‘G’ Is For Governance

March 01, 2020

[This article appears in our March 2020 issue of ETF Report. Check out the other stories on the pillars of ESG, 'S' Is For Social and 'E' Is For Environmental]



Of the three pillars of environmental, social and governance (ESG) investing, governance is the least loved by investors.

Most ESG-minded investors have strong opinions on environmental stewardship or social impact. But corporate governance?

“I’ve never had a client actually ask me about corporate governance,” said Maya Philipson, wealth manager and principal for San Francisco-based Robasciotti & Philipson. “Most people don’t care.”

While governance doesn’t inspire the same depth of conviction as climate change or social causes, it’s still included in the ESG package for a good reason: Research (and common sense) indicate that well-run companies tend to perform better than poorly run ones. Long-term, well-run companies exhibit higher returns and more sustainable profits—with less risk of a scandal or shock that could tank the stock price.

So if you’re not factoring corporate governance into your ESG investment process, maybe you should start.

Good Governance Defined
What makes for “good” corporate governance is something of a nebulous concept. Aside from sound accounting principles—which indexers tend to break out into its own “fundamental” or “quality” factor—what distinguishes good corporate governance from bad?

Some metrics include board independence and diversity, equitable compensation levels, how a company votes its proxies, and so on. “It’s the stuff that creates a corporate environment where voices are heard and there are lots of checks and balances,” noted Eric Balchunas, senior ETF analyst for Bloomberg Intelligence.

Often, however, it’s easier to quantify governance gone wrong, in the form of bribery, corruption, fraud, and other scandals and controversies.

Most ESG ratings providers apply governance screens as part of their ranking methodologies, including a screen for severe business controversies. For example, MSCI (whose ESG ratings are featured on every ETF.com fund report) evaluates companies across nine criteria, including structural metrics such as board makeup, pay and ownership; and corporate behavior such as business ethics, tax transparency and anti-competitive practices.

ETFs Screening For Governance
As a result, most of the broad-based ESG ETFs, which rely on ESG ratings to select and weight constituents, offer exposure to stocks with “good” corporate governance.

But even those that don’t use ESG rankings to select stocks often incorporate some form of governance screen. For example, the $861 million WisdomTree Emerging Markets ex-State-Owned Enterprises Fund (XSOE) is an emerging market fund that excludes any company with more than 20% government ownership—technically a governance screen.

Paying attention to corporate governance can lead to some surprises in ESG index composition, says Balchunas, who points out the example of Berkshire Hathaway (BRK.B). The fifth-largest publicly traded U.S. company appears in almost no ESG ETFs, despite its investments in wind farms and commitment to various social causes. The reason? Berkshire’s board is only 57% independent, and its chairman and CEO are the same person.

“When you get deep into the weeds [in ESG rankings], you almost wish you could separate various segments of the business,” he said, “since the good a company does in one area can be outweighed by other factors.”

Few Governance Pure Plays Exist
Roughly two-thirds (68%) of ESG ETFs incorporate some sort of governance evaluation in their selection or weighting methodologies. The ones that don’t tend to be narrow thematic funds focusing on the renewable power space, where constituents are selected and weighted purely on the basis of green energy revenues—think the Invesco Solar ETF (TAN), as one example.

Unlike environmental stewardship or social issues, however, few ETFs—ESG or otherwise—prioritize corporate governance over all other factors. We’ve listed a few of these in Figure 1.

Unfortunately, this list is inherently a little subjective, because when it comes to corporate governance, “there’s probably little agreement on what to measure and how to measure it,” noted Elisabeth Kashner, FactSet’s director of ETF Research and ETF Analytics.

Plus, it’s worth noting that what’s true of many ESG ETFs is true for these funds as well: An ESG ETF’s overall MSCI ESG rating, which ranges from AAA to CCC, isn’t always all that great. In other words, just because an ETF tracks the governance vector well doesn’t mean it’ll also rank highly in environmental or social metrics, which could lead to a lower score overall.

Governance Performance Bump?
That said, there’s some evidence that using governance in concert with other environmental and social screens can lead to a noticeable performance bump.

Figure 2 compares the average one-year returns of ESG ETFs using a governance screen against vanilla ETFs in the same category. In each category, the governance-screened ETFs outperform the vanilla ones, sometimes by substantial margins.

It’s tough to draw too many conclusions from Figure 2. After all, these ETFs largely use broad-based ESG rankings, so perhaps it was their social or environmental stewardship that made more of a difference to their overall returns.

Still, it’s an interesting data point, and one that makes some intuitive sense: When you select for better-run companies, that quality will probably be reflected in returns.



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