Governance, the most important ESG factor?

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

Corporate governance basically boils down to two points: accountability and alignment.

How important is responsibility?

Well-run businesses cultivate a culture that allows the business to thrive without taking too many risks. They give people the power 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, such as their boss or a client, senior executives also need to feel accountable to the non-executive directors on their boards. And the board of directors will be more effective when it feels responsible to the shareholders.

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

The chairman of the board is responsible for facilitating the debate, so it is generally advantageous if the chairman is an independent non-executive director. If the chairman is not independent or if the roles of chairman and chief executive officer (CEO) are combined, as is often the case in the United States, it may mean that one person has too much influence over board discussions. In this case, they might not feel responsible to anyone.

The most successful boards of directors bring together a range of people with diverse skills. This should liven up and enrich the debates, while helping to avoid “group thinking”.

Why alignment is important

“Show me the incentive and I will show you the result” – Charlie Munger, vice president of Berkshire Hathaway.

Ownership is a great incentive. If you own something, you’re more likely to take care of it and make sure it lasts.

Business leaders often do not own the businesses they run and instead act on behalf of shareholders. This may mean that their interests are not fully aligned with those of the 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 could undertake vanity project acquisitions, even if they greatly increase the risk to shareholders.

This is why it is essential to consider how senior managers are incentivized. The best executive compensation packages usually include company stock, which must be held for a certain number of years. This aligns the interests of directors with those of investors. Part of their compensation should also be tied to long-term goals, such as increased customer satisfaction.

When bad governance impacts investors

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

Perhaps the most famous was Enron, the American electricity trading company. The company used an array of fraudulent accounting techniques to appear extremely profitable, even on projects that had just started. When the company’s wrongdoing became public knowledge in 2001, it collapsed, dragging its auditor, Arthur Anderson with it.

But corporate scandals aren’t written down in the history books. In 2015, it was revealed that Volkswagen had rigged US emissions tests on its diesel engines. Their cars used software that could detect when they were being tested and modify performance to improve results. The company’s stock price fell nearly 40% in the wake of the scandal. He also lost over € 30 billion in fines, financial settlements and redemption fees, with some lawsuits still pending.

Even before the scandal, many investors were concerned about the company’s lack of accountability. The voting shares were mainly held by the founding families, the local government and the government of Qatar. These groups also dominated the company’s board of directors.

Consider governance issues in your portfolio

This week is Good Money Week. This is a national campaign aimed at raising awareness of responsible investment. We think this might be a great time to make sure the people who run the companies you invest in are given the right incentives. 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 may want to consider a fund that takes governance factors into account. We look at one in more detail below.

Investing in funds is not for everyone. Investors should only invest if the fund’s objectives are aligned with theirs and there is a specific need for the type of investment being made. Investors should understand the specific risks of a fund before investing and ensure that any new investment is part of a diversified portfolio.

Legal & General Future World ESG Developed Index

The Legal & General Future World ESG Developed Index invests in over 1,400 companies around the world with the aim of tracking the Solactive L&G ESG Developed Markets Index.

The index places greater emphasis on companies that perform well on a variety of ESG criteria, which include several governance-related factors. The CEO / Chairman separation, the expertise of the audit committee and the quality of information on executive compensation are examples. The index also reduces the amount invested in companies that perform poorly on these metrics.

The benefit of reducing investments in low-rated companies, rather than selling their shares entirely, is that the Legal & General team can engage with low-rated companies to help them improve. Increased investment in exchange for improvement in various factors is a good incentive, so investor money makes a positive difference.

The fund shuns tobacco companies, pure coal producers, and manufacturers of controversial weapons (such as cluster munitions, anti-personnel mines, and chemical and biological weapons). It also avoids persistent violations of the principles of the United Nations Global Compact (a United Nations pact on human rights, labor, the environment and the fight against corruption).

The managers use derivative products which adds risk.

Learn more about Legal & General Future World ESG Developed Index, including fees

Legal and general information Future World ESG Developed Index Key investor information

This is not personal advice. If you are not sure what is right for your situation, seek financial advice. Remember that all investments can go down or up, so you might get back less than what you invested.

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If you would like to learn more about Responsible Investing, check out the new Responsible Investing section of our website.

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