How is Good Governance Rewarded?

Today, we’ll turn our attention to the individual KPIs that form the “Governance" piece of the "Environmental, Social, & Governance" investment framework. We’ll also provide this week’s update on market and factor (US & worldwide) trends. Unsurprisingly, we've seen Total Risk spike in the US and worldwide models, while the risk-on factors of Market Sensitivity and Volatility have sold off heavily.

‍Governance - Performance Decomposition

‍Thus far, we’ve broken out returns for the individual KPIs in the Environmental and Social portfolios we’ve constructed, based on ESG metrics provided by our partner, OWL Analytics. Today we’ll run the same analysis on Governance, which has been the most successful of the three groups since 2014, to see how the market has valued its KPIs. In general, Governance revolves around how companies manage their internal affairs and relationships with stakeholders.

‍Methodology:

• Take OWL Analytics’ three Governance KPIs (full hierarchy below) and create equal weighted portfolios that are long the top 200 and short the bottom 200 companies in the Russell 1000, ranked by their scoring on those KPIs.
• Bucket and aggregate all 3 portfolios to create a higher level “Governance” portfolio.
• Create a sector neutral version of each of these portfolios to remove sector bias, then measure performance from 2014-2019.

Here's what the broader Governance portfolio has done since the beginning of 2014:

Governance - Aggregate

The overall trend for this portfolio has been mostly positive, particularly when it staged a massive, near-8% rally during 2H 2015. There was a substantial downdraft in the first few months of 2019, with returns falling -3.31% between January and May. Since then, performance has been on a steep incline. Let’s take a look at the individual component portfolios:

Governance - Board Effectiveness

• This metric is up over 9% since 2014, showing a mostly positive trend save for a huge drawdown from April - August 2015 (down ~5.7% during that time). After seeing significant positive movement for much of 2018, the portfolio peaked at +11.7% on 7/23/18, and has traded between 8-9% in 2019.
• Of the 9.3% return since 2014, 3.4% came from factors while 5.9% came from alpha.

Governance - Disclosure & Accountability

• Since 2014, this KPI has seen good performance, with the exception of a few steep selloffs. Most recently, this portfolio lost 1.7% in the first two weeks of Jan 2019, but has since rebounded to where it sits today at +8%.
• Factors created a tailwind of 8.45% during this period, while there was slight negative alpha (-0.42%)

Governance - Management Ethics

• The highest flying KPI under the Governance umbrella, Management Ethics is up over 13% over the last 5 years. After experiencing weakness from March - September 2015, the portfolio enjoyed a huge rally in 4Q 2015 (up ~6%). More recently, it saw some weakness in Spring 2019, and has rallied sharply since early May.
• Of the 13.4% in total return since 2014, 8.3% came from factors and 5.1% was alpha-driven.

Conclusions

‍The broader Governance portfolio has performed well over the past 5 years on the strength of each of the three KPIs it’s comprised of. Of the three, we consider Board Effectiveness and Management Ethics to be more investable due to the significant amount of positive alpha contribution. With all three metrics performing exceptionally well recently, we consider Governance to be a good place for sustainable investors to allocate their dollars.

‍This Week's Market and Factor Update:

US Market (8/2/19 - 8/8/19)

• After taking a dive last Friday, the market saw slight relief early in the week, then had its biggest one-day percentage gain in two months on Thursday.
• All major indices were down on Friday (not captured in above chart) after Trump took a deal with China off the table for now.
• Investor fears about a slowdown in the global economy were compounded by a potential political morass in Italy (the Eurozone’s third-largest economy), and the revelation that the British economy had shrunk for the first time since 2012.

‍US Model

• Growth was the biggest winner this week, now poised to shed its Oversold designation as it heads back towards the mean.
• After a meteoric rise into Overbought territory over the past couple of weeks, Earnings Yield has started to revert.
• Market Sensitivity and Volatility both took a major tumble as investors sought to shed risk.
• Size continued to sell off heavily and has plunged into negative return space.
• US Total Risk (using the Russell 3000 as proxy) increased +0.75% week-over-week, currently at 13.79%.

‍Worldwide Model

• Profitability continued to be bought up on a normalized basis, now up a whopping 2.26 SD in the past month.
• Just as we’d seen in the US - global Size, Market Sensitivity, and Volatility have plummeted from recent highs.
• Global Total Risk (using the ACWI as proxy) shot up to 12.56% on 8/5, ticked down slightly, and has since popped back up to finish at 12.36% (+0.71% week-over-week).

Regards,
Omer