Governance – the most important ESG factor?

Corporate governance is all about how a company is managed and overseen. It might not sound like the most exciting topic, but if a company gets governance wrong, investors will pay the price.

Corporate governance broadly boils down to two As – accountability and alignment.

How important is accountability?

Well-managed companies cultivate a culture that allows the business to thrive without taking too much risk. They give individuals the authority to make decisions, but the decision-maker is held accountable for the consequences of their actions.

Just as individuals work most effectively when they feel accountable to someone, like their boss, or a client, senior executives also need to feel accountable to the non-executive directors on their board. And the board will be most effective when it feels accountable to shareholders.

Reading a company’s annual report is the most important way for shareholders to understand a company’s financial position, in order to hold the company to account. The accounts are reviewed by an independent auditor which reports formally to shareholders once a year and is reappointed by shareholders annually at the Annual General Meeting (AGM). Investors should consider the expertise of the auditor and any potential conflicts of interest they might have before investing in a company.

The chairman of the board is responsible for facilitating the debate, so it’s usually beneficial if the chairman is an independent non-executive director. If the chairman isn’t independent, or if the roles of chairman and chief executive officer (CEO) are combined, as is often the case in the US, this can mean one person has too much influence on board discussions. In that case, they might not feel accountable to anyone.

The most successful boards bring together a range of people with mixed skillsets. This should liven and enrich debates, while helping to avoid ‘group think’.

Why alignment matters

“Show me the incentive and I’ll show you the outcome” – Charlie Munger, Vice Chairman of Berkshire Hathaway. 

Ownership is a big incentive. If you own something, you’re more likely to look after it and make sure it lasts.

Company managers often don’t own the businesses they run, and instead act on behalf of shareholders. That can mean their interests aren’t fully aligned with shareholders. For example, they might be more inclined to think about short-term profitability, rather than the long-term health of the business. Or they might undertake vanity project acquisitions, even if they significantly increase the risks for shareholders.

That’s why it’s essential to consider how senior managers are incentivised. The best executive pay packages usually include shares in the business, which must be held for a certain number of years. This helps align directors' interests with investors’. Part of their remuneration package should also be linked to long-term goals, like an increase in customer satisfaction.

When poor governance impacts investors

History is littered with corporate governance scandals that have cost unsuspecting investors billions of pounds.

Arguably the most famous was US electricity turned energy trading firm Enron. The company used an array of fraudulent accounting techniques to appear hugely profitable, even on projects that had barely begun. When the company's misdeeds became public knowledge in 2001, it collapsed, taking its auditor, Arthur Anderson, with it. 

But corporate scandals aren't consigned to the history books. In 2015 Volkswagen was revealed to have cheated US emissions tests on its diesel engines. Their cars used software that could detect when they were being tested and change performance to improve results. The company's share price fell almost 40% in the wake of the scandal. It also lost more than €30bn to fines, financial settlements and buyback costs, with some lawsuits still ongoing. 

Even before the scandal, lots of investors had concerns about a lack of accountability at the company. The voting shares were mostly held by the founding families, the local government and the government of Qatar. These groups also dominated the company's board.

Considering governance issues in your portfolio

This week is Good Money Week. It's a national campaign that aims to raise awareness of responsible investing. We think it could be a great time to make sure the people who run the companies you invest in are appropriately incentivised. But also that there are the right mechanisms to hold them accountable to shareholders.

If you don’t have the time or knowledge to consider governance factors when investing in individual companies, you could consider a fund which takes governance factors into account. We look at one in more detail below.

Investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.

Legal & General Future World ESG Developed Index

The Legal & General Future World ESG Developed Index invests in more than 1400  companies across the globe with the aim of tracking the Solactive L&G ESG Developed Markets Index.

The index gives greater weight to companies that score well on a variety of ESG criteria, which includes several governance-related factors. CEO/ chairman separation, audit committee expertise and the quality of disclosure on executive pay are examples. The index also reduces how much is invested in companies that score poorly on these measures.

The advantage of reducing investments in poorly-scoring companies, rather than selling their shares completely, is that the Legal & General team can engage with poorly-scoring companies to help them improve. An increased investment in exchange for improvement on various factors is a good incentive, so investors' money makes a positive difference.

The fund avoids tobacco companies, pure coal producers and makers of controversial weapons (like cluster munitions, anti-personnel mines and chemical and biological weapons). It also avoids persistent violators of the UN Global Compact Principles (a UN pact on human rights, labour, the environment and anti-corruption).

The managers use derivatives which adds risk.

More on Legal & General Future World ESG Developed Index, including charges

Legal & General Future World ESG Developed Index Key Investor Information

This isn’t personal advice. If you’re not sure what’s right for your circumstances, ask for financial advice. Remember all investments can fall as well as rise in value so you could get back less than you invest.