Taking company activities that generate undesirable social or environmental impacts into account with investing could improve portfolio performance, finds research by Sustainalytics.
Using analysis of so-called incidents between 2014 and 2017 to build a portfolio of stocks with the cleanest incident track records resulted in cumulative outperformance of the global equity market by 11 percentage points, said the firm.
Sustainalytics also found that a high- to severe-level incident, with the research report highlighting examples such as the Volkswagen emissions scandal in 2015, was associated with a 6% average decline in company market capitalization, when measured over a 10-day incident window — five days prior to and following an incident.
Understanding ESG Incidents: Key Lessons for Investors covered 45 incident types and found the most common issues to be related to quality and safety, and business ethics, which made up 30% of all incidents. Of the 45 incident types, the 10 most common accounted for two-thirds of all incidents in the research.
The research also identified industry sectors most exposed to incidents, with the banking industry accounting for 19% of all incidents, and found that more than 40% of incidents occur in the U.S. That was followed by the U.K., at 6% of all incidents and India at 5%.
The firm analyzed 29,000 incidents that took place across 176 countries between 2014 and 2016.
For its portfolio of top-incident performers, the firm took a market-neutral approach to build a set of 50 best-in-class names, said Doug Morrow, associate director, thematic research and co-author of the report, in a telephone interview.
This portfolio returned a total 45.9% for the period of January 2014 to October 2017, vs. a 34.9% return for the FTSE Global All-Cap index over the same period.
"There are lots of ways to backtest and to execute this investment thesis, but it shows some outperformance against the market. It might trigger investors to think about incorporating incident analysis in new ways" in terms of design and weighting of securities in portfolios, said Mr. Morrow.
He added that more research and more track record data are needed. "But it is interesting that a portfolio with best-in-class incident performance, which you could use in the same way as ESG scores … comprehensively outperformed the market. There could be a little nugget of alpha in this information," said Mr. Morrow.