Unlocking value with corporate governance Zurich, August 29, 2017

Stephen Freedman, Executive Director, Head Sustainable Investing Wealth Management America

When asked to characterize what modern sustainable investing really is, I find it most useful to conceive of it as an investment approach that is thoughtful, holistic and stresses a longer time horizon than traditional approaches. One of the widespread acronyms in the field, ESG, which stands for environmental, social and governance analysis, best captures this philosophy by highlighting the importance of considering a larger set of information than traditional financial analysis into investment decisions. E, S and G factors are viewed as financially relevant non-financial dimensions that investors ought to understand to make informed decisions.

Even for investors not particularly inclined to consider environmental and social factors, it is relatively intuitive to accept that a company’s corporate governance should be a matter of concern. Why would shareholders not care whether the composition of the board of directors allows an effective monitoring of senior management on their behalf? Why would they not want to know whether management is appropriately incentivized to generate sustainable shareholder value? Why would minority shareholder not be concerned that a controlling shareholder may decide to direct resources in a manner that conflicts with their interests?

Yet, judging by the plethora of investment research reports on individual companies, corporate governance considerations hardly appear to be a priority for investors at large, with shorter-term considerations such as the earnings prospects for the following quarters often garnering the bulk of the attention. This short-termism in financial market is often criticized, including by investment luminaries such as Warren Buffet. A greater focus on ESG in general and on corporate governance in particular may well be an effective way to lengthen investors' time horizon. Indeed, a recent study by the consulting firm Mercer1 found that portfolio turnover at global equity asset managers is 58% suggesting an average holding period of less than two years. In contrast, for ESG-oriented managers, turnover was found to be approximately a third lower.

So what are aspects of corporate governance that investors may wish to focus on? Board composition is a primary. The key question is whether the board as a group has the skills and experience to oversee the complex activities of a modern corporation. The overall level of competency matters, but so does the diversity within the board. Recent academic research2 suggests that gender diversity may be a useful proxy for broader diversity of skills within boards. Similarly, board independence is worth analyzing. Understanding whether enough outside directors are on the board and whether their role is influential enough within the key board committees is critical. As discussed in a recent Wealth Management CIO report3, a number of well-publicized corporate scandals can be linked at least in part to a lack of independent board oversight of company activities. This illustrates a broader implication that corporate governance analysis can be a powerful tool for controlling investment risk.

There has been some progress. In the US, according to Spencer Stuart between 2006 and 2016, the percentage of S&P 500 companies with an independent chairperson rose from 10 to 27%. During the same time, the proportion of boards with stock option programs fell 51 to 14%, while the percentage of women directors rose from 15 to 21%. On the latter indicator, the UK saw a surge from 10 to 24% during the same decade. There are also considerable differences between countries. The percentage of female board members ranges from 16% in Spain to 44% in Norway. The variety of national securities laws and corporate governance codes mean that the minimum standards on most corporate governance dimensions will differ across countries. That needs to be borne in mind when making cross-country comparison.

The authors argue that negative screening cannot capture the value added by the various sustainability initiatives across companies and most importantly across industries. What becomes of greater importance is the distinction between "material" and "immaterial" ESG issues, in line with the definitions of the Sustainability Accounting Standard Board. To give an example, it is of critical importance for a company specialising in fossil fuels to manage its environmental impact ("material" ESG issue), as opposed to - for instance - financial institutions ("immaterial" ESG issue). Conversely, marketing or advertising is significantly more important for the latter.

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