Indexing and Corporate Governance

November 26, 2003

Should index funds and ETFs focus more on corporate governance as long-term investors?

December 1, 2003

The financial scandals of 2000-2002 have changed the face of corporate America.  Amidst a spate of high profile scandals, a confluence of media critics, investors, and regulators came to the conclusion that something needed to be done about poor corporate governance.  The government responded quickly, enacting the Sarbanes-Oxley Act of 2002, and the NYSE substantially reformed its listing standards.  The Sarbanes-Oxley Act and ensuing regulations mandated director independence - especially in the auditing and compensation committees - and demanded increased overall financial transparency.

At the same time, organizations such as Institutional Shareholder Services (ISS) began ranking corporations for good corporate governance.  The ISS Corporate Governance Quotient (CGQ) rates over 5,000 American corporations, primarily according to eight core criteria: (1) board of directors (2) auditing procedures (3) charter and bylaw provisions (4) laws of the state of incorporation (5) executive and director compensation (6) qualitative factors (7) ownership and (8) director education.  Ideally, CGQ assists investors in evaluating both the independence and quality of corporate boards and the effect of governance on corporate performance.   Similar services are available from the Investor Responsibility Research Center (IRRC) and other independent assessment firms.

Institutional investors own or control over fifty percent of all of the equity of American corporations.  Thus, it is clear that institutional holdings could give major pension funds, mutual funds, hedge funds, and investment banks a stranglehold over corporate governance.  Yet, only a select few institutional investors act on the belief that shareholder involvement results in greater long-term corporate value.

Prior to the passage of the Employees Retirement Income Security Act of 1974 (ERISA), private pensions funds invested solely in the debt market.  ERISA expanded the common law prudent man standard, allowing for the evaluation of a manager's performance based on portfolio performance, not just individual investment performance.  Under ERISA, pension fund managers maintain various fiduciary duties with their stockholders, including the duty to actively monitor governance where doing so promotes better performance in fund investments.  Yet, despite private pensions' large equity holdings, most managers have not traditionally been involved in using their voting power to promote good corporate governance.  This inertia results from the combination of a belief that shareholders are traders and not owners, as well as potential conflicts of interest in generating investment banking and asset management business from portfolio companies.

Some, notably the California Public Employees Retirement System, have overseen their long-term investments' management to provide shareholder gains.  CalPERS has 8 people employed specifically to monitor companies and vote proxies.  Hermes Investment Management, a UK asset manager, is a very activist shareowner and employs 47 people to monitor companies and vote proxies.  In part, this disparity in staffing may reflect the UK's generally greater emphasis on socially responsible investing (SRI) issues and compliance, which require staff with skills outside traditional corporate governance issues, but also reveals something about the lesser importance given to corporate social responsibility (CSR) by even leading American institutional investors.  TIAA-CREF, the largest private pension system in the United States, with assets of approximately $275 billion, has actively utilized its shareholder powers to ensure better corporate governance.  TIAA-CREF managers believe institutional stockholder corporate governance programs produce better shareholder outcomes.  Both formally and informally, those managers have worked to ensure corporate director independence and financial transparency.  Sometimes, TIAA-CREF managers have been forced to fight anti-shareholder provisions, such as the "dead hand pill," and egregious corporate executive compensation.  More often, managers have worked through corporate management to better protect TIAA-CREF's investments.

The Council of Institutional Investors (CII) was set up in 1985 by leading U.S. public pension funds to coordinate the pursuit of their interests with the government, the securities industry, and money management industry.  Today, it brings together public, corporate, and Taft-Hartley pension plans; foundations, endowments and mutual funds.  Corporate governance is an important theme in much of the work of the CII.

In contrast to the varied history of private pension funds, active and index mutual funds have generally avoided using institutional holdings to promote good corporate governance.  The vast majority of mutual funds either rubber stamp management decisions or sell their investments in poorly managed companies.  Few maintain investments long enough to compel improved decision-making.  Consequently, most mutual funds' short-term strategies provide no long-term incentives to improve the corporate governance regime.    Index-based mutual funds and ETFs as long-term passive holders face a particular quandary, and responsibility, with regard to corporate governance.  The responsibility comes in that these funds will be holding all of the stocks in their underlying indexes and should promote good governance in the pursuit of the portfolio's optimal performance.  The quandary lies in the fact that index funds are generally low-fee investments, and increased focus on governance issues requires the expense of increased monitoring resources.

Index-based mutual funds, and particularly ETFs, have provided little if any pressure on companies to improve their corporate governance standards.  As of yet, for example, we do not believe ETF managers have utilized their voting rights to monitor management.  Currently available ETFs are based on indexes, which select constituent stocks/bonds for many reasons, but not (at least yet) for their CSR characteristics.  Thus there may be little motivation for ETF management and ETF shareowners to vote individual company proxies.  If the security is in the index, it usually must be in the ETF portfolio, optimization techniques aside.  In addition, the research and engagement processes necessary to apply pressure for good company governance add costs that detract from the ability of the fund to achieve index-like returns.  This is not to say that index-based mutual funds don't take their proxy voting seriously.   The major index mutual funds do have rigorous proxy-voting guidelines, and these are generally publicly available.[i]  To take the concept further, James Bicksler, in an article in The Journal of Indexes, stresses that index funds, in contrast to active investors, have long-term investment horizons and do not have the option of selling individual stocks.  As a result, Bicksler posits that index funds should find activist corporate governance strategies even more compelling as a return-enhancing tool.[ii]   This claim obviously would need to be backed up with substantial research, and back-testing such an approach would pose significant challenges and pitfalls.

In the final analysis, important questions persist. Do institutional investors, many of whom disregard their voting rights, benefit from corporate governance and consequently, stressing corporate governance in their index-based investing?  Are corporate governance and long-term shareholder gains inherently linked?  Moreover, even if they are, do positive and negative corporate governance ratings equally predict long term shareholder value?  The results are unclear and worthy of further research.  Moreover, even assuming a link between good corporate governance and shareholder value, some of the current metrics may be less useful than advertised.  Critics point out that check-the-box ratings may disregard some of the subtleties of corporate governance and thereby inflate the ratings of some companies.  For example, "resume" director independence may hide deep connections between directors and management.

Anecdotal evidence suggests that poor governance does undermine shareholder value.  Director-management relationships and conflicts of interest transactions contributed in great part to the Adelphia and Enron collapses.  Yet, armed with a seemingly independent board and a then-accredited auditor, Enron may have scored well on the CGQ.  Consequently, while a low CGQ rating may accurately predict poor shareholder returns, a high CGQ rating may not necessarily be correlated with future shareholder returns.   Similarly, Standard & Poor's research findings on best practices in corporate transparency and disclosure could provide insights to produce a systematic approach to weighting portfolios with a 'strong corporate governance tilt.' [iii] We believe that this is an important area for further research, and the Duke Global Capital Markets Center hopes to play an active role in exploring the implications.



[i] For example, Vanguard's proxy voting policies are available at ProxyVoting.html.

[ii]  Bicksler, James, "The Value of Good Corporate Governance,' Journal of Indexes, Second Quarter, 2003

[iii] S&P produced a research paper on T&D that focuses on 98 disclosure items grouped into categories of ownership, financial transparency/disclosure, and corporate board/management structures and processes.  (George Dalllas and Sandeep Patel "Transparency and Disclosure: Overview of Methodology and Study Results" Standard and Poor's New York October 16, 2002).  We believe that like ISS' CCQ, this data could be used to develop systematically-developed index weightings reflecting slight portfolio tilts, which could appeal to certain types of investors.    Duke's GCMC and the Center for Benchmark Research and Development (CIBRD) is currently exploring this robust research area.

 A shorter version of this article will appear in the forthcoming book, Active Index Investing, to be published by John Wiley and Sons in Spring 2004.


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