Investors need to know how to distinguish good apples from bad in the corporate barrel – and they might soon have a new divining rod, if FTSE and Standard & Poor’s get their way. The firms are investigating whether corporate governance indices can aid the process of improving and maintaining good governance. Some professional investors in the UK strongly approve of the concept, while others are skeptical about its usefulness and measurability.
The success of the FTSE4Good and the Dow Jones Sustainability indices in focusing business minds on the area of corporate social responsibility supports the concept of a corporate governance index. An index of this type could also validate the various surveys that suggest a link between higher returns and good governance.
FTSE is analyzing the feasibility of a corporate governance index in the UK, while S&P focuses on the US. Both have yet to decide whether to go ahead. Nick Bradley, managing director of S&P Governance Services in the UK, believes such an index could be created in the US within a few months, if the markets support it. And if a US model is successful, the UK and Europe could follow.
Creating a corporate governance index is not without its problems, though. Establishing whether a company meets the criteria for a market capitalization index is based on tangible, often quantifiable measurements. Determining whether a firm is eligible for a corporate governance index is a whole different ball game because governance issues are so much more difficult to measure.
But S&P has established a good basis for this with its internationally applicable corporate governance evaluations and scores methodology. This focuses on four key areas: ownership structure and concentration; financial stakeholder protection; transparency and disclosure; and board structure and process.
Process over structure
Bradley notes that examining a company’s corporate governance record – which is harder to analyze using public disclosures alone – is more important than structure. For example, even with the right board structure in place, if directors do not communicate sufficiently with each other and the operating side of the business, or if they are not actively engaged, structure alone is of limited value.
In 2002 S&P produced a transparency and disclosure report for S&P 500 companies, which Bradley says could be a starting point for a corporate governance index. It showed that most of the S&P 500 already meet high disclosure levels, highlighting the problem of differentiating between them purely on the basis of public information. For an index to be meaningful, the entrance bar might need to be raised.
For fund managers, the attraction of an index lies in giving clients a choice. Many investment managers feel compelled to include benchmarked stocks in a portfolio, even if they have doubts about those stocks’ governance record. With an index, managers can offer their clients more choice over benchmarking – and clients seeking low-risk pension portfolios, such as local authorities, have shown a strong interest in the concept.
However, demand for this type of index is mixed because many major fund management companies in the UK have bolstered their own corporate governance operations recently. Colin Melvin, director of corporate governance at UK fund manager Hermes, says its clients benefit from Hermes’ very proactive approach to corporate governance, thus reducing demand for an index.
Karina Litvack, head of governance and socially responsible investment at Isis, sees such an index as a positive force, similar to the FTSE4Good index – but she is wary of it becoming a superficial ‘box-ticking’ exercise.
For Andrew Tusa, head of corporate governance at Deutsche Asset Management, the main framework of corporate governance should be ‘comply or explain’, not ‘comply or be excluded’. He considers the level of corporate governance in the UK to be adequate, and notes that ‘exclusion [via an index] doesn’t serve the process of governance.’
Ultimately, though, as the Parmalat scandal illustrates so well, a screening tool that identifies such excluded companies can only be beneficial for the markets.
