As investors learn more about the different approaches to Sustainable Investing, the governance factor within ESG may be the most intuitive of the three. Investors already realize that efficiency can be a key component to profitability and assessing how a company is run is at the heart of governance. Governance includes considerations such as anti-corruption, tax transparency, risk management and corporate structure. Conflicts of interest, poor disclosures or a lack of independent board members could be red flags for weak governance.
In particular, assessing the governance of a company has always been paramount in Emerging Market (EM) investing. Why? State-Owned Enterprises (SOEs), or companies in which the government or a government entity is the majority shareholder, are a large percentage of many EM indices. The aims and objectives of SOEs often differ from companies focused on increasing value for shareholders, customers and employees. While the S&P 500 has zero SOEs, the MSCI EM index is chocked full of them. Looking at the universe of EM companies (Exhibit 1), we can see by sector, the percent of market cap composed of SOEs. The heaviest SOE weightings are in energy, utilities and industrials, but are significantly less in tech and healthcare.
If we go a layer below and look at the governance scores of SOEs, it becomes clear that only a small percentage score highly. For instance, only 6% of SOE energy companies had a governance score that was considered “good practice” or “leading”; for financials, this was 8%.
For long-run fundamental investors focused on owning a company, (and not just “renting” it for the short run), governance issues are paramount. These issues often prompt a more thorough examination into the company and its long-term outlook. Looking at governance as part of a mosaic of company and market data has always been a large and prudent part of EM investing, and the “G” is getting renewed focus in light of the rise of ESG investing.
*Governance score is one component of a broader ESG score each company receives from FTSE.
MSCI EM Index state owned enterprises and governance by sector
% of market cap in USD