The Corporate Library's Governance Ratings and Equity Returns

Research on the relationship of governance ratings systems to investment performance has shown mixed results, and the significance of particular governance features to equity returns is widely debated. A recent study by The Corporate Library suggests their ratings system, focused on the identification of agency problems rather than supposed best practices, can contribute significantly to generating excess returns.

TCL backtested a model portfolio benchmarked to the Russell 1000 that excluded companies they rated “high” or “very high” risk in board, compensation and/or overall governance. Unlike “best of class” studies, TCL didn’t hesitate to underweight entire industries where poor governance is widespread and risk is higher.

In comparison to the benchmark Russell 1000, the model TCL portfolio with the strictest standards had a smaller weighted average market-cap ($42 billion, vs $79 billion) and a slight growth tilt (P/E ratio of 20.3 vs 18). It was persistently underweight in financials and energy, while overweight in technology stocks. Annualized performance was 6.91%, compared with 4.16% for the benchmark for the 2003-2010 period.

Download the study for free from TCL.

I consider studies such as this one extremely important. We can shout from the rooftops about the need for corporate governance reforms until we’re blue in the face, but once a few funds have been initiated that make excess returns using corporate governance indices to overweight or underweight issuers, the walls of resistance will really come down. Please let me know of additional studies and especially of any funds using corporate governance strategies.