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Kimberly Gladman, CFA, Ph.D., Director of Research and Risk Analytics
A recent study of investment applica�ons for The Corporate Library’s governance ra�ngs shows outperformance in 2003-2010 for three hypothe�cal por�olios benchmarked to the Russell 1000. The highest level of outperformance—275 annualized basis points—was found for the por�olio applying the strictest governance screens. Performance a�ribu�on indicates that 121 basis points of the annualized outperformance for this por�olio was stock-speciﬁc and hence directly a�ributable to the ra�ngs. Approximately 74 addi�onal basis points resulted from diﬀeren�al industry weigh�ngs produced by the applica�on of ra�ngs standards to each company on an absolute (not “best-in-class”) basis. Por�olio standard devia�on was comparable to the benchmark, and tracking error was 3.3 percent. The por�olio outperformed the benchmark in over 60 percent of the test months, and had an informa�on ra�o exceeding 0.8.
Growth of $1 Billion Invested
The chart below shows the growth of $1 billion invested in each of the three por�olios vs. the Russell 1000 (in blue), with the por�olio using the strictest governance screens shown in dark red.
© 2010 The Corporate Library
The Corporate Library’s Governance Risk Ra�ngs
The Corporate Library’s governance risk ra�ngs seek to iden�fy companies where a divergence between the interests of management and shareholders may be placing investment value at risk. The ra�ngs process has two parts. First, a database algorithm scores each company’s governance by assigning or deduc�ng points for a range of data items related to board composi�on, execu�ve compensa�on, takeover defenses, and accoun�ng compliance. Second, a ra�ngs analyst researches each company and adjusts the automa�c scores where appropriate. To ensure consistency across �me and among analysts, a detailed protocol containing extensive decision rules guides this qualita�ve research. On a quarterly basis, The Corporate Library’s senior staﬀ, including specialists in board prac�ces, takeover defense, and compensa�on, review and if necessary suggest amendments to this research protocol. It thus represents the ﬁrm’s evolving collec�ve intelligence and expert opinion on how best to iden�fy governance-related investment risks. The ra�ngs process is en�rely bo�om-up and evaluates each company individually (not on a “best-in-class” basis). As a result, if what The Corporate Library believes to be poor governance prac�ces are widespread in a par�cular industry, a large propor�on of the companies in that industry will receive low ra�ngs. The Corporate Library’s ra�ngs are from A to F, corresponding to a scale from low to very high risk. This overall ra�ng is comprised of individual component ra�ngs for board, compensa�on, takeover defense and accoun�ng compliance, which are also expressed in le�er grades corresponding to risk levels. Board and compensa�on scoring components together make up the majority (about 80 percent) of the overall scoring system.
The Quan�ta�ve Services Group Study
Commissioned by The Corporate Library and conducted by Quan�ta�ve Services Group, the current study covered the period from July 2003 to February 2010 and modeled three por�olios. All por�olios were based on the Russell 1000 but excluded the following companies: 1) those whose overall governance The Corporate Library rated D or F (the green “TCL” line in the chart above); 2) those rated D or F in overall governance as well as both board and compensa�on (this “Long Only Inclusive” por�olio is represented by the bright red “LOI” line); and 3) those rated D or F in either overall governance or board or compensa�on (this is the “Long Only Exclusion” por�olio, represented by the dark red “LOE” line above). For each case, the simula�on assumed market-cap weigh�ng, quarterly rebalancing, and reinvestment of dividends at each quarter-end. It also incorporated market-impact transac�on costs for a por�olio size of $1 billion. The third por�olio showed strongest outperformance and is the main focus of this report. In what follows, it will simply be referred to as “the por�olio.”
On average, the por�olio excluded about half the benchmark names and had annual turnover of 65 percent, corresponding to an average holding period per company of 1.5 years. In comparison to the benchmark, the por�olio had a somewhat smaller weighted average market-cap ($42 billion vs. $79 billion) and a slight growth �lt (P/E ra�o of 20.3 vs. 18); it was also persistently underweight in ﬁnancials and energy and overweight in technology stocks. These diﬀeren�al factor exposures were much diminished when the por�olio was compared to the benchmark on an equal-weighted basis, demonstra�ng that the market-cap weigh�ng played a large role in their crea�on.
© 2010 The Corporate Library
Annualized performance for the por�olio was 6.91 percent, compared to 4.16 percent for the benchmark, producing an annualized outperformance of 275 basis points and cumula�ve outperformance approaching 25 percent. Standard devia�on was 22.29 percent (vs. 21.84 percent for the benchmark). Tracking error was 3.3 percent, the informa�on ra�o was 0.82, and outperformance was seen in 61 percent of test months. Fortyfour percent, or 121 bps, of the 275 annualized bps of ac�ve return was stock-speciﬁc, and another 74 bps are a�ributable to the ﬁnancial industry underweight produced by the applica�on of ra�ngs standards to each company on an absolute (not “best-in-class”) basis.
Previous research on the rela�onship of governance ra�ngs systems to investment performance has shown mixed results, and the signiﬁcance of par�cular governance features to equity returns is widely debated. The current study, however, suggests that The Corporate Library’s ra�ngs system—focused on the iden�ﬁca�on of agency problems rather than supposed best prac�ces—can contribute signiﬁcantly to alpha genera�on.
For more informa�on
• Request the full study here or call (207) 874-6921 • Request a free trial of Board Analyst® and gain access to The Corporate Library’s Risk Ra�ngs • Speak to The Corporate Library team about how you can incorporate our Risk Ra�ngs into your investment decisions: click here or call (207) 874-6921
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© 2009 The Corporate Library, LLC. All rights reserved. No part of this publication may be reproduced, republished, altered, posted, transmitted, or distributed without written permission from The Corporate Library, or, in the case of photocopying, under the terms of a license issued by The Corporate Library.
© 2010 The Corporate Library