How Stock Exchange Indices Can Advance Good Corporate Governance Practices

Since 2001, eight stock exchanges around the world have launched corporate governance indices (CGIs), sometimes as part of a broader environment, social, and governance (ESG) initiative. The comprehensive analysis of these indices is presented in our World Bank/IFC study: “Raising the Bar on Corporate Governance – A Study of Eight Stock Exchanges Indices”. The study is the first of its kind, and it reveals that CGIs may have a positive impact in enhancing legal and regulatory frameworks by contributing to the development of objective and measurable governance benchmarks. The study also shows that CGIs offer companies an opportunity to differentiate themselves in the market and be more attractive to foreign and domestic capital; and, ultimately, CGIs incentivize companies to adopt better governance practices. Nevertheless, as the process for vetting companies to access the indices continues to evolve, the scrutiny of underlying methodologies, the disclosure of company ratings or company self-assessments, and the on-going monitoring process have still room to improve.

Table: Indices studied, number of constituents

Source: Di Benedetta and Grimminger (2013)

CGIs offer a market solution to address shortcomings in corporate governance. Common weaknesses in governance frameworks, such as lack of shareholder protection, poor corporate disclosure, and weak requirements for independent directors, are some of the main reasons behind the creation of CGI and ESG indices. CGIs have proven that they can elevate the legal and regulatory “ceiling” for governance, can allow companies to differentiate themselves in the market, and can increase their access to capital.

CGIs also enhance adoption of voluntary national codes of corporate governance. Across all the indices, stock exchanges tend to pick and choose from the national codes of governance those provisions that are objective and measurable. This approach is critical in elevating the stature of the codes and in supporting the evaluation and monitoring of their adoption, as well as in boosting the overall credibility of the index. In addition, most indices employ market-based criteria such as minimum free float and liquidity. These factors are important for the marketability of the index, but they can also be detrimental in illiquid markets, since the number of companies eligible for inclusion in an index can be severely reduced.

The commitment of companies to governance differs across types of indices. There are two types of indices: listing tiers (Brazil’s Novo Mercado and Italy’s STAR) and those in which companies meet a rating threshold. Since adherence of companies to mandatory rules in listing tiers is binding, the “tier” option leads to a higher level of commitment from the constituent companies.

Evaluation and monitoring of the constituent companies and transparency of the index are critical for the index’s credibility. Stock exchanges that have not set up a listing tier tend to outsource the evaluation process to mitigate conflicts of interest with client companies. In most cases, stock exchanges pay for the evaluation to ensure an independent rating process. Most of the stock exchanges disclose index criteria and methodology, but generally, access to this information is a challenge. Rating results are rarely disclosed, mainly because of the companies’ reluctance to have their rating reports published. Exclusion from indices occurs primarily during annual reviews and is rarely due to a failure to meet governance criteria. This pattern suggests that stock exchanges are reluctant to exclude companies for governance considerations because of the associated reputational risks.

For investors, CGI can close an important gap. While most investors today recognize the importance of corporate governance in their investment decisions, many are facing difficulties in gathering related information, especially so in emerging markets. CGIs can bridge the information gap and become useful investment tools if setup right. However, given the qualitative nature of CGIs, investors need to be careful to properly understand the building blocks and the related vetting methodology an index is based on as information and expectation asymmetry may pose unforeseen risks.

Growth and performance of the indices in our study show a mixed picture. The indices have been growing in number of constituents but struggle to beat the main market indices. As can be seen in the table above, most of the indices studied have shown strong growth often in only a few years, underlining their attractiveness and their potential to influence corporate behavior. However, in terms of performance, almost all indices studied merely track the main benchmark index of their markets, which mainly reflects the large overlap in constituents between the main index and the CG and ESG indices. It also shows the lack of depth in most of the capital markets in the indices of the study, where few blue chip companies move the market. These blue chips are also natural constituents of CGIs since they usually tend to adopt good governance practices. Brazil’s BM&FBOVESPA CG Index and the newly launched Mexican IPC Sustentable are the only CGIs that have significantly outperformed the market over a period of time since their launch. The lack of differentiation in performance also explains the slow development of investment products such as exchange-trade funds tailored to the indices.

The full World Bank/IFC study can be accessed here.