(November 14, 2013) — Investing in companies with strong corporate governance principles will lead to a stronger rate of return, according to new evidence from research firms Inalytics and PIRC.
At a time when environment, social, and governance investing is becoming increasingly popular, PIRC and Inalytics’ report has claimed the return profile of these types of corporates outperforms the index by 13.9%.
The foundation for the analysis was PIRC’s scoring of companies’ governance profiles, which are based on a number of factors including the independence of their auditing process and their disclosure of executive pay. These different criteria are combined to rank companies as high, medium, or low risk.
Of the 423 Companies analysed, the firms which are ranked “high-risk” by PIRC underperformed the index by an average of 4.1% over a 23-month period, but those ranked “low-risk” outperformed the same index by 13.9%.
The effect is most pronounced at the small cap end of the equities market: ‘low-risk’ firms outperformed the index by 15%, “medium-risk” by 8.15%, while “high-risk” companies underperformed by 0.4%.
“For small caps, governance may have a larger effect because the decisions and behaviour of management are more critical in smaller organisations,” said Rick DiMascio, CEO of Inalytics.
The phenomenon was far less evident when assessing large cap stocks however. “Low-risk” companies were found to have underperformed by 1.6% and “high-risk” companies underperformed 2.2%, but “medium-risk” companies outperformed 0.4%.
DiMascio confessed that the reasons for the reduced impact of governance were “as yet unclear”, adding: “Perhaps it is because governance’s effect is diluted for large companies who have many factors impacting their performance.”
Despite this variance Inalytics is confident the research will help pension funds understand the influence governance has on their investments. The research will be continued, using the Merseyside Pension Fund’s portfolio.
“The on-going research will compare the fund’s portfolios to see how performance is affected by governance ranking,” said DiMascio.
“Clients are using this information to assess the overall profile of their portfolios and gauge whether their managers own high or low risk companies from a governance perspective. We are confident that this research area will provide greater understanding of the impact of corporate governance in the future.”
For further information on the process and methodology, click here.
Related Content: Your Next New Asset Class: Impact Investing and 11.2% of Total US Assets are Now Responsibly Invested