The quest for higher returns with lower risk is a fundamental principle of successful investing. Study after study shows that investors can use sustainability data to identify companies that have paired higher profits with less risk and higher long-term returns. However, torpedoes in your portfolio — those sharp drawdowns in share prices that are hard to recover from — can undo all of an investor’s hard work. But which sustainability-related risks or opportunities were most likely to manifest as torpedoes, and which were most closely associated with long-term outperformance?
Good governance helped avoid performance torpedoes
To answer these questions, we grouped the companies in each sector into quintiles based on our assessment of how well they managed a selection of different risks and opportunities.[1] We then compared the outcomes for the top and bottom quintiles, to see whether the companies we rated most highly on each issue were less likely to see major drawdowns than their worst-rated peers.
The kind of issues a company is exposed to will vary depending on its business activity — the sustainability issues that could have the biggest financial impact on electric utilities or gold miners, for example, are very different from the ones that software or media companies need to worry about.[2] In contrast, governance-related risks (such as those relating to the board, executive pay, ownership and control, accounting or business ethics) are relevant for all companies. Perhaps unsurprisingly then, we found that poor performance on one of these governance issues was a frequent early earning signal for large drawdowns.
The top three key issues for signaling large drawdowns, by sector
Governance-related key issues served as the most useful indicators for avoiding large drawdowns in seven out of the 11 sectors. Our assessment of business ethics was the best signal for large drawdowns in four sectors (consumer staples, health care, industrials and real estate), while our assessment of a company’s board was the best signal in two sectors (information technology and utilities). For the financials sector, it was our assessment of accounting-related risks that was the clearest leading indicator for drawdowns.
In the remaining four sectors, social- and environmental-related issues were more significant. For example, in the materials and energy sectors, risks relating to toxic emissions and waste and opportunities in clean technology were the most useful early warning signals for drawdown risk. As we look at the second and third best signals, the dominance of governance-related issues diminishes. For example, health and safety was also an important issue in four of the 11 sectors.
Although this analysis focused on identifying the strongest leading indicators for drawdowns, in many cases fewer drawdowns was also associated with positive stock-specific contributions to performance. But which key issues gave us the best indication of long-term outperformance?
The top indicators for long-term performance varied by sector
Governance may have dominated when it came to avoiding torpedoes, but when it came to picking long-term winners, environmental and social key issues increased in importance. For example, better company performance on toxic emissions and waste was the best signal for higher stock-specific returns in the materials and industrials sectors. In health care, the best signal for stock-specific returns came from a company’s approach to improving access to healthcare.
The top three key issues for long-term outperformance, by sector
Some risks mattered for drawdowns and long-term performance
As the table below shows, in many cases the best indicators for stock-specific risk were also indicators of lower drawdown risk. This makes sense given that drawdowns and stock-specific contribution are related aspects of share-price performance. Overall, strong performance was often accompanied by a lower risk of significant drawdowns. But the differences across sectors underline the importance of focusing on the most relevant issues for each sector.
Top three key issues for drawdowns and stock-specific contribution, by sector
Balancing performance and risk
Over the past 12 years we have seen a relationship between a company’s approach to different sustainability-related risks and opportunities, and the likelihood of it outperforming or seeing a sudden fall in its share price. In historical studies, there is always the risk of finding something that was there in the sample period only by pure luck. In this blog post, we have applied basic statistical methods to mitigate this potential issue. In a future publication, we plan to expand these techniques to increase the robustness of our results.
In most sectors, investors could have looked to governance-related risks to avoid sudden drawdowns. But overall, taking a sector-specific approach would have allowed for better-informed decisions, balancing long-term performance with drawdown-risk mitigation. When comparing companies within a sector, investors can use sustainability data as part of a wider strategy to seek long-term outperformance while mitigating the risk of significant drawdowns — picking the winners and avoiding torpedoes.
Endnote:
Our analysis involved creating size- and region-adjusted equal-weighted quintiles within each sector and for each key issue of the MSCI ESG ratings model. We excluded key issues that did not have significant weight in the MSCI ESG ratings methodology (i.e., those not deemed financially material). Quintiles were calculated on a monthly basis. Data start date for environmental and social key issues is September 2012, and July 2019 for governance key issues. New governance key-issue definitions and methodology were put in place in 2019 which differs significantly from previous methodologies, so a consistent governance key-issue dataset from 2012 was not possible to obtain. We chose to use the shorter time series, but with a more recent methodology. The end date is August 2024 for all key issues. We then compare the top (Q5) and bottom (Q1) quintiles in two main aspects:
- Drawdown Risk: We evaluate the frequency of large drawdowns (exceeding 50% over the course of the next 3 years) in Q1 and Q5, calculate the statistical significance (t-stat) of the frequency differences. We then plot the relative percentage decrease of frequency between Q1 and Q5. With this definition, negative decrease means that the drawdown frequency increased. Key issues are then sorted by the statistical significance of the frequency differences. We refer to this type of risk as “event risk.”
- Long-Term Performance: We measure the annualized performance difference between the highest (Q5) and lowest (Q1) quintiles, adjusting for known systematic equity factors using the MSCI GEMLT model. We also assess the statistical significance (t-stat) of these performance differences and rank key issues accordingly. We refer to this type of risk as “erosion risk.”
Community relations and tax-transparency key issues were excluded from the study because of their short history of data coverage.