Corporate Governance: Market Matters
Key findings
- In the U.S., companies that displayed governance leadership consistently outperformed governance laggards between 2015 and 2023, with an excess annualized return of 2.7% over our full nine-year study (26.3% cumulative).
- Globally, country effects had a big impact on performance. South Africa suffered long-term underperformance despite strong corporate governance, while we saw weak performance from governance leaders in Canada and the U.K.
- Good governance generally meant higher profitability, lower volatility and lower earnings variability in developed markets (DM), but it tended to be a weaker signal in emerging markets (EM).
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
The chart shows the cumulative difference between the top and bottom quintiles' performance between January 2015 and December 2023. Equally sized quintiles were created in each month based on size-, region- and industry-adjusted governance pillar scores. Performance was adjusted for currency effects. Source: MSCI ESG Research
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.
Country exposure played a significant role in our hypothetical governance portfolios
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This chart set summarizes the composition and performance of each of our three hypothetical governance long-short portfolios between January 2015 and December 2023. The top two charts show the composition of each hypothetical portfolio over time with companies grouped by home-market classification. The top-left shows companies in the bottom quintile and the top-right shows companies in the top quintile. The bottom-left chart shows the average governance-pillar scores for these hypothetical portfolios and for the market generally, while the bottom-right chart shows the country factor's returns over our observation period for this market (or the average performance for aggregated markets). Source: MSCI ESG Research
How to interact with this chart: Use the dropdown menu to select a portfolio. Click on a market in either of the top charts to focus on that market's performance.
How to interact with this chart: Use the dropdown menu to select a portfolio. Click on a market in either of the top charts to focus on that market's performance.
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 chart shows the performance of U.S. constituents of our MSCI World Index hypothetical long-short portfolio between January 2015 and December 2023. As our quintiles were adjusted monthly, the number of companies in each group varied over the course of the study. On average, the leader quintile comprised 115 companies (35.8% of our DM hypothetical long portfolio), while the laggard quintile comprised 131 companies (40.7% of our DM hypothetical short portfolio). Source: MSCI ESG Research
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
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This chart shows the difference between average z-scores for leader and laggard quintiles across several risk and profitability metrics. Z-scores were calculated relative to all other companies in the hypothetical portfolio. Color indicates whether the z-score was considered statistically significant, meaning that its associated t-statistic was at least 2.0 (or at minimum -2.0 for negative z-scores). Source: MSCI ESG Research
How to interact with this chart: Use the dropdown menu to select a portfolio. Hover over a bar to see the underlying data.
How to interact with this chart: Use the dropdown menu to select a portfolio. Hover over a bar to see the underlying data.
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.
1 We began our analysis in January 2015 to coincide with the introduction of the MSCI Governance Metrics methodology into the MSCI ESG Ratings model. Our approach was similar to that used in “MSCI ESG Ratings in Global Equity Markets: A Long-Term Performance Review.” Quintiles are created every month based on governance pillar scores. We first regressed governance scores on market capitalization to eliminate any size bias. We then obtained the regression residuals and standardized them by region (North America, Europe, Pacific and EM sub-indexes of the MSCI ACWI Index) and Global Industry Classification Standard (GICS®) sector. Finally, we formed quintiles within each region and sector based on these standardized z-scores. GICS is the global industry classification standard jointly developed by MSCI and S&P Global Market Intelligence.2 Two major updates to the governance-pillar methodology did occur during our observation period. In November 2020 (seven months before June 2021), the corporate behavior theme was added to the governance pillar alongside the corporate governance theme. In June 2022 (13 months after June 2021), certain key metrics were removed from the accounting key issue while new key metrics were added to the board key issue.3 Because the latter period was significantly shorter (31 months vs. 76 months in the first period), overall factor returns — whether positive or negative — were generally smaller in magnitude over the second period.4 The Magnificent Seven stocks include the common shares of Alphabet Inc., Amazon.com Inc., Apple Inc., Meta Platforms Inc., Netflix Inc., Nvidia Corp. and Tesla Inc.
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