With the emergence of vociferous and watchful online communities, stocks have become more sensitive to environmental, social and governance (ESG) controversies breaking online.
- Quantitative research shows that stocks that are associated with a higher level of controversial online chatter underperform.
- Research also shows that portfolio volatility is affected by controversial media reports.
- Real-time natural language processing (NLP) can be used to analyse chatter on social forums about ESG controversies enabling emerging risks to be captured before their impact on stocks is fully realised.
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In our last blog post, we described how accounting controversies reported in the media precede negative price drift in stocks, providing an advance warning to investment risk managers.
Controversies affect stock prices, and finding them early (and avoiding them) is a key best practice in portfolio risk management.
Our aggregated ESG controversies score is a general score that reflects the percentage of all ESG-related chatter about a company that concerns its association with ESG controversies.
Importantly, this score is a relative ranking within each industry. Each industry has a similar number of companies with ESG controversy scores of 100 (lowest controversy) and 1 (highest controversy) constituents.
This relative ranking prevents bias in favour of technology stocks (which tend to have fewer ESG controversies) or away from oil and gas stocks (which are associated with more controversies).
High media ESG controversy scorers have lower stock market returns
In quantitative research, we find that stocks associated with a higher level of controversial online chatter underperform. In part one of this blog, we examined a specific type of controversy – accounting controversies.
For the study below, we used the aggregate ESG controversy score.
Our study universe included the most buzzed-about 3,000 U.S. stocks in the media each month in a monthly rotation model.
First, the average ESG controversies score was determined for each stock over the prior month. We then simulated investment returns over the following month in three hypothetical portfolios:
- The 20 percent of stocks with the lowest controversy scores (green line).
- The total basket of covered stocks (the dotted line).
- The 20 percent of stocks with the most controversies (the red line).
Each portfolio’s growth was plotted without considering transaction costs.
The U.S. stocks associated with more ESG controversies (red line) have underperformed since 2012. The spread between the highest and lowest controversies stocks was 2.3 percent annually. Additional testing statistics are detailed in the caption.
High media ESG controversy scorers have higher volatility
Portfolio volatility is additionally affected by controversial media reports.
The chart below was generated using a similar selection methodology to the study above. However, it displays the average volatility of stocks high in ESG controversies versus the lower controversy group.
The volatility is plotted in the following month, after the controversies ranking was made in the prior month. The market appears to have a long memory.
Stocks with higher ESG controversies as a percentage of all media are clearly and consistently more volatile over the next month than stocks with fewer ESG controversies. This relationship appears since approximately 2007.
Using NLP to analyse ESG controversies
Real-time news, and the online investment social communities who amplify controversial news, appear to have an impact on stock prices.
With real-time natural language processing of the discussions in these forums, data feeds based on NLP are able to capture emerging risks before their impact is fully digested into stock prices.
