The “G” in ESG – Magni’s Perspective

March 2016

While the origin of Responsible Investing dates as far back as the 1500’s, in the 1960’s the term Socially Responsible Investing (SRI) was adopted. In the late 1990’s, SRI began to incorporate other factors, including environmental, social, and corporate governance (ESG). The launch of the United Nation’s Principles of Responsible Investing (PRI) helped give rise to the term, Responsible Investing, which describes the process by which risk and return investors use ESG factors. PRI has around 1,200 signatories and those signatories now represent about 15% of the world’s investible assets[1].

Many improvements have been incorporated into Responsible Investing. Initially, ethical portfolios tended to use negative screening (i.e., excluding companies). A whitepaper by Deutsche Bank[2] focused on studies of performance from negative screening. It documented that only 42% of these studies showed companies with high SRI scores as exhibiting outperformance. The whitepaper also found mixed results at the fund level.

Increasingly, there has been a shift from negative to positive screening (i.e., security selection and weighting based on adherence to a framework). The same whitepaper found overwhelming academic evidence that companies with high ESG scores have a lower cost of capital. It also documented meaningfully better performance from positive screening.

Within ESG ratings, the “G” had the strongest influence on performance[3]. Another study showed a strong positive relationship between corporate governance and company valuation[4]. Specifically, strong shareholder rights have been found to increase corporate valuations[5]. Board and audit committee independence better protect shareholder rights and help increase corporate valuations[6].

By 2008 there were 11 providers of ESG ratings. An SSgA study found little consistent predictive power from these ratings, though the predictive power did strengthen over time[7]. A subsequent article[8] explained some limitations in these ratings, including underdeveloped definitions, insufficient data, and untimely publishing.

Increasingly, the historical perception that Responsible Investing products deliver subpar performance is diminishing. Despite considerable progress, there is room for meaningful improvement. Further, given the demand for such products, there is significant room for product innovation to provide both better alignment with values and better prospects for attractive returns. In the not too distant future, Responsible Investing could become a proven source of alpha.

MSCI published an insightful study on the best practices in constructing Responsible Investing portfolios[9]. This study highlighted the need for a strong emphasis on corporate governance.

Countries can play a large role in improving corporate governance. This role includes strengthening the information reported by corporations, while also assuring common definitions. A report by the UNEP Finance Initiative[10] specifically identifies a stronger role for governments in requiring more ESG information be reported. Fundamentally, corporate governance is significantly impacted by the requirements of the countries under which they are regulated[11].

If two companies in different countries receive the same ESG score, the country can be the deciding factor regarding which company is a better investment. The company in the country with the better reporting requirements and where Responsible Investing is more important is more likely to further improve its ESG score. Incorporating country selection into investing can help identify where the greatest improvement is most likely. Country research may be the next major improvement to Responsible Investing.

A prior whitepaper by Magni Global Asset Management[12] documents the current status of country research for investment purposes. Researching country-level information has traditionally encountered significant challenges. The available information is mostly not standardized and is inherently qualitative. Non-governmental organizations perform substantial research on countries, including economic performance and progress on social welfare. While such research is important and has many uses, it does not address the investment analysts’ need for frameworks containing available facts that yield clear overall pictures where countries can be compared on an “apples to apples” basis. This is not easily accomplished; if it were easy, analysts would already access such information.

Country scores are a Responsible Investing measure and have also demonstrated a correlation to investment performance. Decisions about Responsible Investing can be enriched through the incorporation of country scores.

The “G” in ESG has received less attention than the “E” and the “S”, yet it is more correlated with investment performance. While the existing ESG measures have room for improvement, a better “G” can be used now. Including the impact of countries on corporate governance strengthens the measurement of “G”, incorporates best practices, and positions portfolios for potential outperformance.

[1] “From SRI to ESG: The Changing World of Responsible Investing”, Caplan, Griswold, & Jarvis, Commonfund, 2013, page 3

[2] “Sustainable Investing: Establishing Long-Term Value and Performance”, DB Climate Change Advisors of Deutsche Bank Group, June 2012, page 8

[3] Ibid, page 54

[4] “Corporate governance and firm value: International evidence”, Ammann, Oesch, & Schmid, Journal of Empirical Finance, 2010

[5] “Corporate governance and equity prices”, Gompers, Ishii, & Metrick, Quarterly Journal of Economics, 2003

[6] “Do US firms have the best corporate governance? A cross-country examination of the relation between corporate governance and shareholder wealth”, Aggarwal, Erel, Stulz, & Williamson, National Bureau of Economic Research (NBER) Finance Working Paper, 2007

[7] “A Comprehensive Analysis of the Relationship between ESG and Investment Returns”, Kennedy, Whiteoak & Ye, State Street Global Advisors, 2008

[8] “The Future of ESG Investing” Ye, Taisheng, SSga Capital Insights, June 2012

[9] “Optimizing Environmental, Social, and Governance Factors in Portfolio Construction: An Analysis of Three ESG-tilted Strategies”, Nagy, Cogan, & Sinnreich, MSCI Applied Research, 2013

[10] “The Materiality of Social, Environmental and Corporate Governance Issues to Equity Pricing”, The United Nations Environment Programme Finance Initiative (UNEP FI) Asset Management Working Group (AMWG), June 2004

[11] “Do US firms have the best corporate governance? A cross-country examination of the relation between corporate governance and shareholder wealth”, Aggarwal, Erel, Stulz, & Williamson, National Bureau of Economic Research (NBER) Finance Working Paper, 2007

[12] “Country Selection – A Powerful Technique of International Equity Investing”, Conant and Zimmer, Magni Global Asset Management LLC,, August 2014, page 6