Why using an ESG filter helps prevent stock market shocks

Investors in Indian markets may recall the Satyam Computer Services fraud that was unmasked in the wake of the global financial crisis triggered by the Lehman Brothers collapse.

Satyam was found to have reported profits that never existed, and its auditor, PwC, never raised any alarm. Much of the missing cash was invested in property. The swindle was discovered in late 2008 when the property market collapsed in a city in south India, leaving a trail back to Satyam.

The IL&FS fraud was the largest corporate fraud in India. It came to light in July 2018 when two of IL&FS’s subsidiaries failed to repay loans and inter- corporate deposits to certain banks and lenders. This uncovered a deliberate accounting fraud, such as ever-greening of loans.

IL&FS’s balance sheet size at the time of the fraud was $12 billion and its collapse had a serious impact on the credit market.

These are just a few examples of real economic losses, caused by lack of good governance. Investors that ignore governance and chase the returns of such companies are taking an undue risk. Most of these and other cases are avoidable with proper governance structures.

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So, what is corporate governance? It is the system of rules, practices, and processes by which a firm is directed and controlled. It represents the G in ESG investing. Good corporate governance essentially involves balancing the interests of a company's many stakeholders, such as shareholders, senior management executives, customers, suppliers, financiers, the government, and the community.

Bad corporate governance can cast doubt on a company's operations, its ultimate profitability and how the profit is distributed.

Checking the warning signs

The questions that arise with every corporate governance episode: were the warning signs not visible before the accusations or the collapse, which were, at times, fast and furious? What could an average investor have done to protect her portfolio from the damage that ensued?

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When poorly governed companies do run into business challenges, their collapse can be swift, but in hindsight, signs were always there. Some of them have relied on years of so-called crony capitalism, whereby business contracts are won, or permissions gained, based solely on their government ties.

Some rely on a series of complex corporate structures and accounting practices that might propel their earnings, and therefore, stock prices for some time. These structures mask significant economic risks.

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For the average investor, spotting such governance risks can be challenging. But they could rely on institutional investors that have strong emphasis on governance.

Individual investors have fewer resources (ground research and verification) to judge the quality of governance, unlike institutional investors.

In addition, governance risks may not always be evident in financial statements and disclosure documents. Data is sparse, definitions are imprecise, and disclosures alone do not guarantee good behaviour.

Are active ESG funds better than passive ones?

ESG assessment by institutional investors can go beyond ticking the box, desk research, evaluation of historical episodes of treatment of minority shareholders and asking the management tough governance questions.

This is where actively managed portfolios with an emphasis on strong governance will have an edge over traditional passive investing, which does not give governance aspects their due.

As a way to incorporate governance, are ESG indices a viable alternative?

Even if we assume that ESG indices do the right assessment of companies, investors still cannot entirely rely on them.

Many traditional ESG index construction approaches typically sort a universe of stocks using the companies’ ESG scores, eliminating those with the worst rankings, and cap-weighting the remaining.

This does not render them true to mandate as ESG is just a filter mechanism, and portfolio weighing is determined by market cap and not ESG. A low-rated ESG company, which just meets the threshold, can have outsized weights in the index due to its size.

Therein lies the central problem with such indices. They tend to pick only the largest companies to better compare to a conventional index. Some indices have a strong tilt towards single stocks, and that pushes the limits of what we define as an index.

Thus, till better regulations bring in greater transparency, standardisation of disclosures and quality ESG actions, as well as accurately constructed ESG indices, investors would do well to trust an active ESG fund to account for the fact that what you see is often not what you get.

Chirag Mehta is Chief Investment Officer, Quantum AMC, and Ghazal Jain, is Fund Manager, Alternative Investments, Quantum AMC.