null Episode 9: The G in ESG: How Does Governance Impact Investment Returns, and Why
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Episode 9: The G in ESG: How Does Governance Impact Investment Returns, and Why

Double Take podcast Audio Responsible Investing Equity Fixed Income Index
July 2020
Episode 9: The G in ESG: How Does Governance Impact Investment Returns, and Why

Mellon’s Karen Wong and outside expert Professor Ruth Aguilera examine the importance of transparency and how corporate governance is at the root of good business practices. 

Professor Aguilera’s paper, discussed in the podcast, can be found here.


Rafe Lewis: Welcome to Double-Take, the Mellon podcast. I'm Rafe Lewis, Mellon's Director of investigative investment Research.

Jack Encarnacao: And I'm Jack Encarnacao, also a Mellon Investigative Research Analyst. On today's episode, a dive into the methods investors have used to push ESG considerations to the forefront, forcing companies to be more transparent about everything from their impact on the environment, to how they govern themselves and what happens to returns as a result.

Jack: We come at this from two angles this time. First, we'll talk with Mellon's Karen Wong about how passive index funds have been able to force change, even though they have little choice in which companies they own. Then we'll speak with Ruth a Northeastern University Business School Professor, who's done some fascinating work analyzing what happened when a massive Scandinavian sovereign wealth fund drew hard lines around what governance practices its portfolio companies must follow.

Rafe: But first, let us take a step back and put some context around this conversation. In the past decade or so, two of the biggest changes in the investment world have been, A, the rise of passive and index investing, which is what Karen does every day. And B, the rise of ESG, which stands for environmental social and governance risk analysis.

Rafe: It was just over a year ago when passive assets under management globally eclipsed actively held portfolios. That is a 12-year rise that was nothing short of breathtaking. And for much of that time, passive portfolio managers really paid little heed to ESG risk factors, unless specifically socially conscious or ESG branded. Because the beauty of passive investing is that it mimics an index and it's agnostic to any one company's impacts on the planet or society.

Jack: Then though, the passive world was reshaped about five months ago when Larry Fink, Chairman and CEO of the largest passive money manager on earth, published a letter to clients and public company CEOs, both stating that henceforth, sustainability considerations would sit front and center in the firm's investment decision making.

Jack: This letter had garnered a lot of media attention and to put executives and shareholders alike, on notice that passive and index strategies would now scrutinize sustainability factors as much as active managers did. But the fact of the matter  is, environmental, governance and social considerations have been increasingly important to the passive money manager. And if anything, the Fink letter marked the culmination of a trend that has been steadily advancing.

Rafe: And that brings us to Karen Wong. Karen is Mellon's Head of Index Portfolio Management, overseeing the firm's equity and fixed income indexing strategies, including exchange traded funds. And she's quietly been working on this thorny ESG issue for a long time. Way back in 2014, Karen launched Mellon's carbon efficiency strategy. She serves on the S and P index Advisory Panel, MSCI's Index Client Advisory Panel, the FTSE Russell Policy Advisory Board, and most pertinently to this conversation, she's a member of Mellon's ESG Council and our parent corporation, BNY Mellon's ESG Investment Council. Karen, welcome.

Karen Wong: Well, thank you very much Rafe and Jack.

Jack: Thank you.

Karen: Great to be here today.

Jack: Very, very good. So Karen, given all that history and context, let's just ask you a simple question, okay. As someone who runs index, you basically have little to no choice in which equities you hold. So if you can't threaten divestment from a company, to force these changes or at least advocate for them, how can you achieve anything meaningful from an ESG perspective?

Karen: Well, so we do have a number of tools. I would answer this question from two different angles. One, very importantly is proxy voting and engagement, and I will call it our secret weapon. We certainly take this fiduciary responsibility very seriously. And just because we cannot divest, as you pointed out, and because we're a long-term investor, it's imperative that we ensure companies that we invest in, have strong governance and focus on long-term shareholder value creation.

Karen: Now we have index portfolio managers that sit on the Mellon Proxy Voting committee. We manage over $300 billion in index assets, which makes us a top 10 shareholder in many companies that we invest in. Now, what we bring to the table is that our message and engagement actions can carry a significant weight to drive changes in corporate behavior because we're a top 10 shareholder.

Karen: Now, change perspective a little bit, and let's take a look at investment strategy. As you mentioned, there's been significant interest in recent years, in ESG product. Definitely not short of anything on the index side. We've been managing money to perhaps one of the longest-standing ESG index, the MSCI KLD 400 Social Index.

Karen: Recently, we have worked with a sister boutique in creating a fixed income index solution. And having the index solution in a multi-asset strategy brings and highlights the importance of having a low cost solution to ESG investing.

Karen: And I should also mention obviously, the Green Beta strategy, the carbon efficiency strategy that I helped develop in 2014. And that is a very important strategy for index investors who may be willing to take on a little bit tracking error, while at the same time, achieving a target to reduce carbon footprint in their portfolio.

Rafe: So you can have your ESG cake and eat it too, there a little bit. Well, let's talk about the importance of corporate disclosure for a little bit here. Because if a company in your index isn't disclosing data on say, their carbon emissions, how does someone in your position measure and manage that company's ESG risk to your index fund?

Karen: It's definitely a very key point here. If you think about it just at a high level, any risks can only be managed if measured. So we've been a strong advocate for years for corporate disclosure. When we were creating the carbon efficiency strategy back in 2014, a real challenge that we faced was what are we going to do with the non reporter, companies that did not care or did not have the resources to report carbon footprint?

Karen: Now, I think there are a number of ways to address that. I talked about proxy voting and engagement, and there's one thing that we can always do. And that is working with a number of industry organizations, such as CDP, TCFD, and engaging in shareholder initiatives, such as signing up as a supporter to be a Climate Action 100+ supporter or TCFD supporter. So that is one area that we would collaborate with our peers in the industry to help in encouraging companies to disclose.

Karen: The other aspect that we can do, now obviously when it comes down to managing an investment portfolio, is the need to have accurate or as accurate as possible data. And for companies that decided to not report, our choice is limited, but it's still possible in that we just need to make sure that we do the due diligence in looking for a robust estimation methodology in estimating data such as carbon footprint.

Jack: Very good. So take a stab at it either way, even if the disclosure isn't up to your standards. But disclosing, let's say carbon emissions that's of course an environmental item, in terms of the ESG. But it also has relevance in assessing a company's governance, right, the level to which they disclose?

Karen: Absolutely. If you think about it, E-S and G are actually well intertwined. I'll give you an example. A few years ago, is a pretty well known scandal in the industry that a company failed to accurately report carbon emissions. Now that was an environmental issue on the surface, but it's really a governance issue in its core.

Karen: This particular company's board lacked diversity and independence. And as a result, created a culture and a business environment that make emission test cheating possible. Now, if we take a look at what we actually do in our proxy voting and engagement to advocate for independence and advocate for disclosure.

Karen: For years, we have advocated for strong corporate governance. And the other example I would give is, look at the TCFD framework. It provides a framework for companies to make financial disclosures associated with climate change related risks.

Karen: The final recommendation is a four level framework. It starts with governance. Governance is on the very top of this four level framework. And then it goes down to strategy related to business planning and financial planning. And it goes down on the third level on risk management and that is related to implementing business processes. Now at the very bottom and this is not the least, is reporting and disclosure. This framework highlights the significance of governance in the ESG world.

Rafe: Got it. And by the way, I just want to clarify for our listeners, if they don't know, the TCFD is the task force on climate related financial disclosures, pretty important body in here. And what we're really talking about, it sounds like, is carbon emissions versus carbon omissions, a little bit here and disclosure obviously counts. How are you building that portfolio to be simultaneously passive, while also actively excluding companies with a big fat carbon footprint?

Karen: Well, it comes down to a reward and penalty model. Now carbon efficiency  has two main objectives. One, is to achieve an index like return, meaning low tracking error. The second objective is to reduce carbon footprint of the portfolio, while at the same time, improving its ESG profile.

Karen: Now, the key here is to look at companies that we want to invest more, in other words, overweight. So we would be looking at companies with low carbon footprint or high ESG profile. And the companies that we would want to penalize or underweight would be companies with a high carbon footprint and companies with low ESG score.

Karen: And obviously, we also have to make sure that we look at the key features, such as factor and factor neutrality. The other very important aspect of the strategy is to incorporate engagement, proxy voting and engagement, that I talked a little bit about earlier. And what we get at the end of the day is a product that we call Green Beta. It's nonetheless a beta strategy, but it's a green product.

Jack: So there's a bunch of third-party ESG ratings agencies out there. We've already mentioned some of them. And some work we've done, Karen, on the investigative research team found that many of the agencies, the ratings agencies, they sometimes lack industry specific expertise. They use wildly different methodologies in some cases. And as a result, there's actually very little correlation among the different agencies ratings on a given company. How do you overcome issues like that?

Karen: That's exactly the challenge that we faced as we were developing the strategy. And we still face that issue nowadays, as you mentioned. The main rationale in selecting the robust data set or third party data, is really don't let perfect be the enemy of good. There's no perfect data. There's no 100% disclosure on just anything ESG related.

Karen: I think it's important for us to understand that it's a stepping stone in including data, but we do have a few prerequisites or requirements. One, we need the data provider to have the breadth and the depth of data coverage. Now this is particularly important in the index world when we invest in thousands of companies. So we need to make sure that there's an adequate level of coverage.

Karen: Also, very importantly, for non reporters, for any particular metric that we need disclosure for. And if for whatever reason, a company decided to report, then we need to evaluate the effectiveness of the estimation methodology and make sure that the estimation philosophy is consistent with our belief in the data set.

Rafe: A lot of work going into this behind the scenes. Well, I mean, do passive investors have reason to think ESG integration actually helps their returns or are they accepting the risk of sacrificing performance, at the altar of feeling better about themselves?

Karen: So unlike the early day values-based investors, the mainstream current investors really believe that they're reasonable approaches to do well and do good. And ESG integration if done correctly, can help improve return and/or reduce risk. 

Karen: And it's also interesting to look at during this COVID-19 pandemic, ESG strategies have done well generally. There are a number of studies or research papers that have been done looking at how ESG-leading firms are doing relative to the overall market. And those firms actually have performed better. And conversely, the ESG-lacking firms actually have done worse than overall market.

Karen: So there's a pretty substantial positive spread between the ESG leaders and lackers. And the thesis is this, that the ESG leaders are better at mitigating ESG risk. 

Jack: Well, that's great, Karen. We've talked a lot about the past five years. Let's look ahead five years from now, how would you like to see ESG risk considerations, which are essentially nonfinancial factors incorporated?

Karen: Yeah, so being in the index industry for nearly two decades now, observed the record breaking growth in assets and the evolution from cap weighting to alternative writing. And I believe the infrastructure and the framework are now in place for the industry to expand to incorporating nonfinancial factors in the index construction.

Karen: And whether that is creating an ESG index or in creating another beta strategy that would capture the ESG considerations in the strategy and would still use a spender or what I would call the cap weighted index as its benchmark. Now the other aspect, where I would really love to see more action is what the index providers can do.

Karen: And being a member to a number of index advisory panel or board or committee, I would like to see the index providers play a bigger leadership role in addressing some ESG issues. A well-known issue that we face right now, is the non-voting or the unequal voting share class. And what should we do with those companies with the non-voting or the unequal voting share class in the index? And I really think that as a leader in the industry, index providers can do more in addressing this issue in the share cost structure.

Rafe: Well, it sounds to me, Karen, like the era of the term passive is going by the wayside a little bit here, because these may be passive strategies, but the management of them is anything but, it sounds like to me. Well, Karen Wong, Mellon’s, "Passive guru," thank you so much for joining us here on Double-Take.

Karen: Thank you very much. I would close with this statement. If it's passive, why do we have to work so hard?

Jack: That's a good question. Well, let the hard work continue.

Jack: All right we've heard how passive managers are increasingly wrangling with ESG factors as they modernize their approach to portfolio risk. Now, let's dive deeper into ESG by examining how institutional investors are impacting public company management practices, governance practices by establishing baseline sustainability requirements for the companies in which they invest and what those mandates mean for performance. To examine this topic, we've invited a true expert on the subject to Double Take. Rafe give us a little background on our next guest.

Jack: Ruth Aguilera is Darla and Frederick Brodsky Trustee Professor in Global Business, distinguished professor at the D'Amore-McKim School of Business at Northeastern university in Boston here, and has spent time teaching and researching previously at the National University of Singapore Business School at the Wharton school, and the college of business at the university of Illinois, Champaign-Urbana. She did her doctoral and masters studies at Harvard university and her undergraduate studies at University of Barcelona in her native Catalonia. Among her many other roles she is an editor at Corporate Governance and international review and a senior editor at Organization Science. Senior editor at Organization Science, you must have a very organized house, Ruth?

Ruth Aguilera: Thank you. It's a pleasure to be here to talk to you.

Jack: Very good. So tell me what are the key reasons we thought it'd be great to have you on Double Take, Ruth is you recently coauthored a really cool article that studied the after effects of a Scandinavian sovereign funds decision to foster really specific pro shareholder corporate governance practices. And it's kind of like a lab experiment, right? We can actually see the isolated impacts of investor led corporate governance mandates and understand their true impact. So in this particular case study, what did we come away learning about companies willingness to actually respond when a fund says change your practices thusly, we demand it. Do they respond?

Ruth: Thank you. Thank you for reading my paper. So let me tell you a little bit about this study. And it's a nice what we say in finance, it's a nice lab experiment because there was an external shock. So there's this sovereign wealth fund that have been founded many years ago, trying to invest their liquidity and diversify their market. And in 2012, they were convinced by some finance philosophy or finance ideology that having good corporate governance leads to better performance of the funds. So in November, 2012, they announced a mandate that all the companies that they were invested in, which is around 8,000 companies all over the world, they had to change their corporate governance practices to fulfill this mandate. And the goal for that was so that they would improve their financial performance. 

Rafe: So it was about improving the fund's financial performance and not about kind of improving the world or improving the behavior and ethics of the companies that they invest in?

Ruth: So they thought that by improving the funds' performance, they will also help improve the company's performance. Okay? So this is a little bit tricky. So what we do is these external shock goes in December, 2012, and then what we have done is we have seen one, if they walk the talk that they were... is basically like if they invested from firms that they were not changing. And then if the new firms that they were adding to their portfolio had the corporate governance that they was in their mandate. And basically they were interested in two aspects of corporate governance because it could be in many different aspects. One aspect was the board accountability. So they wanted boards that they had independence, but this is kind of corporate governance from the last century. They also wanted boards that had enough diversity.

Ruth: So this is actually pretty easy to do because you can always add a new person in the board and increase your diversity. The second thing that they wanted to do, the second issue, it's a little bit harder. It has to do with shareholder rights. So that's harder because sometimes it entails to change the corporate charter of your company. They were not too comfortable with dual-class shares. So they wanted more including themselves so that investors would have one share one board, and kind of weighing out or win out this lack of shareholder democracy. So as you can imagine, it was much easier... We see as we follow all these companies, we follow about 8,000 companies since 2012. Most of the companies that they have kept in the fund have been able to change the board composition, accountability aspect, whereas the shareholder rights, that's a little bit harder. So in a way it's easier to do the more symbolic versus the more substantive.

Jack: Interesting. So in terms of performance, this is always what it comes down to, right? In terms of what I think our listeners would be most curious about, your paper had some interesting findings. There was an improvement in the corporate governance practices of some of the firms that were falling short once they came into this fund. So they clearly were responsive to the mandate, but the firms that already had pretty good corporate governance practices that were in the fund didn't change much in terms of the score that's used to decide if you have good corporate governance practices or not. So we kind of know the degree to which the firms change their corporate governance or not and what that profile looks like. But was the fund able to say that this improved performance versus if we ignored these factors and didn't try to force this change? And is that even the right question to ask in terms of what this fund was out to achieve ultimately?

Ruth: Yeah, so obviously the performance is a very important aspect of it. And there's previous research that shows that there is like a turning point, an inflection point. Usually, the companies that change the most are the ones at the tails. So if you are doing really poorly, you have... If you're doing really performance... So one thing is if your performance, if your financial performance is very weak, then you try a new thing, and you might improve your corporate governance to try to catch up. The ones that they have a strong financial performance, they also have the leeway, they have the degrees of freedom to improve their corporate governance. So it's kind of an endogenous question in the sense that the firms that they were already financially doing well, by improving a little bit their corporate governance, they were able to enhance their performance. So we see these, the firms that they were... So because we control performance, the firms that were lagging behind in performance, this might have been just changing a little bit their corporate governance might have been a way to continue to retain these investors, the sovereign wealth fund investor and survive in this kind of segment of the market. The very interesting thing is if we do a little bit of cross national research, things that we see when we compare markets. So there are markets that just the market itself, the institutional setting of market, let's say a market like the US by law you need to do certain things. You need to have like Sarbanes-Oxley or Dodd-Frank, you need to have independent boards. If you are listed you need to have certain diversity or your investors will ask for that.

Ruth: Even in some other markets, let's say the non-liberal markets or more stakeholder-oriented markets, many of the corporate governance regulation is non-mandatory. So it's basically it's their practices that they are mandated by codes of good governance. And those are only on the basis of comply or explain. That means that you can choose as a young firm or as a firm that struggling or as a family firm, you can choose to have a board that it's all insiders, and as long as you disclose why you don't have to comply, you don't have to have a good corporate governance. So these types of firms will be dropped from the sovereign wealth fund portfolio.

Ruth: So what we see in this study, what we see very, very clearly in this study is that, as time progresses, they dropped some of the firms that they were not complying with their mandate of corporate governance, and the new firms that they were having were already at the level that they require. And we also see that over time, the firms that they have better corporate governance will perform better. So some of this better corporate governance is really quite minor, things that they can do, but that it adds accountability, it adds transparency and all that together leads to better performance because it will... When a big fund invest in a firm, it will also attract other funds that they don't have the research capabilities to-

Jack: It's indexed.

Ruth: Yeah, exactly. He will attract other... If they see that 5% is owned by a big sovereign wealth fund, then other smaller index... some indexes, some even venture capitalist, some other they might invest. So it attracts. It's kind of a diffusion effect.

Rafe: One thing you said Ruth, that really caught my ear was that if you're a low performing firm, you might be able to retain your place in this fund despite your low-performance by showing goodwill and corporate governance reform. It's almost a survival mechanism for underperforming companies in some cases it sounds like?

Ruth: Exactly. So there are some markets that they have very poor corporate governance as a country. So because they don't mandate, because there is no transparency because there is no accountability, and there is no enforcement that usually, some markets the law might be beautiful, but there is no enforcement and there is no penalties. So nobody follows the law. So in those cases, and the investors know that that market basically, it's very unreliable. And so in those cases, if the firms do a good job improving their performance, it will overcome the liability of the corporate governance of that country.

Rafe: And in terms of this experiment, I mean, did the sovereign fund performance improve as a result of this policy?

Ruth: Yeah, we see that overtime. It definitely improves. Yeah.

Rafe: And is that because this was a flight to quality and they kind of changed the type of company they were going after and maybe they were willing to pay a premium for quality. And so maybe the bar moved in terms of what they're going to consider evaluation that would be worthwhile to them? Or is it really a result of the fact that these are companies that have excellent governance?

Ruth: Yeah, so I think it's a little bit of both in a way... Sovereign wealth funds are in general quite liquid and they have more options. And sovereign wealth fund are not shareholder activists, but they do have... more sovereign wealth funds they have a mandate, whether it's a New Zealand sovereign wealth fund that they has a mandate about environmental issues or a sovereign wealth fund from the middle East or in this case from Scandinavia, they have kind of a purpose to exist because they are not a state owned funds. It's not a state own, but they are lean to a government kind of ideology.

Ruth: And in this case being in Scandinavia, they have kind of an ideology that want to spread all over the world about what is a well run company and a well run company cannot be a company that it's not transparent that it doesn't have accountability if they want investors to put their money in there, and then to be able to deliver to their shareholders, to pensions, to all sorts of long-term investors. So it will be too risky. So this is why this particular sovereign wealth fund from Scandinavia believes that in order to have sustainable long term resilience and a strong performance, we need to focus on these structural issues that will make the company more resilient long-term. So we're thinking about these kinds of investors that they are institutional investors, long-term institutional investors.

Rafe: How unique was this? I mean, was this sovereign a total trailblazer out in the world and maybe still alone or are we starting to see some follow on activity from other sovereign wealth funds or other large institutions?

Ruth: So this was a kind of a... 2012 is a while back, but they made the big deal in terms of the PR that they follow, and the different, The Financial Times, The Wall Street journal and the European journal newspapers follow these. So there's an entire machine behind it. But the interesting thing, there's a study that a Minnesota has done that basically that small... what I said before a little bit that there's a diffusion effect of this overall practice kind of. It's almost an ideology on good corporate governance. Because good corporate governance could be also let's compensate our managers in a way that it's completely aligned to the goals of the firm. And this is not the case. Or good corporate governance is let's make sure that we can allow for external corporate control. They're thinking here in a very kind of a structural firm things that can be done at the firm level. And some of the things can be very easily done and not very costly because I mean corporate governance can also be very costly.

Jack: In terms of this sovereign wealth fund we're talking about, they were already screening to keep out companies that produce cluster munitions, nuclear weapons, tobacco, caused severe environmental damage, serious human rights violations. Some of the things we think about when we think about ESG, that was already off the table in terms of who they picked. So we're talking about a group that already is carved out of that consideration. Do you think that governance might come to be seen as how well you govern those factors as opposed to how well you manage your internal board and affairs? Did you get the sense that governance is coming to mean how much not only you care about diversity on your board, how your voting shares are issued, but also how much you care about what happens outside the four walls of your office?

Ruth: Absolutely. I mean at this point the ESG is completely intertwined because the decisions that the board makes, I mean, the type of board that we have will determine how educated they are, how sensitive they are to issues that they are relevant to the performance of the firm, to their brand, to the people that they are able to retain and attract like human capital, to the social capital that they have. So let's just take the board for example, so the individuals that you have within the board and how you rotate the board and how long are people to stay in the board, will determine how agile that company's in becoming sensitive to all sorts of non-market issues that might have to do with politics. It might have to do with sensitive environmental issues. Might have to do with what is the goal or what is the purpose of the company.

Ruth: So I don't think you can separate the G because when we think about governance seems very legalistic and very tedious, but it's actually a very strategic decision making in the firm that affects both the social and environmental. And the three of them are related to the long-term survival of the firm. The long-term survival of the organization, and to retaining the investors as well. And the type of combinations of investors that you're interested in having in your firm. And the interesting part about investors is that many times and these were so in our study, many times you cannot tell who is your investor and maybe you have an investor that actually you don't want to be related to because they are not congruent with the goals of your company, but you don't know until they reach 5%. Right? And then it might be too late when three of them get together and decide that you need to get off the board.

Jack: Did there come a point where this sovereign wealth fund said to themselves, we may in the short-term look like were sacrificing performance to drive this broader change, but because they're a sovereign wealth fund as opposed to some index or equity fund, they're not so much focused on the degree of success being defined by returns because they believe that even if we sacrifice short-term returns we're setting the necessary conditions to literally change how all companies govern and invest. And that's a goal when you think like everyone acts like their long-term, right, investing. That's the real long-term isn't it? Is making decisions in here and now that could in the next two quarters costs you performance, but long-term restructure the way firms govern themselves so as to attract investment?

Ruth: So we've talked to them several times and when you talk, depending on who you talk in the company, they will say, no, we follow the policy and we are interested performance. They definitely like going back, they definitely drop some companies just for ethical reasons. They have an ethical mandate that was before this one, and those companies are just dropped. It's however important to note that they see it in top of the world. They are in a very luxurious position that they have so many degrees of freedom that they can breathe and make mistakes and be very patient because of their liquidity and because they have... it's-

Jack: There is no client that can just pull funding.

Ruth: Exactly. And basically because they own the market, they own the entire market so they are not doing diversification. But they have kind of a... I mean, I would call it as strongly as ideology on what good corporate governance and that the world should run like that. And will we ever get to companies in China, India, other emerging markets to be run like these particular sovereign wealth fund who sits on top of the world want to. I mean when they have completely different culture, different power to enforce the law, to enforce or even different markets. They don't have a liquid markets. They don't have strong stock markets.

Ruth: So my response to that thinking about are we going to converge finally? Is everybody going to look like the sovereign wealth fund that because if they are controlling most of the firms in the market, and my answer to that would be that we are converging in diverging. So we are converging in that everything is changing, because I am sure that these firms in emerging markets that they don't have the ability to completely fulfill these mandates. They will find ways to do arbitrage and to continue to differentiate themselves and to have something that is attractive to investors. But there has to be a minimum thresholds that the fund would invest if they don't have a minimum board of accountability and a minimum shareholder rights.

Rafe: Ruth, is there a way to game the system here by these firms? Are there ways to kind of symbolically attempt to appease a sovereign with these kinds of new mandates and play for time a little bit? Or is it pretty easy to figure out whether this is just a fig leaf or if it's an actual substantive change in governance policies?

Ruth: So there's, there's been a lot of what's called window dressing or pink washing. There's been a lot of that because it's very easy... It's like, oh, more diversity. Okay, let's add another woman to the board, and that doesn't change things. So you have to be firm by firm trying to understand whether the change is symbolic. They are going to see much change to tick the box or the change is substantive in the sense that it's internalized, and the firm believes that you it will help them. And only in that case the performance will improve. When they do a change, it's like, Okay, we need to add a woman. Let's add a female that actually can help us understand that if we need to do some investment in CSR, what is the best investment that we can make? Where is our company best equipped to invest there? That will not only help our employees or our suppliers, but it will also help the company.

Ruth: So then you would kill two birds in one, like to put somebody that actually is useful as opposed to... This window dressing is harder to do when it comes to shareholder rights because that's the kind of class that you have, the kind of share that you have is really like, that's the letter of the law. So that's kind of hard to maneuver. But other corporate governance changes are easier to dilute such as the independent is like, well, how independence is really... And in the United States we have a lot of regulation about that.

Jack: And splitting up the CEO and chairman role, whether that's required from the top down. I mean some of the most successful American firms have CEOs serving as chairman as well. So there's no clear decision on what's best practice even in a developed economy like ours?

Ruth: Yeah. So this is a question because typically is when things go wrong, you go back and you point fingers at oh, the corporate governance of the firm. So recently we had a couple of examples. There was a recent one in the UK where thousands of people lost their jobs and were stranded. 

Rafe: This was a famous travel company, right?

Ruth: Yeah. You were traveling at the time?

Rafe: Thankfully. No. You were coming from personal experience for a beat there.

Jack: I watched from my desk saying to myself for once, I'm not the one stuck at the terminal. This is fabulous.

Ruth: So they're shareholder rights. Nobody was monitoring, no accountability, because at the end of the day, we're all shareholders because we're all pensioners. We all have mutual funds. We have all index fund. So it is relevant to every single one of us from the bottom to the top how our money is invested and yeah.

Jack: Can we talk just briefly about, cause this always comes up, if we're going to score companies on corporate governance, there has to be agreement on what the criteria are. I think in this case the sovereign wealth fund had about like a 34 criteria set of what constituted good governance. And they were specific and they were kind of deferring almost outsourcing that judgment to affirm a service that was keeping track of that for them. And we hear a lot about this when we talk about ESG because folks want a sort of independent third party to tell them this company is rated X on this, Y on this. When it comes to governance, how can you explain to us what the composite parts are of those scoring systems and criticisms of whether they're too inclusive, not inclusive enough, because people have to pass this judgment if this kind of a governance movement is going to work. So what are the composite parts of that and what's the state of the dialogue there?

Ruth: Yeah, this is a very tricky question because there's definitely a split on what is good corporate governance. So if you ask some of the policy advisors, they have exact categories of what are these 40 good corporate governance practices? And then companies go and tick the boxes. So I don't think that is very fruitful because some of these practices are completely what we would call academically as functionally equivalent. You are totally duplicating the role. Sometimes if you have a very strong independent board, you can have dual leadership, you can have the CEO and the chairman to be the same person. So kicking the box is definitely in my opinion, not the way to go. As some policy advisors they need to... Yes, I understand they need to invest in thousands of companies. They draw the line somewhere. It's like, okay, these are good, these are bad. We don't have very good and there are lots of companies out there that risk, that drag firms on their corporate governance. We don't have very good ratings. This is why we need researchers.

Jack: Trust. Yeah. There you go. 

Rafe: Shout out.

Jack: I have to ask, is it possible to come up with a scoring system that everyone agrees fosters the right behavior or is it just a free for all of people plowing preparing trying to sell their wares. Here's my scoring system. It's better than this guys. Will we ever get to a place where there's enough agreement on what matters in terms of corporate governance that a gold standard will emerge?

Ruth: Yeah, I think the best would be for everybody to believe for the owners, the board to truly endorse the idea that there are certain practices that will lead to better performance. Because I don't think we can have a goal of standard, one size fits all for all firms. The firm can be a very new firm, the firm may have just gone through a major transformation. The firm might be growing with new investors that want to be more discreet. So I don't think there is a one size fits all, and what there should be is minimum standards that all firms should adhere to and then have, I mean maybe it's my own, but then having firms disclose why are they doing what they're doing? Yeah,

Rafe: No, it's fascinating. By the way, It's funny. It's very different than railroads, right? Where everyone has to have the same size rail or you can't get this rail car from California over to Maryland. Right? I mean, everyone's going to have their own proprietary recipe, and maybe someone who comes up with a really good recipe isn't going to want to share it. I mean, we're developing our own scoring system here right now. I don't know how much we're going to want to proffer it. On the other hand, maybe if it's really good and we want to do well by society, maybe it's something we would consider.

Ruth: Yeah. And sometimes these scoring systems are good in terms of having a yard stick, and sometimes like in Germany they had one, and then it became law because they play with it. So sometimes having this is... You need to at least reach 60% of these. Figure out how you're going to get there. But at least the plain field you should get 60%. And this is what they did in Germany with some of the corporate governance. They first have them as non-compulsory, and then they make them law later after they experiment with it.

Rafe: I see.

Ruth: Once enough companies have had the chance to invest on it because corporate account is costly. Some of these practices are costly. Even having a new board, you have to pay them. So that's costly for some companies, and it's an opportunity costs, it's a cost of maybe information, the few information leakage. So yeah, I would say, yeah, the rankings are good because measuring things is good. Measuring things is very good.

Rafe: Last question for me. I guess maybe this is too simplistic, but I want to keep it wide open and hear your discretion on this, but as other sovereign wealth funds and institutional investors are looking at potentially instituting a mandate like this sovereign funded in 2012, what do you think is the main lesson, the main takeaway here for them as they're looking to do this? Is there a cautionary tale here or like an overarching theme that you think they should really focus in on?

Ruth: Yeah, so the different sovereign funds, they have different goals on their distance depending on where they are in world. Like why do they exist? But what is clear is that everybody likes to be part of the family, so they like to... You don't want to be different. You don't want to be an outlier that you stand out because you are so opaque. So I think that in their own way, because many of them for instance, are located in London or in New York, in Boston.

Ruth: In their own way, they are in these places because they want to learn how business is done here and they want to get up to that level. And I'm not saying that, that level is a better level, but that's like the rules of the games or how the market operates here, and they want to be seen as legit, as a very interesting and attractive funds. So this why I'm thinking that whereas the Scandinavian fund, may set up their own rules. There are other rules as well that other funds might be able to attain, right? Like to... Am I clear? Do you understand what I'm talking about?

Rafe: If I'm hearing you correctly, you're saying that it's not a one size fits all solution, right?

Ruth: Exactly. Yeah.

Jack: Is it too much to ask you to maybe give us your thoughts on what needs to be in that minimum threshold every time?

Ruth: Yeah, so I think first of all, there has to be transparency. So if you are a publicly traded firm, I mean you have to know who the other owners are. So who the other owners are, how much control do they have over the firm. So not only the cash flows but the voting rights. And then know who's on the board, what are their terms? And know about the compensation as well. Know about the compensation because those are the incentives and the risk that these companies are going to be willing to take.

Jack: Ruth, thank you so much for joining us. It's been a great pleasure for Rafe and me. And just remember folks, if you want to dive much deeper into this topic we're going to post doctor Aguilera's research on our website, or at least the link on and you'll be able to find all of her papers and journal entries.


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