Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Governance: Raising the bar
Governance is the pillar of environmental, social and governance (ESG) principles that investors have been actively considering for the longest period of time. This is not surprising, as in some ways, it could be said that governance is probably the most important aspect of ESG. An organisation’s board’s role is to appoint the CEO and management and set the strategic direction for the company; in other words, choose the right people to lead and implement the agreed strategy. In addition, in the words of the Australian Institute of CompanyDirectors (AICD): “Boards must set a clear tone from the top on their cultural expectations of management and of themselves. Key decisions will be seen as tangible evidence of what is valued and prioritised.”
Glaring examples of failure to act according to the above statement on values are the recent actions of the boards at Rio Tinto, Cleanaway and AMP, and the ensuing consequences. Each case has been somewhat different. With Rio Tinto, the decision to blast the Juukan caves demonstrated poor business ethics and insensitivity to the cultural value of a site the company had been told was of “the highest archaeological significance in Australia”; the board’s subsequent handling of the aftermath has been a showcase of the lack of accountability. The AMP board exercised extremely poor judgment by choosing an executive with a proven track record of sexual harassment, to lead the AMP Capital business; while at Cleanaway, the board had been ignoring for years the bullying and intimidating behaviour of its CEO.
The common thread underlying these events is that the boards seemed to have been sleeping at the wheel. They have not been keeping an ear to the ground – at their own company, let alone to the shifting expectations of investment and the wider community.
And these expectations have been changing over the last decade. In the wake of the GFC, a number of company and investor-led initiatives and regulatory changes were aimed at increasing board oversight and accountability. As a result “say on pay” became widely adopted, and more emphasis has been placed on board quality. Specific actions related to the latter have included board diversity, shareholder rights, and independence. These three governance areas (in addition to risk management and remuneration) have traditionally been the key factors in assessing corporate governance.
The latter half of this decade saw the Paris Climate Agreement signed (2016) and a growing awareness of the need to address climate risks. Around the same time, high-profile corporate crises (the Facebook data privacy scandal, Wells Fargo account fraud scandal) and the rise of the #MeTooMovement have raised social issues to prominence. Domestically, the Banking Royal Commission’s findings in 2018 and the Westpac money laundering and child exploitation incident in late 2019 have galvanised public scrutiny over corporate behaviour and its impact on society at large.
In addition, over the last few years a growing number of asset managers and asset owners became signatories to the UN’s Principles for Responsible Investments (PRI). This has led to increased investor activity concerning ESG topics and greater expectations of companies to manage a wider range of risks and improve disclosure related to ESG.
In 2018 in the Reporting Framework Main definitions, the PRI has provided a comprehensive list of issues that need to be considered under governance. “In the listed equity context these include: board structure, size, diversity, skills and independence, executive pay, shareholder rights, stakeholder interaction, disclosure of information, business ethics, bribery and corruption, internal controls and risk management, and in general, issues dealing with the relationship between a company’s management, its board, its shareholders and its other stakeholders. This category may also include matters of business strategy, encompassing both the implications of business strategy for environmental and social issues, and how the strategy is to be implemented. In the unlisted asset classes governance issues also include matters of fund governance, such as the powers of advisory committees, valuation and fee structure”.
Compared to ten years ago, the list of governance issues is longer and includes the complex field of relationships management. While improving board quality, shareholder rights, and incentive structure will remain in focus, it is clear that the management of environmental and social risks will become a new standard of “best practice” corporate governance. As board responsibilities grow, the need to upgrade its skill set will grow too. Experts who understand a company’s impact on the environment and society are likely to be become key additions to boards, and highly sought-after people.
