RepRisk data on ESG risk incidents, with its consistent history of 17 years, has long been on the radar of equity investors. Data granularity and a comprehensive research approach make it valuable for fundamental analysis, as well as for integration in a systematic investment process.
# I. Academic insights into active investing with RepRisk data
While practitioners are understandably reluctant to share their know-how on the construction of over-performing strategies, academic researchers, on the contrary, often appreciate knowledge-sharing and publish their results in open access. Different aspects of using RepRisk data for active investing are being covered in a number of recent academic studies, with findings summarized in this brief overview.
# II. Unlocking abnormal returns with RepRisk Index
As shown in Harjoto et al. (2020), monthly rebalanced long-short portfolios could earn significantly positive abnormal returns over the period 2007-2017, when constructed based on the systematic approach leveraging RepRisk Index (RRI) of portfolio holdings – listings of MSCI All Country World Index with market capitalization of over USD 100 million. Controlling portfolio exposure to traditional factors, researchers argue that portfolios of companies with high reputational risk (high RRI) tend to underperform, compared to portfolios of companies with no reputational risk (low RRI).
# III. Enhancing performance using RepRisk ESG scores
Martin et al. (2022) continued exploring the use of RepRisk data for systematic investing and published results of backtesting several investment strategies. Portfolios based on S&P500, STOXX 600, and SPI were constructed for the period 2010-2021 using RepRisk ESG scores. Combining the traditional factors with an additional ESG scores-based signal allowed researchers to achieve a significant improvement in risk-adjusted performance of simulated portfolios, compared to a benchmark.
# IV. Optimizing portfolio construction
Weibel and Iwata (2023) contributed to existing studies by demonstrating an optimization method to the portfolio construction using RRI for US companies. Keeping the same exposure of the portfolio to traditional factors as given by the benchmark (S&P 500), researchers tilted a portfolio to an increase in ESG exposure and showed that a higher sustainable performance and higher investment performance can be achieved simultaneously.
# V. Supply chain ESG risk and portfolio performance
While previously mentioned researchers were using data on all ESG incidents, Lin et al. (2023) focused their study on ESG risk of supply chains of US companies. Using RepRisk data on the number of ESG incidents linked to company suppliers, researchers showed that portfolios of companies with the least exposure to the supply chain ESG risk significantly outperformed portfolios of companies with the most exposure, thus indicating a potential for alpha-generation.
# VI. Event studies with RepRisk data
Several researchers suggested further insights for practitioners by conducting various event studies with RepRisk data. Thus, Gantchev et al. (2022) found significant negative three- and five-day abnormal stock returns around ESG incidents. Running an event study with options, Orpiszewski et al. (2023) found that implied volatility of a stock tends to increase once the corresponding company faces severe ESG risk incidents. Authors see particular value of these insights for investors considering stock options in their portfolios.
# VII. The impact of greenwashing
Further narrowing down the focus, Akyildirim et al. (2023) explored market reaction to greenwashing and showed that companies are often penalized for deceptive environmental claims with a negative abnormal stock return. Exploring the greenwashing incidents country-wise, researchers found regional differences in the results, where a stronger investor response was observed in Canada, Germany, Italy, and the US.
# VIII. Earnings forecast adjustments post-ESG incidents
Exploring the mechanisms of negative market response to ESG incidents, Derrien et al. (2022) found that analysts often do negative revision of earnings forecasts after manifestation of ESG incidents of analyzed companies. According to researchers, analysts cut their earnings forecasts primarily due to an anticipated reduction in company revenues after ESG incidents.
# IX. E&S-conscious investors and stock price movements
Analyzing investor exits after ESG incidents, Gantchev et al. (2022) pointed out that E&S-conscious investors may react to ESG incidents more often or more determinedly than others. Consequently, stock prices of companies with a larger proportion of E&S-conscious investors may decrease as a result of associated sell-offs.
# X. Linking ESG incidents to a company's cost of equity
Interesting results were also shown in Becchetti et al. (2023), suggesting that ESG incidents captured by RepRisk can be linked to the cost of equity of companies. Working with MSCI USA listings, researchers found that while an increase in RRI indicates increasing ESG risk, it may raise the cost of equity of an associated company by influencing the risk perception by market participants.
These and other academic studies provide evidence of significant potential of using RepRisk data for investment analysis and various investment approaches. Explore RepRisk Research Lab for further insights.
List of references:
Akyildirim, E., Corbet, S., Ongena, S. R. G., & Oxley, L. (2023). Greenwashing: Do Investors, Markets and Boards Really Care? Swiss Finance Institute Research Paper No. 23-90.
Becchetti, L., Cucinelli, D, Ielasi, F., & Rossolini, M. (2023). Corporate Social Irresponsibility: The Relationship between ESG Misconduct and the Cost of Equity. International Review of Financial Analysis, Vol. 89(C).
Derrien, F., Krueger, P., Landier, A., & Yao, T. (2022). ESG News, Future Cash Flows, and Firm Value. Swiss Finance Institute Research Paper No. 21-84
Gantchev, N., Giannetti, M., & Li, R. (2022). Does Money Talk? Divestitures and Corporate Environmental and Social Policies. Review of Finance, Vol. 26 (6).
Harjoto, M. A., Hoepner, A. G. F., & Li, Q. (2021). Corporate Social Irresponsibility and Portfolio Performance: A Cross-National Study. Journal of International Financial Markets, Institutions and Money, Vol. 70.
Lin, X., She, G., Yoon, A., & Zhu, H. (2023). Shareholder value implications of supply chain ESG: Evidence from negative incidents. Working paper.
Martin, W., Pramov, A., & Huwyler, D. (2022). Seeking Financial Performance by avoiding ESG Risks: Sustainable investing in the world of equities. Working paper.
Orpiszewski, T., Thompson, M., & Schwendner, P. (2023). The Stock and Option Market Response to Negative ESG News. Working Paper.
Weibel, M., & Iwata, T. (2023). A Factor-Tilt Approach to ESG Investing. The Journal of Impact and ESG Investing. Forthcoming.
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