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ESG Investing Should Start with the “G”

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Country Level Governance is the Next Generation of Responsible Investing

Responsible Investing has evolved greatly over the past 50 years. In the 1960’s, it was known as Socially Responsible Investing (SRI) and used an exclusionary approach with regards to social, ethical, and environmental issues. In the late 1990’s, SRI began to shift away from solely being values driven to incorporate other factors in the decision making process. This evolution added a set of positive screens and a new emphasis on risk and return in an effort to maximize the return of a socially responsible portfolio. In 2003, the United Nations Environment Programme (UNEP) Finance Initiative formed a task force to research the impact of environmental, social, and corporate governance (ESG) issues on security evaluation. The UN Secretary General launched the six Principles of Responsible Investing (PRI) in 2006, which gave rise to the term, Responsible Investing. This term describes the process by which risk and return investors use ESG factors in their investment process.

Today ESG investing still mostly starts with the E and S. It is interesting to note that the quality of corporate governance varies more by country than by company. It is crucial to understand the legal and regulatory requirements related to corporate governance which are imposed by each country.

Country level governance also plays a very important role in creating an environment for implementing favorable policies relating to the “E” and “S”. Widely-accepted economic studies have shown that countries which have an open, honest, and transparent economy outperform those that do not. Assessing countries for their ability to create an environment conducive to high-quality corporate governance is critical investment information. Countries Matter™ when investing internationally.

Applying country governance is the next generation of Responsible Investing and portfolio construction should begin with the G.

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G= Responsible Investing

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Measuring Corporate Governance

by Country is Challenging Understanding corporate governance at a country level is a better way to measure the “G” in ESG. This same measure can be a leading indicator of future environment and social improvements. Accordingly, professionals with Responsible Investing portfolios should incorporate this measure into their strategies.

Unfortunately, the available information about country-level governance has not been standardized and is inherently qualitative. Up until now, most governance information is available at a company level and it typically incorporates stakeholder, corporate social responsibility, or similar analysis.

Non-governmental organizations perform substantial and important research on countries, including economic statistics (e.g., GDP, GDP per capita, trade balances) and social welfare (e.g., child labor, environmental quality). Such research does not provide insight into the legal, regulatory, and economic infrastructure most conducive to good corporate governance. The information needs to be placed into frameworks yielding clear overall pictures of each country’s environment for high-quality corporate governance.

If it were easily accomplished, analysts would already access such information.

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Need to Look Below the Surface

Besides being beneficial in creating a better measurement of governance, assessing countries is crucial in building international portfolios. Since the data is difficult to get and difficult to convert into useable investment information, analysts instead tend to look at GDP, trade balances, inflation, and related numbers.

This numerical data is readily available and easily analyzed. Comparing stocks in the same country using this data is a sound method of analysis. However, availability and analytical ease are not sufficient when comparing stocks of different countries. The laws, regulations, and economic infrastructures of each country are different and hence comparing two stocks in different countries may be like comparing apples with oranges.

An iceberg is a metaphor for current analyses using traditional sources. Most international analyses focus on the easy to find and easy to analyze information that is akin to the visible part of the iceberg. The hard to find, yet important information is like the submerged portion of the iceberg. While not readily discovered, such information can be the key to identifying problems and opportunities.

Existing measures of

G

have important limitations

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Traditional Investment Analysis

Magni Analysis

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A Better “G” in ESG

Studies have shown that as the measurements of governance have improved, the performance of ESG portfolios has also improved (see “Country Selection – An Important Addition to Responsible Investing” at www.magniglobal.com/white-papers). These studies include one with strong statistical evidence demonstrating that, among all examined factors, governance has the strongest influence on the performance of ESG portfolios1. Another study addresses the increasing impact of governance on ESG portfolio performance as the governance measures have improved2. Yet another important study addresses the implications for portfolio construction, including best practices in positive screening and strong emphasis on governance3. Collectively, the studies highlight the importance of governance and the opportunity for better measures of governance.

A better “G” starts with asking key questions: • • •

Do financial statements accurately reflect a company’s position?

Do shareholders have protections and adequate controls?

Does company leadership have access to good information when making decisions?

Magni has an objective, repeatable process based on widely-accepted economic concepts for measuring the answer to these questions. Countries with high scores for their corporate governance environment tend to have greater wealth, while their citizens consider environmental and social issues as more important.

A good measurement of improvements in a country’s environment for corporate governance becomes a leading indicator of likely environmental and social improvements.

A strong “G” in a country leads to a place that values “E” and “S”

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“Sustainable Investing: Establishing Long-Term Value and Performance”, DB Climate Change Advisors of Deutsche Bank Group, June 2012 “A Comprehensive Analysis of the Relationship between ESG and Investment Returns”, Kennedy, Whiteoak & Ye, State Street Global Advisors, 2008 “Optimizing Environmental, Social, and Governance Factors in Portfolio Construction: An Analysis of Three ESG-tilted Strategies”, Nagy, Cogan, & Sinnreich, MSCI Applied Research, 2013

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Social Progress Imperative Measures the “E” and the “S” The Social Progress Imperative created the Social Progress Index in 2013. It measures social and environmental performance for every country in the world. Since this index measures E and S and Magni measures G, the two rankings have a complementary nature and could create an interesting composite ESG ranking.

Analysis shows that a little over half the countries have fairly similar scores when using the two country rankings.

For the remaining countries in the comparison, there are major differences in ranking and these differences can have significant implications for both portfolio construction and prospects for returns. For example, New Zealand is considered a country with very strong social progress, while Magni measures its corporate governance environment as average within the developed markets. Accordingly, there is a risk that portfolios built with Social Progress rankings would allocate too large a position to New Zealand when compared to the prospects for investment returns. Over the last ten years, New Zealand underperformed the benchmark by 141 bps per year4.

Conversely, there are eight countries where their corporate governance environment is ranked higher than their social progress. In these countries, there is a risk that portfolios built with social progress rankings would allocate too little to the countries when compared to the prospects for investment returns. Over the last ten years, these eight countries have collectively outperformed the benchmark by 107 bps per year5.

There are another eight countries with extremely low rankings on social progress, though their corporate governance environments vary significantly. The use of the Social Progress Index to build portfolios would portray them as very similar when they are quite different, thereby masking important investment information. The countries within this group who have somewhat stronger corporate governance environments outperformed those who had weaker ones by 335 bps per year6.

4 MSCI New Zealand GR USD vs. MSCI ACWI Ex USA GR USD for a ten year period ending 6/30/15.

5 Equal weighted portfolio of the eight countries using MSCI performance (Gross Return and USD) for a ten year period ending 6/30/15.

6 Equal weighted portfolios of four countries using MSCI performance (Gross Return and USD) for ten year period ending 6/30/15.

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Countries Matter™ in Responsible Investing Portfolios

Magni has developed a process for researching and assessing the legal, regulatory, and economic infrastructures of countries. The process uses Magni’s Sustainable Wealth Creation principles, which are based on widely-accepted economic concepts. Countries that receive high scores according to the Sustainable Wealth Creation principles are required to have more than strong intent and/or rules; there must be evidence that the companies within the country adopt the intended behavior. Furthermore, high-scoring countries also have healthy economic infrastructures in which investors are more likely to consider Responsible Investing important, thus creating demand for continued improvement by the companies within the country.

To convert principles into an objective, repeatable process, they are divided into twelve Economic Standards covering key aspects of a country and its infrastructure. The Economic Standards are further divided into 280 Qualitative Sovereign Factors. Countries are scored by determining a country’s actual level of adherence to the standards and factors.

Magni Economic Standards Banking Securities Insurance Corporate Regulations Fiscal Policy Monetary Policy

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Accounting Auditing Payment Systems Market Integrity Data Dissemination Insolvency

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Countries Change

A country’s environment for corporate governance can change at a faster pace than many might expect. This is illustrated by the nearby graph of weightings which are based upon Magni’s Country Selection Technique. It clearly show that over a multi-year timeframe, the countries can change significantly. Since the systems that are being measured vary over time, they need to be continuously monitored to gain timely insights when making investment decisions.

Collectively, Magni research provides deep insight into important investment information about the environment for corporate governance in each country and that information is not available in traditional methods. The research has been produced over the last 15 years and is constantly being updated.

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ESG

Countries Matter

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Qualitative Sovereign Factors

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A Better “G” in ESG

Look Below the Surface

Sustainable Wealth Creation Principles

Responsible Investing

Economic Standards Country Scores

Transparency

Corporate Governance

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About Magni

Magni Global Asset Management LLC is the leader in country-level research on corporate governance. The Minnesota based research and asset management firm was founded by Dr. Roger Conant, previously the Chief Investment Officer for the St. Paul Companies/Travelers. Magni believes Countries Matter™ when investing internationally and scores countries on their ability to provide an environment conducive to effective corporate governance.

The firm developed its Sustainable Wealth Creation research process based on widely-accepted economic concepts. Those concepts are disaggregated into 280 Qualitative Sovereign Factors about the legal, regulatory, and economic infrastructure of a country. Magni has fifteen years of proprietary research on the investable countries of the world.

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