A new materiality concept focuses on seeking investment value where the interests of shareholders and other stakeholders intersect

Among the great difficulties of using ESG in an investment context are measuring it and integrating these measures fairly across various contexts into a global investment portfolio. A new article published in the CFA Institute Financial Analysts Journal provides refinements to some well-established ESG measures and provides evidence that those refinements improve the prediction of future returns. 

In ‘Corporate governance, ESG, and stock returns around the world’ published in the Financial Analysts Journal, Mozaffar Khan finds that ‘materiality’ in ESG scores (that is the relevance of a particular ESG measure to a company or industry sector) make all the difference. Furthermore, the author provides the first evidence that a governance score adjusted for country-context adds information for future returns in a global investment context. 

A year ago, the same journal published the results of an extensive survey of institutional investors to determine why and how investors use ESG information. Most respondents (82%) said that they were motivated to use ESG information in their investment process because it is financially material to investment performance. This underlined that the issue facing investment professionals is not so much whether to use ESG information, but how. 

In the same survey, the biggest barrier to using ESG data in the investment decision process was a lack of comparability of reported information across firms. Khan extends this to the particular challenge of comparing corporate governance scores across different jurisdictions and cultures when compiling a global portfolio. The author argues that “the nature of the governance problem varies fundamentally among countries”. Global investors must incorporate the sources of this variation in order to more accurately measure the strength of corporate governance across their investment opportunity set. 

Earlier academic literature points the author to three main sources of this variability in governance among countries. 

The first is a variation in ownership structure and the nature of the conflicts implied by each structure. In a dispersed ownership structure (typical in the US) the conflict most likely to affect the firm is between shareholders and external stakeholders. But firms with a few controlling shareholders are likely to have materially conflicting objectives between the majority and minority shareholders. The nature of the governance that appropriately addresses each of these types of conflicts is different and so the context of share ownership structure is an important refinement. 

Differences in shareholder orientation in different jurisdictions is another key source of variation in governance across the world. In some markets, shareholder interests are well protected by policymakers, and in others, less so. The author takes the legal tradition of 42 different markets into account in his study, as the evidence suggests that investor protection is strongest in common-law countries, followed by countries with Scandinavian and German legal tradition, and that it is weakest in countries with French legal tradition.

Finally, the institutional setting of firms is important to the context of governance; the extent of the rule of law, enforcement, and accountability all interact with the way in which governance should be measured. 

heidi raubenheimer

Heidi Raubenheimer

To represent the three sources of variability in governance scores the author uses: free float, or shares not held by insiders, as a proxy for ownership dispersion; legal tradition category (common law, Scandinavian/German, French, Socialist) as a proxy for shareholder orientation; and Bloomberg’s political risk score as a proxy for market-level institutional strength.

These global governance factors are then combined with traditional governance scores from MSCI – including board composition, executive compensation, and so on – to create a composite governance score. This composite governance score combines the top-down ESG perspective of the global governance factors with the bottom-up perspective of MSCI’s scoring to give a more contextual and rounded picture.

The author’s composite governance measure demonstrates good future results; the top-quartile governance companies outperform those in the bottom quartile by some 33bps a month. Return increases and risk decreases with each quartile of improved governance score. 

Furthermore, ownership dispersion, shareholder orientation, and institutional strength are each found to be significant predictors of stock returns: ownership dispersion has a 26bps return spread between the top and bottom terciles; monthly returns are 19bps higher for firms operating under common law than for those in Scandinavian/German code law countries; and there is a monthly return spread of 30bps between the top and bottom quartiles with regard to institutional strength.

Key points 
ESG presents challenges both in terms of measurement and integrating this fairly into investment portfolios
There are three main sources of variability in different national contexts: ownership structure, shareholder orientation and the institutional setting of firms
The concept of materiality involves looking for investment value where the interests of shareholders and other stakeholders intersect
The proposed ESG materiality framework in a recent study can be seen to potentially enhance the performance of global portfolios

Having successfully tweaked the G in ESG, the author uses the concept of ‘materiality’ to further improve the E and the S scores in the ESG composite. Materiality looks for investment value where the interests of shareholders and other stakeholders intersect. So, for example, while a company’s fuel efficiency score reflects an important environmental factor with important consequences for the environment, materiality focuses on the impact of fuel efficiency on the company’s financial performance. If a healthcare distributor, a heavy fuel consumer, improves its fuel efficiency, that is good for the environment and the shareholders. But if a healthcare provider does the same, its fuel efficiency score may improve, but it is likely to overinvest in fuel management to the detriment of its shareholders because in its case fuel-efficiency is not material to its business. 

This is an example of two companies in the same sector who may do the ‘right thing’ but only one is material. The author adjusts MSCI Environment and Social scores along Sustainability Accounting Standards Board (SASB) guidelines to produce a more material E and S. 

Finally, the author constructs a new ESG rating by combining his proposed composite governance score with ESG scoring based on materiality. He shows that this new ESG rating is an improved predictor of future returns after controlling for the usual style factors. The author’s new ESG rating produces a spread of 36bps a month between the top and bottom quartiles (see figure).

a composite governance score based on materiality

The results suggest that how ESG performance is measured is key to achieving outperformance for ESG-focused portfolios.

The author’s proposed ESG materiality framework, which aims to identify only those ESG issues that are important to shareholders and stakeholders, can be seen to potentially enhance the performance of global portfolios.

Equally, the corporate governance findings suggest that exercising economic discipline in capital allocation decisions over the long run does preserve and grow capital. This long-run sustainability approach should benefit both company shareholders and stakeholders.

Heidi Raubenheimer is managing editor of the CFA Institute Financial Analysts Journal