interpret the dispersion of ratings among other ESG raters to find the alpha in the dispersion itself. They conclude that an alpha of around 4.5% can be achieved using SASB material grades.
Clearly relevant to all asset managers, this methodology also provides companies with a means of self-reflection on the dispersion of ESG ratings for their business, and at least in theory, a means of understanding their investors’ movements.
An interesting implication not explored in this article is that ESG information (and perhaps other “new” categories of information) have a long lag (three years in this study) before the market absorbs the information as actionable knowledge. This contradicts highly simplified versions of the efficient market hypothesis, the basis of financial theory, models and practice.
A three-year lag may be an artifact of data coverage at a time when markets as a whole were just beginning to understand and integrate ESG information. In the future, this long delay could be considerably shortened. Clearly, a three-year lag is not easily achievable, calling for follow-up research with current data to see if the gap is closing and by how much. That said, even a three-year lag could be useful for longer-term ESG-focused investors.
What ESG corporate news is the market reacting to?
Yoon and Serafeim presented a second article on a similar theme during the panel discussion. “What corporate ESG information does the market react to?” examines how stock prices react to various types of ESG news.
Key points to remember:
- Share price reaction is greatest when news is positive
- More attention is paid to positive issues of social, human and natural capital
- Information important to a company’s fundamentals is more important than non-material (and therefore non-financial) information. Therefore, stock prices react to financial information rather than non-financial (“non-monetary”) information.
The authors focus on the exact ESG news that elicits a market reaction. An interesting finding from their paper is that market reaction to ESG news is generally not directly related to fundamental company operations and information, but rather to the content of the ESG news itself, primarily around capital issues. human/social and natural.
The data from Truvalue Labs had several advantages for the authors:
- Artificial intelligence and natural language processing can capture massive amounts of data with less measurement error than human analysts
- The data has a much lower selection bias
- Daily data allows an event study
Additionally, Truvalue Labs data is linked to all 26 SASB categories and captures both negative and positive information.
One of the authors’ most important findings is that news coverage (more positively oriented but also including negative news) showed statistically significant market reactions for small businesses (with adequate coverage volume). ). This suggests that the normally larger coverage of larger companies was already priced in to some degree, while for smaller companies the news was “news”. Data from Truvalue Labs allows for a granular understanding of the news markets are reacting to, as shown in the chart below, with a high positive market price reaction of 4.5% and a negative reaction of 4.0%.
The authors found that Truvalue Labs data is the only data available with daily sensitivity to market news on ESG sustainability topics analyzed using SASB criteria. They found significant alpha, especially for mid-sized companies, which are often the most difficult to obtain reliable ESG information.
The FactSet ESG Academic Network has over 120 academics worldwide who use Truvalue Labs data in their research and have produced approximately 40 articles and published papers to date.
Download the recording to hear leading academics dive into their ESG research and show how data from Truvalue Labs can be used to analyze ESG trends and events.
This blog post is for informational purposes only. The information in this blog post does not constitute legal, tax or investment advice. FactSet does not endorse or recommend any investment and assumes no responsibility for any consequences related directly or indirectly to any action or inaction taken based on the information in this article.