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This is a summary of “Corporate Governance, ESG, and Stock Returns around the World,” by Mozaffar Khan, published in the Financial Analysts Journal in the 4th quarter issue of 2019.


Overview

This In Practice piece gives a practitioner’s perspective on the article “Corporate Governance, ESG, and Stock Returns around the World,” by Mozaffar Khan, published in the Fourth Quarter 2019 issue of the Financial Analysts Journal.

What’s the Investment Issue?

The author proposes improved environmental, social, and governance (ESG) measures by considering the “materiality” of ESG factors.

ESG factors are considered “material” only if they could have a meaningful impact on a company’s financial performance. Material ESG issues vary by industrial sector: Fuel efficiency, for instance, is a material ESG issue for health care distributors but not for health care providers.

In comparing companies across different jurisdictions and cultures, global governance presents particular difficulties. To obtain a more accurate global comparison, the author examines three sources of variability in governance scores across markets: ownership structure, shareholder orientation, and institutional setting.

How Does the Author Tackle the Issue?

To represent the three sources of variability in governance scores, the author first uses free float, or shares not held by insiders, as a proxy for ownership dispersion.

Second, the author addresses shareholder orientation—the fact that in some markets, shareholder interests are well protected by policymakers, and in others, less so. The author takes the legal tradition of the 42 markets in the study, whether that be common law, Scandinavian/German code law, or French code law, as a proxy for shareholder protection. This follows evidence that investor protection is strongest in common law countries, followed by countries with Scandinavian and German legal tradition, and that it is weakest in countries with French legal tradition.

Third, he assesses the institutional setting: the extent of the rule of law, enforcement, and accountability. To measure the institutional setting, a political risk score from Bloomberg is used as a proxy for market-level institutional strength.

These global governance factors are then combined with traditional governance scores from MSCI—including board composition, executive compensation, and so on—to create a composite governance score. This composite governance score combines the top-down ESG perspective of the global governance factors with the bottom-up perspective of MSCI’s scoring to give a rounded picture.

Finally, the author constructs a new ESG rating by combining this composite governance score with ESG scoring based on materiality. He assesses whether this new ESG rating is predictive of future returns while controlling for style factors.

What Are the Findings?

There is significant variation in stock performance using this new ESG methodology, suggesting the approach could improve ESG portfolio performance.

For the composite governance measure, the top-quartile companies outperform those in the bottom quartile by some 33 bps a month. Ownership dispersion, shareholder orientation, and institutional strength are all found to be significant predictors of stock returns. Ownership dispersion has a 26 bps return spread between the top and bottom terciles. For shareholder orientation, monthly returns are 19.1 bps higher for firms operating under common law than for those in Scandinavian/German code law countries. In terms of institutional strength, there is a monthly return spread of 30 bps between the top and bottom quartiles.

The author’s new ESG rating produces a spread of 36 bps a month between the top and bottom quartiles.

What Are the Implications for Investors and Investment Managers?

The results suggest that how ESG performance is measured is key to achieving outperformance for ESG-focused portfolios.

The author’s proposed ESG materiality framework, which aims to identify only those ESG issues that are important to shareholders and stakeholders, can be seen to potentially enhance the performance of global portfolios.

Equally, the corporate governance findings suggest that exercising economic discipline in capital allocation decisions over the long run does preserve and grow capital. This long-run sustainability approach should benefit both company shareholders and stakeholders.

About the Author(s)

Phil Davis

Phil Davis is a London-based financial journalist.