Even though corporate governance may not be as much of a headline-grabbing subject, it can still be just as critical to successful ESG investing.
In the world of asset management, responsible investment assets have skyrocketed in recent years.
Despite that overall popularity, the three letters that make up ESG don’t always receive equal attention. For example, environmental worries and social issues like diversity and inclusion have recently put the “E” and the “S” at the forefront for investors, with the “G” sometimes being overshadowed.
But even though corporate governance may not be as much of a headline-grabbing subject, it can still be just as critical to successful ESG investing—particularly because it can affect both the “E” and the “S” as well, says Kent McClanahan, vice president of Responsible Investing for RBC Wealth Management-U.S.
“Governance is the forgotten piece of ESG, but it can be super important in informing the other two,” McClanahan says. “Environmental concerns like climate change might be more tangible, and social issues have been big the last couple of years with the COVID-19 pandemic and the Black Lives Matter movement. But how a company governs itself can impact how it manages these important issues.”
Think of governance as the plumbing in your house, McClanahan says. It may not be the most gripping matter, but it’s still absolutely critical to the functioning of your home. If it’s not working properly, you are in real trouble.
In the same way, governance is the behind-the-scenes infrastructure of a company: How it makes decisions; how it treats employees, clients and communities; how diverse and independent its board of directors is; and how ethically it behaves in avoiding corruption and scandal.
Increasingly, retail investors are recognizing just how important these issues are—not only in driving performance, but in avoiding unnecessary risks. When RBC Wealth Management polled clients in 2022 on the relative importance of 16 different issues, “the top three were corporate ethics, accounting practices, and regulatory compliance and transparency,” says McClanahan. “In fact, five of the top 10 were governance issues.”
Governance is an especially important issue because of the interconnected nature of ESG principles. If a corporate infrastructure isn’t in working order—if a company’s board doesn’t perform proper oversight, for example—it’s easy to see how every other strategic decision, including those related to environmental and social matters, could be adversely affected.
“If a company isn’t well-governed, it stands to reason that environmental and social issues may not be handled well either,” says Catherine Philogène, vice president of Product Management at RBC Global Asset Management (GAM). “To help visualize it, you can think of governance as being at the top, and then management of environmental and social risks are impacted by how a company is governed.”
In this way, good governance is not just nice window-dressing for a company—it’s something directly impacting outcomes for investors. When consulting giant McKinsey & Co. looked at available data, its researchers found ESG performance historically led to an array of positive results—for example, lower cost of capital, reduced energy costs, improved employee productivity, and less stock-price volatility.
“Good governance drives good decision-making, and that impacts the value of a company down the line,” says McClanahan. “Just one example is the positive relationship between strong ESG practices and a lower cost of capital: If you want to raise money, it’s 10 percent cheaper.”
With those kinds of numbers, it’s easy to see why governance is of material interest to asset managers. And not just in terms of passive observance, but also in terms of active engagement: Interacting with companies and nudging them in the direction of improved diversity, independent audits, justifiable executive pay and so on.
That kind of thoughtful engagement can happen in a couple of ways, including directly with a company’s management and via votes on shareholder proposals. “It’s important to understand that as an asset manager, we have an obligation to vote our shares on behalf of our unit holders because it’s our fiduciary duty,” says Philogène. “So things like proxy voting can have a real impact.”
As an example, if a board’s gender diversity levels aren’t meeting RBC GAM’s minimum guidelines or if there is a shareholder proposal requesting greater transparency on ESG issues, “we don’t always align with management on our votes,” says Philogène. “This is a way for asset managers to be active and engaged.”
There are a few ways interested investors can look under the hood and research how companies are faring on governance issues—although some involve more legwork than others. Research providers such as Sustainalytics specialize in compiling ESG data and grading companies on that performance.
Many asset managers also produce special engagement reports, McClanahan points out, which detail how responsive companies are to feedback and making positive improvements. For owners of individual securities, proxy statements may be examined to see whether companies are actually walking the talk on governance issues.
For the majority of busy investors, perhaps the easiest way to construct a portfolio with good governance principles is to purchase shares in ESG-oriented funds that have governance-related criteria or that consider governance factors as part of the investment decision. Professional managers not only select companies with the best governance practices, but also have the clout to directly engage with those firms to help ensure their practices continue to improve.
And as interest in ESG investing continues to rise, Philogène expects investors to pay even closer attention to those types of practices.
“More investors than ever are looking at how companies are managing all these governance risks because they want to understand what the financial implications might be,” she says. “That’s why more and more companies are taking governance issues very seriously.”
Due diligence processes do not assure a profit or protect against loss. Like any type of investing, ESG and responsible investing involves risks, including possible loss of principal.
RBC Wealth Management and RBC Global Asset Management are affiliated companies.
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