‘G’ Is For Governance

[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.

Evaluating Broad ESG ETFs For Governance
Given the paucity of pure governance-focused ETFs, investors and advisors to whom this matters are often left to choose among broad-based ESG ETFs, where governance is only one of three levers simultaneously being pulled.

In that case, says Balchunas, it’s important to understand whether a fund takes a “best-in-class” approach, selecting specifically for high-ESG-ranking firms; or a “best-of-the-worst” approach, where firms whose ESG scores fall below some threshold are excised from the index.

The “best-in-class” ETFs will include companies with higher governance ratings, but may not include FAANG stocks, for example.

“You have to remember your goals,” he said. “If you want to replace your whole allocation [with ESG ETFs], then maybe you want to go for beta exposure, minus some of the nasties. But if you believe ESG is an alpha generator, then you might want to go for the gold and ride the companies that get the best scores.”

Plan Of Approach
The best thing investors can do to better incorporate good corporate governance into their portfolios, said Kashner, is “understand how their asset manager votes their shares”—something that’s true of all ETF issuers, not just those offering ESG funds.

“Proxy voting has immediate impact on corporate governance,” she added.

Philipson agrees, but also cautions advisors to consider the question of whether an ETF issuer holds itself to the same standards as the companies in their ESG funds. Overwhelmingly, the answer is no.

“A lot of ETF providers use governance screens like, say, women on boards; but they don’t hold themselves to the same standard,” she said. “It’s super hypocritical.”

That’s led Philipson’s firm to eschew equity ESG ETFs altogether in favor of their own in-house approach, and to select fixed income ESG ETFs based on whichever issuer “does the least harm.” For example, she only considers bond ETFs from issuers that specialize in fixed income, like PIMCO, rather than those that invest in a range of asset classes.

“We felt that approach was a little cleaner,” she explained.

Her parting advice to advisors: Do your homework on holdings, no matter what the name of the fund or what its governance rankings might suggest: “We feel that, as advisors, we have a fiduciary responsibility to understand what we’re holding on behalf of our clients and why. We can’t just go with ‘good enough.’”