Corporate Governance: Market Matters

Good governance is foundational to effective capital markets, promoting accountability, transparency and sound decision-making aligned with investor interests. But how do those potential benefits translate into market performance?

To find out, we used a long-short quintile analysis over the nine-year period between January 2015 and December 2023 to compare the long-term, relative performance of governance leaders and laggards across constituents of the MSCI ACWI (i.e., globally), MSCI World (i.e., in DM) and MSCI Emerging Markets Indexes.^[1]

Governance leaders outperformed in developed markets but struggled in emerging markets

While governance leaders outperformed laggards overall, two divisions stood out:

• Region: higher governance pillar scores were associated with equity-market outperformance in DM but not in EM.
• Time: the positive relationship between governance pillar scores and equity-market performance was stronger prior to June 2021, and weaker afterward.

These trends reinforced one another, with only middling performance after June 2021 in DM and very poor performance in EM. As June 2021 did not coincide with any significant changes to our global governance methodology, we asked what other factors could have contributed to the governance pillar’s underperformance in EM and globally after June 2021.^[2]

First, we examined the specific countries composing our hypothetical long-short portfolios. We then paired this analysis with factors from the MSCI Global Equity Factor Model to help quantify the trends we observed. We applied our factor analysis across two periods: January 2015 through May 2021 and June 2021 through December 2023.^[3]

Because corporate governance is grounded in local law and regulation, we expected to see market concentration in our hypothetical portfolios. As shown in the exhibits below, we were not disappointed.

Country exposure played a significant role in our hypothetical governance portfolios

Developed markets: US vs. UK

On average, more than two-thirds of our DM governance leaders comprised equities from four anglophone markets: the U.S. (36%), Australia (13%), the U.K. (11%) and Canada (9%).

U.S. governance leaders consistently outperformed laggards between 2018 and 2023, with top-scoring companies delivering a cumulative return 26.3% higher than their worst-scoring peers. Well-governed companies bounced back more strongly in the months following the global COVID-19 pandemic and maintained their gains in the years that followed.

Good governance consistently outperformed in the US

The U.S. contributed an approximately even proportion of companies to both the leader and laggard camps, with members of the Magnificent Seven stocks appearing in both.^[4] In contrast, the three key Commonwealth markets overwhelmingly contributed leaders and laggards.

The U.K., for example, offered very few laggards for most of our study. This concentration contributed a -3.1% loss up to June 2021 and tepid performance afterward — both of which reflected poor overall market performance. Canada’s effect was smaller but grew worse over time (-0.2% before June 2021, and -0.6% after). Of the three large Commonwealth markets, only Australia contributed a positive return after June 2021.

As a market, Japan performed well over our study period. But despite recent improvements in Japanese corporate governance practices, Japanese companies were three times more likely to be classified as governance laggards than leaders, resulting in a consistent hypothetical short position in Japan.

Emerging markets: China vs. South Africa

While country concentration was generally stable in DM, the inclusion of China A shares in the MSCI ACWI Index beginning mid-2018 significantly altered the home-market composition of both our governance leaders and laggards.

At the start of our study, China represented 18% of our leaders and 25% of our laggards for EM. By the end, it represented 35% of our leaders (about the same as the U.S. in our DM analysis) and a substantial 60% of our laggards — a higher proportion than any other country in either analysis.

The concentration of Chinese equities among EM laggards reflected myriad governance risks, ranging from pervasive related-party transactions (seen at 86% of Chinese laggards vs. 46% of all other companies) to non-majority-independent boards (46% vs. 24%) to a lack of claw-back provisions for executive pay (87% vs. 47%).

The resulting country exposure had little impact on performance, however, with EM outside China generally moving in sync with Chinese equities over most of our study period.

South Africa was an outlier of an opposite sort. It represented, on average, 15% of our leaders and less than 1% of our laggards. This reflected local governance achievements such as the King IV corporate governance code (released in 2016), which further strengthened what were already continent-leading governance practices.

But the country failed to reward investors over most of our study, contributing a notable -14.4% to the hypothetical EM portfolio’s total loss leading up to June 2021 (though, afterward, the market recovered somewhat with a 2.1% gain through 2023).

Beyond borders: corporate fundamentals

Country effects may have taken the wheel when it came to equity returns, but the value of good governance was clearly demonstrated by corporate fundamentals. On average, the best-governed companies had significantly higher profitability and, in DM, significantly lower risk throughout our study.

These results are hardly surprising. Our governance model is intended to signal companies where decision-making structures and outcomes are better aligned with the long-term interests of investors. As investors will generally benefit from higher profitability and better risk-adjusted returns, the model appears to have succeeded over our study’s time frame.

Governance leaders in developed markets had better fundamentals over both time periods

Governance can be governed by markets

When it comes to governance, market matters. Governance was an effective investment signal in the U.S., but country effects weakened it across other DM — and overwhelmed it in EM. Despite mixed equity returns, good governance was aligned with strong corporate fundamentals throughout our study. We intend to further explore the importance of governance in the U.S. and EM in forthcoming publications.