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Report No: . Foreign Institutional Investors and Corporate Governance in Emerging Markets . May, 2016 . . Document of the World Bank . Standard Disclaimer: . This volume is a product of the staff of the International Bank for Reconstruction and Development/ The World Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. . Copyright Statement: . The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The International Bank for Reconstruction and Development/ The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA, telephone 978-750-8400, fax 978-750-4470, http://www.copyright.com/. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202-522-2422, e-mail [email protected]. Foreign Institutional Investors and Corporate Governance In Emerging Markets May, 2016 Table of Contents Executive Summary .................................................................................................................................. i Introduction ............................................................................................................................................ 2 1. Institutional Investors: Global Trends................................................................................................... 5 1.1 Institutional investors are the largest shareholders in the developed world ................................... 5 1.2 Domestic institutional investors are growing rapidly in emerging markets ..................................... 6 1.3 Institutional investors are major investors across borders.............................................................. 7 2. How do institutional investors take corporate governance considerations into their investment decision-making?..................................................................................................................................... 8 2.1 Governance Factors in Investment Decision-Making ...................................................................... 8 2.2 Investor business models ............................................................................................................. 10 2.3 Investment decision-making: Results from the Survey ................................................................. 11 3. What are the key corporate governance concerns for foreign institutional investors? ....................... 16 3.1 International corporate governance standards ............................................................................ 16 3.2 Evidence from the academic literature......................................................................................... 17 3.3 Corporate governance concerns: Survey Results .......................................................................... 18 4. Ownership Engagement and Stewardship .......................................................................................... 22 4.1 International standards of ownership and engagement ............................................................... 22 4.2 Challenges to the stewardship model........................................................................................... 23 4.3 Stewardship across borders ......................................................................................................... 25 4.4 Stewardship and Engagement: Results from the Survey ............................................................... 25 5. Conclusions and Implications for World Bank Policy Work ................................................................. 30 Annex 1: International Data on Institutional Investor Assets and Asset Flows ........................................ 33 Bibliography .......................................................................................................................................... 36 Annex II: ................................................................................................................................................ 41 -1- Executive Summary Two of the most pressing challenges in the developing world continue to remain: attracting foreign capital and striking a balance between financial development/growth and stability. In both instances, good corporate governance presents a solution to ensuring adequate investor protection and resilient institutions. This paper aims at identifying what corporate governance obstacles can be removed to further facilitate international institutional investor investment flows towards the developing world. To further explore the corporate governance concerns of foreign institutional investors in emerging markets, the Finance and Markets Practice of the World Bank decided to partner with the Rotman International Centre for Pension Management (ICPM) to conduct a survey of its research partners/pension fund asset owners. Surveying ICPM research partners allowed us to reach out to some of the largest asset owners in the world, and to keep our approach comprehensive, reachable, and focused. ICPM is a global, research-based network of pension delivery organizations that stimulates leading-edge thinking and practice about pension design and management. The survey was sent to 35 research partners of ICPM. A total of 20 usable responses were received. The paper first briefly describes the growth of institutional investors around the globe and then combines existing literature with survey responses to attempt to answer these three closely-related questions: How do institutional investors take corporate governance considerations into account in their investment decision-making in emerging markets? What are the specific corporate governance concerns of international institutional investors? And in which manner can corporate governance bridge the “trust gap” between wary institutional investors and persistent funding needs in emerging markets? Once shares are held in a portfolio, what are the obstacles to further engagement and stewardship in emerging markets? Given the advantages of improved corporate governance, it seems straightforward that companies and countries should adopt corporate governance frameworks that increase accountability, responsibility, transparency, and good decision-making. But reform has moved slowly in many countries, and a complementary approach that has emerged is to encourage shareholders and other stakeholders to directly monitor portfolio companies to directly improve governance practices. Because of their size and sophistication, the key players in this movement are institutional investors, both domestic and foreign. In order to give a dimension to the presence of institutional investors around the globe, in the US institutional ownership of total outstanding equity in 1950 was at 6.1%, today it is at over 50%. In the UK, direct individual ownership in listed companies was at 54% in 1963, and it dropped at 11.5% in 2012. Institutional presence is also growing rapidly in emerging markets along with domestic institutional investors. If emerging markets are potential investment outlets, then why investment volumes are not higher? Does corporate governance really matter to institutional investors? And if so, to what extent? -i- Apparently it does. Institutional investors have begun to integrate governance considerations when making decisions to invest in emerging markets. Given the limited exposures, they still tend to outsource most of the analysis to proxy firms and local asset managers. Also, corporate governance shortcomings do not represent yet a barrier to invest and this is mainly due to two reasons: economic and financial considerations take precedence when exploring new markets and corporate governance risk premiums are still hard to quantify properly in emerging markets. What concerns then institutional investors when they decide to engage in the developing world? Quality of financial reporting, quality of boards, quality of audits, level of shareholder rights, weak rule of law and problematic voting procedures are the most recurring preoccupations both at the normative/country level and at the company/practice level. In light of these findings, it seems clear that there is a need to continue to bring WB partner countries more in line with international practices and expectations and continue to use the WB convening powers to spur regulators engagement and to find better ways to enhance investor dialogue. Regional research initiatives ala Asean Corporate Governance Association seem to be a potential useful option. On research, more can be done to gather concrete evidence on the bad practices that investors are facing around the globe. This can be achieved if research efforts attempt to include proxy voting firms and local asset managers, which appear to have a better pulse of the corporate dynamics in emerging markets. -ii- Introduction Over the past two decades, the WBG has been engaged in three global mandates in the financial sector: (1) promoting financial depth, stability, and integrity; (2) promoting financial inclusion; (3) contributing to the post-2015 sustainable development agenda. Within this operational framework, the WBG has remained engaged on legal and regulatory corporate governance (CG) reforms as an important pillar for financial stability and sustainable financial growth. The post-crisis financial landscape has left a lot of challenges on the table for emerging market countries, reinforcing the need to remain engaged in the financial development and stability agendas. The global financial system remains fragile, as it continues to absorb the market and regulatory impacts of the recent crises. Moreover, it may be subject to further shocks as developed countries exit out of their extraordinary monetary policies and interest rates increase worldwide. Several developing countries still lack the institutional capacity and market depth to manage these impacts and are already suffering from lackluster growth and remain exposed to global and regional shocks. Recent empirical research concludes that financial development contributes to growth, but with some important caveats. First, the link between financial deepening and growth is still strong at intermediate levels of financial development (the range within which most of the WBG’s client countries operate) but diminishes at high levels and can become eventually negative (the “too much finance” effect). Second, the pace of financial deepening matters – a very rapid pace leads to instability and can erode hard-won gains. Third, the quality of the enabling environment (e.g. regulation and supervision, financial infrastructure) matters and can improve the links between financial deepening and growth and the trade-offs between financial development and financial stability. Fourth, at higher levels of development the contribution of financial markets (relative to institutions) to growth tends to increase. 1The recent literature has important implications and emphasizes even more the importance of a strong enabling environment and the need to address potential trade-offs. Research also shows that improvements in the quality of the regulatory framework and of financial infrastructure are important determinants of financial development and that a sound enabling environment strengthens the positive impact of finance on growth and helps policy-makers address more effectively the trade-offs between financial development and stability. The most important challenge for our client countries continues to remain how to strike that trade-off between financial development and financial stability, how to facilitate new investments and new players in their financial sectors while ensuring stability and sustainable growth. Research shows that finding a balance in this constant trade-off can be facilitated and supported by solid adoption of good CG practices. Indeed many studies agree that better governance frameworks benefit firms through greater access to financing, lower cost of capital, and better firm readiness to absorb economic and financial shocks and ultimately more prepared and resilient to crises. 1 See, e.g., Rousseau and Wachtel (2011), Arcand, Berkes, and Panizza (2012), Barajas, Chami and Yousefi (2013), Aizenman, Junjarak and Park (2015), Singh and Huang (2015) and, especially, Sahay et al (2015). The OECD (2015a) shows that the impact of financial development on growth in OECD countries is mostly negative, but the sample consists primarily of countries at a high stage of financial and economic development. -2- Given the advantages of improved CG, it seems straightforward that companies and countries should adopt CG frameworks that increase accountability, responsibility, transparency, and good decisionmaking. But reform has moved slowly in many countries, as both the public and private sectors resist change and openness. This in turn has resulted in a long debate on the best approaches to encourage change in these areas. As is often the case, two basic “carrot and stick” perspectives have emerged. On the one hand, laws and regulations can be changed to encourage or force companies to change their behavior and adopt modern CG standards. 2 A complementary approach is to encourage shareholders and other stakeholders to directly monitor portfolio companies to improve CG practices. Because of their size and sophistication, the key players in this movement are institutional investors, both domestic and foreign. Many initiatives have been launched to encourage and convince institutional investors to play a more active role. However, not enough is known about how institutional investors utilize CG in their investment decisions, in particular in emerging markets, where funding needs are high and investor protection standards often still low. While some studies tend to incorporate emerging markets in a broader analysis which captures developed markets, there is still preoccupying paucity of research data on emerging markets. As Alsarat and Dallas (2011) point out, less than one percent of the available research on CG focuses on these markets. And this may be in part a result of lack of comprehensive investor portfolio data and governance information of companies operating in emerging markets. Institutional investors tend to include governance considerations as part of a broader analysis of environmental and social factors. Our focus remains on governance considerations. But the paper will sometimes refer somewhat interchangeably to both governance and environmental, social, and governance (ESG) factors. To further explore role and activities of foreign institutional investors in emerging markets, the Finance and Markets Practice of the World Bank partnered with the Rotman International Centre for Pension Management (ICPM) to conduct a survey of its research partners/pension fund asset owners. 3 ICPM is a global, research-based network of pension delivery organizations that stimulates leading-edge thinking and practice about pension design and management. 4 The survey was carried out in November 2015 February 2016. The questionnaire was sent to 35 research partners of ICPM. A total of 20 usable responses were received. Survey questions and responses to the survey are presented in Annex II. This paper aims at shedding light on what the key CG priorities and concerns for institutional investors are when investing in emerging markets. It also further refines our policy dialogue with country authorities to design reform paths that can address international institutional investors’ preoccupations and in turn facilitate more investment flows into emerging and developing economies. 2 This has been the focus of the World Bank’s program of Reports on the Observance of Standards and Codes (ROSC), which benchmarks country law, regulations, and institutions against the OECD Principles of Corporate Governance to encourage countries to update their legal and regulatory framework. 3 The World Bank is also a member of the ICPM network. 4 http://www.rijpm.com/about/about-us -3- The paper will first briefly describe the growth of institutional investors around the globe and will then combine existing literature with survey responses to attempt to answer these three closely-related questions: How do institutional investors take CG considerations into account in their investment decisionmaking? What are the specific CG concerns of international institutional investors? And in which manner can CG bridge the “trust gap” between wary institutional investors and persistent funding needs in emerging markets? Once shares are held in a portfolio, what are the obstacles to further engagement and stewardship in emerging markets? The table in Annex II provides some basic data about the survey respondents: The respondents are all pension funds, and come from nine counties, with a relatively large number of funds from English-speaking countries (especially Canada), reflecting ICPM’s membership base. There is a wide variation in the size of funds, ranging from an average fund size of USD 19.5 billion for the two funds in New Zealand, to an average USD 187.5 billion in the US. Out a total of USD 1,211.3 billion AUM, the 17 funds hold a total of USD 501.7 billion in listed equity, or about 41 percent. The funds hold USD 67.27 billion in listed equity, in emerging markets about 5 percent of AUM and 13.4 percent of total listed equity. The funds generally hold diversified portfolios. Most (70 percent) of the funds responding to the survey have broadly diversified holdings. The remainder have holdings that are more concentrated; one of the respondents has a combination of broad EM index and concentrated holdings, the others have more concentrated holdings. Most of the funds will thus have a large number of companies in their portfolio, reducing incentives and increasing costs for preinvestment due diligence, and post-investment monitoring and engagement. This paper was drafted by Alexander Berg (World Bank, Finance and Markets Practice), Pasquale di Benedetta (World Bank, Finance and Markets Practice), and Andreas Grimminger (PGS Advisors International). Mr. John Jarrett developed the survey instrument. The authors wish to thank the ICPM research partners that participated in the survey, Mr. Rob Bauer (Executive Director, ICPM), Ann Henhoeffer (Associate Director, ICPM), and Karin Clarke (Associate, ICPM). We would also like to thank the Treasury Department of the World Bank Group and in particular Mr. Sudhir Rajkumar, Lead Financial Officer and Head of Pension Advisory Management of the World Bank and Vice Chairman of ICPM, who facilitated the connection to ICPM and made the survey possible. -4- 1. Institutional Investors: Global Trends Institutional investors are legal persons that mostly act as intermediary investors, managing and investing other people’s money. Moving beyond this general definition, there are a number of different ways institutional investors can be categorized -- by asset origin, investment strategy, fee and portfolio structure, ownership engagement and lastly country of origin of the investors. Understanding the institutional landscape is important because differences among investors help to explain different behaviors. Institutions can in general be characterized as either “asset owners” or “asset managers”. While both are institutional investors, asset owners are the ultimate (sometimes called beneficial) owners of assets, often held on behalf of beneficiaries. They make asset allocation decisions based on investment objectives and markets forecasts, as well as regulatory and accounting rules. Asset owners can manage their assets directly and/or outsource asset management to an asset manager. Asset managers, in turn, act as agents on behalf of clients (the asset owners). They are not the ultimate owner of the assets under management (although they may be called nominee owners). Institutional investors can also be divided between “traditional” institutional investors (pension funds, investment funds and insurance companies) and “alternative” institutional investors (hedge funds, private equity firms, exchange-traded funds and sovereign wealth funds). 1.1 Institutional investors are the largest shareholders in the developed world Over the past 50 years institutional investors have become the primary providers of equity finance. As Gillan and Starks (2003) state, “In many countries institutional investors became a significant, if not majority, component of equity markets during the latter half of the twentieth century.”5 In the United States, institutional ownership has grown from US$8.7 billion in 1950 representing 6.1% of total outstanding equity to US$10.2 trillion in 2009, representing 50.6% of total outstanding equity.6 In the top 1,000 U.S. corporations the institutional ownership concentration is even higher at 73%. This represents a dramatic shift in the ownership structure of listed companies. This trend is clearly confirmed in most OECD markets where direct ownership has moved to intermediary ownership. Isaksson and Celik (2013) calculate that in 2010, pension funds, mutual funds and insurance companies held nearly half of the listed equity in the world, with a total market value of USD 26 trillion.7 5 Gillan, Starks (2003), p. 3 The Conference Board 2010. Gilson and Gordon (2013) argue that this re-concentration of ownership, especially in the United States in the hand of intermediaries is a consequence of two factors: first, the political decisions to privatize retirement provisioning (beyond the social safety net of Social Security) and to facilitate advance funding; and second, the intellectual triumph of modern portfolio theory, which promotes diversification as the touchstone of investment strategy. 7 Ibid. The investor data does not cover non-OECD countries whose share in the global equity market is believed to be low however. In addition, these numbers are calculated based on the total market value of the corporations, which means that the institutional ownership of the global free float is likely to be considerably higher. 6 -5- In the United Kingdom, direct (individual) ownership in listed companies has decreased from 54% in 1963 to 11.5% in 2012.8 The presence of different types of institutional investors varies widely from country to country and clearly increases or decreases according to the development bracket where countries are in. Overall, their presence remains significant in high income countries (table 1). Table 1: Institutional Investor Assets as a Share of GDP Mutual Fund Assets Pension Fund Assets % of GDP % of GDP High income: OECD High income: non-OECD Upper middle income Lower middle income 201.2 69.2 10.0 5.0 40.9 15.5 15.7 7.6 According to the aggregate country data (presented in Annex 1 and summarized in the table above), pension funds as a share of GDP vary from 184.1 percent in the Netherlands to 104.9 percent in the United Kingdom to 57.9 percent in Malaysia to 40.8 percent in South Africa. 9 The same is not true for mutual funds where their share of GDP varies from 8.6 percent in the Netherlands to 47.3 percent in the United Kingdom to 32 percent in Malaysia to 41 percent in South Africa. A recent survey by the OECD (2011) shows that pension funds are the major institutional investors in countries such as Australia, Chile and Israel, while insurance companies are dominant investors in Germany, France and Sweden, and investment funds play an important role in Greece and Mexico.10 Traditional institutional investors had the largest AUM in OECD countries in 2011 totaling US$73.4 trillion, with investment funds having the lion’s share at just under US$30 trillion.11 1.2 Domestic institutional investors are growing rapidly in emerging markets Detailed numbers for the size of domestic institutional investors in emerging markets are difficult to obtain. Data presented in Annex 1 indicate that countries with higher income tend to have larger institutional investors - average pension fund assets as a percent of GDP is 40.9% in high-income OECD countries compared to, 15.5 percent in high-income non-OECD countries, 15.7 percent in upper middleincome countries, and 7.6 percent in lower middle-income countries.12 8 Isaksson and Celik (2013), p. 28 Finstats 2016 database, World Bank. 10 Footnote OECD Institutional Investor 2011 XXX. 11 OECD (2011). It is important to note, that there is double counting in these numbers as for example both pension funds and insurance companies invest in mutual funds, which are part of the investment fund category. 12 This data does not include 2015, where flows were highly negative. Data should be interpreted with caution; data for many countries is missing, especially for low-income countries, and these averages would almost certainly be lower if all data were available. 9 -6- The size of domestic institutional investors has been growing. In Latin America, for example, pension fund assets under management (AUM) in the region have grown by an average of 16% annually since 1999, reaching US$390 billion by the end of 2006. Pension funds are the most dominant institutional investors in the market in many Latin American countries. 13 In Brazil, however, mutual funds AUM dwarfed pension funds by US$784 billion to US$294 billion in 2009. 1.3 Institutional investors are major investors across borders Portfolio investment increasingly happens across borders. Portfolio investment into emerging market countries has grown rapidly for many years. As countries underwent rapid capital markets development, emerging markets presented unique investment opportunities, including increased returns and diversification.14 Table 2 in the Annex presents net portfolio flows to emerging market countries:15 Total net flows totaled $903.7 billion for the twenty –year period ending in 2014. Flows are very variable, with negative net flows in 2008 (the year of the financial crisis) and very low in 2011. East Asia accounted for the largest proportion of portfolio flows (355.2 billion, or 39.3 percent of the total), followed by Latin America (23.1 percent), South Asia (20.1 percent), Sub Saharan Africa (11.9 percent), and Europe and Central Asia (4.8 percent of the total). A few countries account for most of the flows. The top ten net recipients of net portfolio flows include China, India, Brazil, South Africa, Turkey, Nigeria, Mexico, Thailand, Colombia, Vietnam, and the Philippines. The largest three countries (the BRIC countries, excluding Russia) accounted for almost 73% of the total. On the other hand, only tiny amounts went to smaller and poorer countries. Low income countries (as defined by the World Bank) accounted for only 2.5 billion in capital flows, about 2 tenths of one percent of the total. Isaksson and Celik (2013) show that with increased international integration of equity markets, foreign ownership of listed companies has increased in most countries. For example, in the United Kingdom, the share of listed equity held by foreign investors increased from 7% to 41.2% between 1963 and 2010. 13 OECD and IFC (2011), p. 18 Insert footnote about 2015 XXX. 15 The data in table 2 need to be interpreted with caution, and may not be directly comparable to other related data. They are presented in net terms (meaning gross inflows and outflows are combined). Some country data is missing which affects regional totals. Data not adjusted for changes in prices. 14 -7- 2. How do institutional investors take corporate governance considerations into their investment decision-making? This section reviews how institutional investors incorporate CG considerations in their investment decisions. Broadly speaking, there are two approaches to incorporating governance and other nonfinancial factors. First, governance can be taken into account at the time of investment / disinvestment – good governance increases the attractiveness of an investment at a given price. This topic is introduced in this section. Alternatively, investors can practice “active investment” and engage to improve the governance of companies in their portfolio, and add value instead of selling shares. This topic is introduced in Section 4. In reality, many investors will practice a blend of these approaches. 2.1 Governance Factors in Investment Decision-Making As noted by the CFA Institute in a recent publication (2014), investment analysts have always taken nonfinancial issues into account. “… Many investors have long considered such issues in fundamental investment analysis by including an assessment of reputational risk, regulatory developments, or such megatrends as an aging population.” 16 However, modern approaches to investment decisionmaking“…refer to a systematic consideration of relevant and material ESG issues rather than to a cursory inclusion of one or more of them.” The goal is to complement traditional financial and risk analyses and to deepen the consideration of governance issues throughout the investment process. Thinking on the inclusion of governance factors in investment decision-making has evolved over time. The CFA Institute notes six methods for including ESG considerations in the investment decision, of which three are relevant for CG.17 Exclusionary Screening. Exclusionary screening is the oldest and most traditional approach. It excludes countries or companies from a portfolio based on relatively simple factors or indicators, such as poor performance on standard indicators, or involvement of a company in producing goods that are seen as socially unacceptable. Best-in-Class Selection. Investors using this strategy select companies that score well on governance indicators. A number of stock exchange indices around the world are constructed using this approach. ESG Integration. According to the CFA, ESG integration is the “systematic and explicit inclusion of ESG risks and opportunities in investment analysis.” There are no preconditions, inclusion, or exclusion – governance risks are priced into investment decision-making. Companies with lower governance risks have higher discount rates and higher required returns. A survey of 1,325 CFA members indicated that integration was used by 57% of respondents. A fourth approach is to ignore ESG factors in investment decision-making. This may be because an investor has made the decision to passively hold all shares in a given market, or to match the performance of a benchmark index. 16 CFE Institute Footnote. CFA Institute Footnote. The CFA considers “Active Ownership” (shareholder engagement) to be an additional approach – this is covered in section 3. 17 -8- According to the Global Sustainable Investment Review (2014), for assets invested under a sustainable investment strategy, exclusionary screening is the most common approach ($14.4 trillion), followed by ESG integration ($12.9 trillion) and corporate engagement/shareholder action ($7.0 trillion). While exclusionary screening is the most widely adopted strategy in Europe, ESG integration now dominates in the United States, Australia/New Zealand and Asia in asset-weighted terms. Corporate engagement and shareholder action is the dominant strategy in Canada. (Global Sustainable Investment Alliance, 2015). Among ESG factors, governance criteria are generally viewed as the most important by investors. A 2012 survey of more than 1,000 investment professionals by the consultancy SustainAbility supports this view. Of the professionals using ESG factors in their decisions, 59% of respondents often or always consider governance issues in their investment decision, followed by social issues (40%) and the environment (34%) (Sadowski, 2012). The experience of the California Public Employee Retirement System (CalPERS) in the US illustrates how thinking on investment decision-making has evolved over time. CalPERS is one of the largest pension funds in the United‐States, and is well known for its activism and focus on CG. In 2002, CalPERS introduced its Permissible Emerging Markets Policy, which restricted investments in countries that did not meet a variety of an environmental, social and governance (ESG) country-level indicators, including political stability, governance standards, and labor practices. The Policy argued that companies in countries that did not meet these minimum standards were too risky for investment and that financial returns would not adequately compensate investors for the given level of investment risks. To some extent, the goal was to encourage policymakers to make changes in order to attract foreign capital. In some respects this goal was achieved; while only 13 out of 27 emerging markets met the requirements in 2002, 20 met the investment threshold by 2006. 18 However, while country‐level screening may have reduced risk and encouraged reform, it may not have been in the long-term interests of CalPERS beneficiaries. The CalPERS Policy excluded several emerging markets with high (or potentially high) returns, including China, Colombia, Egypt, Pakistan and Russia. This significantly reduced the return earned on CalPERS emerging markets portfolio over the period. 19 In 2007 CalPERS moved to a combination of an active and integrated approach – reflected in its new Emerging Equity Markets Principles. The new Principles permitted investments in all countries listed in the FTSE All Emerging Index and moved towards equity screening at the company level. External managers could now profit from market opportunities in all markets included in the FTSE All Emerging Index. CalPERS would screen companies according to ESG factors and engage with those companies to raise their standards, reducing risk in its portfolio and providing a better risk/return trade‐off than that of a passive investor. 18 Particularly noteworthy was the case of the Philippines, whose government went to great lengths to improve its policies and regulatory environment in order to qualify for CalPERS permissible market policy. 19 Huppe and Hebb (2010), p. 3 -9- 2.2 Investor business models The extent to which this integrated approach is being followed in practice by other international investors is unclear, especially by foreign investors in emerging markets. As noted above, the key point is that institutional investors have different preferences. Celik and Isaksson (2013) note that there are likely as many investment strategies as there are investors. Nevertheless, they identify four main strategies that are usually associated with distinct investor business models and also determine the influence of non-financial factors on investment decision-making and behavior. These strategies include: Passive index, a strategy that represents a commitment to hold a portfolio of a predefined index of shares, so share selection is automatic and does not represent an active selection. ESG screening and ownership engagement are likely to be minimal. Passive fundamental is distinguished from passive index as investors initially make an active selection of investee companies but then keep them for an extended period of time. A closedend investment company would fall under this category. Active fundamental illustrates a strategy of continuously buying and selling companies that are chosen based on fundamental analysis. A high degree of ownership engagement to achieve certain changes in companies can be associated with this strategy, typically employed by ‘activist hedge funds’. Active quantitative as the name implies relies on quantitative rather than qualitative information on individual companies, based on large inflow of information and frequent trades, for example in high frequency trading. Asset owners may of course manage assets that use many or all of these strategies, or give portions of their assets or asset classes to independent asset managers to do so. There is some academic research that has been conducted focusing directly on the role CG and ESG plays in the investment decisions of institutional investors, with the following main conclusions: Institutional investors’ preferences for different governance mechanisms vary across investor type. McCahery, Sautner and Starks (2010) conduct a survey to elicit institutional investors’ views on investor protection and CG. They survey 118 global investors with holdings in the United States and the Netherlands, representing countries with different legal origins, investor protection regimes, and ownership characteristics. They find CG is important in investment decisions but that issues vary depending on the typology of investors. Hedge funds in their sample value equity ownership by managers, while insurance firms are most interested in high free float; and mutual funds find both equity ownership by managers and transparency about the holdings of large shareholders to be the most important. Pension funds, finally, are most concerned about ownership concentration, board independence, and high free float. Better corporate governance increases institutional ownership. Chung and Zhang (2011) analyze U.S. companies listed on the New York Stock Exchange (NYSE), American Stock Exchange (AMEX), and NASDAQ between January 2001 and December 2006 using CG data from the Institutional Shareholder Service (ISS) to analyze the role of CG in attracting investors. Their results show that the percentage of a firm’s shares that are held by institutional investors is positively and significantly related to its governance quality across all types of institutional investors. Better governance mechanism, in particular sound disclosure practices, can help in reducing the -10- need for investors to employ own, costly monitoring of portfolio companies. This should hold particularly true for investors with large portfolios. Bushee and Noe (2000) find that institutions with a large number of portfolio stocks prefer higher quality disclosure as a way to offset monitoring costs. Anecdotal evidence (from the World Bank’s Corporate Governance ROSC diagnostics, for example) suggests that CG is a relatively major concern for foreign investors. But how and when it is incorporated into investment analyses, and when governance and other ESG concerns trump financial opportunities, remains a question mark. 2.3 Investment decision-making: Results from the Survey The survey reviews how the surveyed pension funds take CG considerations into account. The following sections reveal five lessons learned: The vast majority of survey respondents do take CG considerations into account in emerging markets, both at country and company levels Corporate governance shortcomings generally do not prevent an attractive investment Most CG analysis in emerging markets appears to be outsourced Governance considerations are today an integral part of the ESG analysis Investors continue to find it difficult to quantify CG risks The vast majority of survey respondents do take corporate governance considerations into account in emerging markets, both at country and company levels At the country level, an aggregate 60% of respondents indicated that they ‘always’ (45%) or ‘most of the time’ (15%) carry out country-level due diligence; one third (30%) responded that this is only done “sometimes”, and a small percentage (10%) said ‘never’. When asked about due diligence at the company level, the results were similar – 35 percent of respondents “Always” carried out due diligence, with 35% saying it was done “Most of the time”, 23% “Rarely”, 18% “Sometimes” and 6% “Never”. These figures are slightly lower than the figures for the country level. Feedback through Interviews and comments appears to suggest this is because the level of decision are quite different – country-level due diligence tends to be taken when owners or managers are making fundamental asset allocation decisions, like moving into a new (emerging) market, while decisions at the company level would tend to be taken more frequently. Before making new investments or increasing your asset allocation to an emerging or frontier market do you carry out due diligence on the country’s CG framework? 15. Before you invest in a company in an emerging or frontier market, do you do CG due diligence on the company? -11- Sometime s [PERCENT AGE] Most of the Time 15% Always 35% Most of the Time 23% Never 10% Rarely 6% Always 45% Never 18% Someti mes 18% Many funds tend to use the same policies and procedures for assessing CG risk around the world. “The same country-level due diligence processes are followed” as in mature markets and they “use the same framework” when evaluating countries, with “one policy, applied to all categories and markets”. Others reported heightened due diligence in emerging markets The few respondents that reported less due diligence at the country level did so for three main reasons: the lack of a material investment portfolio in emerging markets, the lack of available information (which of necessity resulted in less due diligence), and a passive investing strategy (in which they followed the index and did not need due diligence); “by and large we are index investors in public equity”. Corporate governance shortcomings generally do not prevent an attractive investment An interesting finding is that many funds (about 80 percent) reported going ahead with investments even though the CG issues in a particular country or company have been problematic. As noted above in the case of CalPERS, funds go ahead with these investments for a variety of reasons, but explanations generally include (1) financial and economic considerations and discounts compensate for the CG risk, (2) companies have differentiated themselves and have better CG than country averages would indicate; (3) full delegation of investment decision to asset managers. Explanations provided by Surveyed Funds: Why are you investing when corporate governance is problematic? Economic and Financial Considerations: The primary investment case remained compelling despite corporate governance risks Primary considerations include: the need to gain exposure to emerging/frontier market securities; global equity diversification; and liquidity/free float availability. Priced competitively, strong relationships Valuation that takes into account the identified risks Corporate governance considerations: Favorable assessment of corporate governance issues Comfort around the alignment of our interests with those of the board and management. Overall reputation of company; quality and independence of board -12- We have sold out of markets where CG concerns have become too great. Delegation to Asset Managers: For external mandates, managers have full discretion to invest at the company level. Internal exposure would largely be in our thematic fund so if it had a strong investment thesis and fit one of our themes, this would outweigh the CG concerns. We have a passive mandate - there are some companies we have excluded based on ESG issues). These are primarily tobacco companies by number but we have made decisions based on armaments, human rights, bribery & corruption and environmental damage also. Given our governance structure, we have no way of imposing a specific CG concern on (external manager). Understanding CG risk is part of PM role, with expected returns changing if poor governance. Most corporate governance analysis in emerging markets appears to be outsourced. Funds in the survey used a variety of approaches to carrying out CG due diligence, as shown in the charts below. About a quarter of respondents rely on internal specialist CG staff, and in another quarter, the work is carried out by the portfolio manager. Almost 1/3 of the respondents rely on the external asset manager, and another 20 percent rely on an engagement agency or other outside firm. Overall, most of the analysis (95%) is outsourced as most of the funds receive considerable assistance from outside advisors and associations. Service providers mentioned include: Specialized proxy service and CG firms (ISS, Glass Lewis, GMO, Sustainalytics, MSCI) Specialized asset managers (Aberdeen, Charlemagne, Origen) Asset managers that provide CG advisory services (BlackRock) The Asian Corporate Governance Association The internal / external split is perhaps not surprising, given the large amount of investment decisions delegated to external managers. If CG due diligence is performed, who undertakes this work? Do you obtain information from outside analysts to assist in examining CG issues in emerging and frontier markets? -13- External Asset Manager 32% No 16% outside firms [PERCENT AGE] Internal Specialist CG staff 24% Other 12% Yes 84% Portfolio Manager 23% Governance considerations are today an integral part of the ESG analysis Last but not least, because of the perceived elevated ESG risks, the vast majority (95%) of the respondents indicated that they clearly consider CG as part of a broader ESG analysis, and therefore they do not treat cg as a stand-alone issue. Investors continue to find it difficult to quantify corporate governance risks The majority of funds expect lower prices and higher returns in emerging markets due to governance risks. Funds were split on the level of the governance premium, and estimates varied widely. One respondent estimated the CG premium in emerging markets to be 15%, and much higher in frontier markets (30% to 50%). Others put a much lower premium (between 1/2 of a percent and 3 percent). Still others estimate the premium on a case by case (company by company) basis, with resulting expected risk premiums that are highly variable between each investment. Factors mentioned that feed into the financial models of the respondents that determine the range of the discount include the CG factors identified below, as well as ownership structures, likelihood of adverse events materializing, and specific CG risks related to each investment. For those investments where CG risks were identified, was the price discounted to take account of the CG risk? Generally, do you expect higher returns in emerging and frontier markets due to CG weaknesses? -14- No 37% No 35% Yes 63% What factors determine the range of the discount (please comment on company and country specific factors Overall quality of investor disclosures, ownership structures (Chaebols, family control, etc.), and strength of regulatory framework. Overall risk assessment and kind of CG issues likelihood of adverse event materialising Assessment of issues identified in questions 14 and 16. The specific type of the CG risks, how the CG risks relate to valuation/investment case Yes 65% If you can, please provide a range and further elaboration on the level of risk premium that is attributable to CG issues. Not a material part of the investment process Although it varies significantly, my own view is that the level of CG premium in emerging markets is approximately 15%, and in frontier markets the premium can be much higher (30% to 50%). Half a percent 2-3% The last two questions are not relevant to our particularly governance structure. We do not specify this premium, but it is a part of why we expect a positive risk premium in EMM's >should be reflected in lower valuation, all else being equal. 2-4% Case-by-case assessment We haven't explicitly estimated that number. It is generally approached on a bottom up basis looking at individual investments and the expected risk premium can be highly variable between each One respondent commented: ‘We believe in mean reversion and achieve EM equity exposure mainly through passive or quantitative strategies. Our active quant manager has tested ESG information as an input to their models - the results are not conclusive enough to impact their current models. However, we have reviewed the academic and other evidence and we also believe CG is important to the long-term value of a company. We believe this information will eventually be priced into the market - we currently remain primarily passive in our approach but see that active fund managers might find it beneficial to integrate CG information into their active risk premium calculations’. -15- 3. What are the key corporate governance concerns for foreign institutional investors? This section attempts to shed light on the question of how we can better understand investor preferences and concerns on CG in emerging markets. It distills a “long list” of key CG concerns of foreign institutional investors, drawing from several sources: International standards of corporate governance Evidence from the academic literature Survey results 3.1 International corporate governance standards The first place to look to reveal the CG preferences of institutional investors is in the global standards on CG. After all, the institutional investor community was an important force in putting these standards in place. The OECD Principles of Corporate Governance are the international standard for CG. First introduced in 1999, they cover shareholder rights, stakeholder rights, transparency and disclosure, and the proper functioning of the board of directors. The OECD Principles are directed to both companies and countries, and also contain recommendations for policymakers, regulators, and supervisors. A more specific source of good practice that may be more relevant for institutional investors are the ICGN Global Governance Principles. The International Corporate Governance Network (ICGN) is an investor-led organization whose “mission is to inspire and promote effective standards of CG to advance efficient markets and economies world-wide.” The ICGN Principles largely reflect the same concerns as those of the OECD, but in many areas go beyond the OECD Principles and are more specific in those areas that are the key concerns of international investors. These include: Specific recommendations for board composition and independence Creation of board committees Specific requirements for conduct of shareholder meetings, voting deadlines, and vote disclosure Detailed requirements for the review and approval of executive and board remuneration Shareholder approval of related party transactions. -16- ICGN Global Governance Principles Responsibilities 1.1 Duties 1.2 Responsibilities 1.3 Dialogue 1.4 Commitment 1.5 Directorships 1.6 Induction 1.7 Committees 1.8 Advice 2 Leadership and independence 2.1 Chair and CEO 2.2 Lead independent director 2.3 Succession 2.4 Effectiveness 2.5 Independence 2.6 Independent meetings 3 Composition and appointment 3.1 Composition 3.2 Diversity 3.3 Tenure 3.4 Appointment process 3.5 Nominations 3.6 Elections 3.7 Evaluation 3.8 Nomination committee 4 Corporate culture 4.1 Codes of conduct/ethics 4.2 Bribery and corruption 4.3 Whistle-blowing 4.4 Political lobbying 4.5 Employee share dealing 4.6 Behaviour and conduct 5 Risk oversight 5.1 Proactive oversight 5.2 Comprehensive approach 5.3 Risk culture 5.4 Dynamic process 5.5 Risk committee 6 Remuneration 6.1 Alignment 6.2 Performance 6.3 Disclosure 6.4 Share ownership 6.5 Shareholder approval 6.6 Employee incentives 6.7 Non-executive director pay 6.8 Remuneration committee 7 Reporting and audit 7.1 Comprehensive disclosure 7.2 Materiality 7.3 Affirmation 7.4 Solvency risk 7.5 Non-financial information 7.6 Internal controls 7.7 Independent external audit 7.8 Non-audit fees 7.9 Audit committee 8 General meetings 8.1 Shareholder identification 8.2 Notice 8.3 Vote deadline 8.4 Vote mechanisms 8.5 Vote disclosure 9 Shareholder rights 9.1 Share classes 9.2 Major decisions 9.3 Conflicts of interest 9.4 Related party transactions 9.5 Shareholder approval 9.6 Shareholder questions 9.7 Shareholder resolutions 9.8 Shareholder meetings 9.9 Thresholds 9.10 Equality and redress 3.2 Evidence from the academic literature The benefits of good corporate governance have been clarified by many academic studies and in several fora. The quality of the CG framework affects not only access to external financing, but also the cost of capital and firm valuation. This is because outsiders are less willing to provide financing and are more likely to charge higher rates if they are less certain that they will get an adequate rate of return.20 They charge these higher rates, as Lombardo and Pagano (2002) explain, since they are incurring higher monitoring costs to ensure their payoff and need these costs to be compensated by a higher rate of return. The extensive literature also provides an indication of the specific factors that matter to investors, including institutional investors. Key indicators used to define good corporate governance in the literation includes: Board composition (especially board independence) and size Quality of disclosure Shareholder rights (including rights during takeovers and changes of control) A key issue in assessing investor preferences is the extent to which investors focus at the country level (looking at laws, institutions, culture and norms and institutions that enforce the laws), or more at the 20 Claessens and Yurtoglu (2012) survey research on corporate governance in emerging markets. -17- company level (focusing on the specific decisions taken by each company). The relationship between country-level and firm-level corporate governance on a company’s performance is of particular interest in the context of our emerging market focus. A considerable amount of research has been published that touches upon this issue. Some of the key findings are: The quality of corporate governance is positively related to performance and this relation is stronger in less investor friendly legal environments. Klapper and Love (2004) investigate this linkage between country governance parameters and company governance in their research. They find that the average firm-level governance is lower in countries with weaker legal systems and also find that better corporate governance is highly correlated with better operating performance and market valuation. This effect seems to be stronger in countries with weaker legal environments as the authors provide evidence that firm-level CG provisions matter more in countries with weak legal environments. Firm-level governance factors are more important than the country-level context in emerging markets. Huggil and Siegel (2012) set out to explain the causes for variation in firms’ CG. Using data from Credit Lyonnais Securities Asia from 2000 to 2010 and data by the Global Reporting Initiative they find that in emerging markets a majority of governance rating variance is explained by firm characteristics, while in developed markets the majority is explained by country characteristics. Investment in in firm-level governance is costly and higher when a country becomes more economically developed and investor-friendly. Aggarwal et al (2007) find strong evidence that foreign firms invest less in internal governance mechanisms that increase the power of minority shareholders than comparable U.S. firms do. Firm-level governance mechanisms that increase the power of minority shareholders to receive a return on their investment are costly, so that the adoption of such mechanisms by a firm is an investment, and the payoffs from that investment differ across countries and across firms. Aggarwal et al postulate that investment in firm-level governance is higher when a country becomes more economically and financially developed and better protects investor rights, plausibly because the return on such investment is higher. Research suggests that country level factors will be more important in emerging markets, where overall standards are lower. Country-level standards of governance tend to be more taken for granted in developed markets. 3.3 Corporate governance concerns: Survey Results The survey also provides insights into the key CG concerns of foreign investors in emerging markets. The survey results indicate that pension funds investing into emerging markets have governance concerns at the country level, and many of the same concerns about corporate governance that they have in their home countries. However, their priorities are different, in line with the issues that they have faced. We have grouped the findings from the survey into two categories reflecting the principal investors concerns we encountered: -18- The quality of financial reporting and audit, the level of shareholder rights, and the weak rule of law are consistent concerns both at country and company level. Voting and general assembly procedures are recurring obstacles in many emerging economies The quality of financial reporting and audit, the level of shareholder rights, and the weak rule of law are consistent concerns both at country and company level. The survey asked pension funds to rank which corporate governance considerations were the most important in their due diligence exercised, at both the country / market level and at the individual company level. The responses are presented in the charts on the following page. In general, the results correspond to good practices, as defined by international standards. However, some of the priorities indicated by the respondents are somewhat surprising. Quality of financial reporting and audit quality. The quality of financial reporting ranked highly in the survey, at both the country and company level. This is notable because of the slow but steady progress made in many countries in adopting International Financial reporting standards (IFRS). However, the quality of financial reporting (and the closely linked integrity of the audit process) remains important to institutional investors, because of the importance of financial information in their investment decisions. The responses show how much more work is left to be done even in more sophisticated countries in improving financial reporting. The quality of non-financial reporting is also mentioned for company-level due diligence, but is ranked at a lower level of importance. Minority shareholder rights. The respondents ranked the importance of shareholder rights very highly for both market-level and company level due diligence. Basic rights, which include rights to appoint directors, receive dividends, and approve special transactions, are typically set by company law. Company law reform thus remains an important priority. Board composition / independence. At the company level, the quality of boards of directors – as measured by the composition of the board, and its degree of independence, was frequently mentioned. Regulation and enforcement. At the country level, respondents mentioned the importance of a code of corporate governance, and a strong securities regulator. Corporate governance codes tend to guide CG of listed companies, especially the role and composition of the boards of directors. Interestingly, codes and securities regulation are ranked lower in priority than the more fundamental shareholder rights. One share-one vote issues. In some countries (e.g. Brazil) one share, one vote issues and the ability of controlling shareholders to maintain a control position with a relatively small amount of capital, remains an important sticking point for institutional investors. Many respondents also mentioned structural features that are clearly important to measuring governance risk. At the market / country level, this includes traditions of misuse of assets and corporate scandals/corruption, and weak rule of law. At a company level, these included ownership structure (government or family ownership). Both can be seen as a symptom of poor governance, but are not easy to directly manipulate by policy-makers. -19- Key Factors Reported: Country Level Due Diligence 13 Quality of financial reporting 13 Level of shareholder rights 12 Quality of audits 11 Weak rule of law Traditions of misuse of assets and corporate scandals/corruption 11 Quality of non-financial reporting (ownership, remuneration, governance) 10 9 Strength of securities regulator 8 Existence of a corporate governance code 5 Ease of voting at shareholder meetings Key Factors Reported: Company Level Due Diligence 120 Board composition/ Quality of directors Quality of financial reporting 114 Weak or limited voting rights 113 108 Board independence 100 Treatment of minority shareholders 91 One share-one vote issues 83 Quality of audit firm Quality of non-financial reporting (ownership, remuneration, governance) 79 Family ownership 79 Government ownership 78 Other 4 * Score is a weighted calculation. Items ranked first are valued higher than the following ranks, the score is the sum of all weighted rank counts. -20- Voting and general assembly procedures are recurring obstacles in many emerging economies As noted in Section IV below, the mechanics of shareholder voting is an important concern for the respondents. It is ranked lower at the country level, but relatively high at the company level, implying that respondents may see the problem as idiosyncratic to specific companies and voting situations. The problems of information, casting votes, show of hands voting, vote confirmation, and lack of split voting, are not just emerging market problems but exist around the world. Proxy voting, particularly important due to the geographical distance between investors and emerging market companies appears overly complex due to often long custody chains, the lack of vote confirmation and a general lack of accountability, according to a number of responses. One pension fund noted, “Proxy voting is the greatest challenges [we] encounter with respect to our equity investments in emerging markets. We have encountered POA (Power of Attorney) issues, which have prevented us from voting shares in Poland, Hungary, and Brazil. Recalling shares on loan for proxy voting is an issue for proxy voting in China and South Korea. Another issue is the transparency of the "Proxy Voting Pipeline". There is no way for us to audit the proxy voting process end to end to ensure votes were properly instructed”. When asked to rank the five emerging markets where investors find it difficult to vote, the five biggest emerging markets by volume were named most often, reflecting their omnipresence in emerging market portfolios (Brazil, Russia, India, China, and Mexico). However, Brazil and Russia came out on top by a relatively wide margin. Even though the sample size is relatively small, this is still a relevant finding. Ranking 1 2 3 4 5 Country Brazil Russia India China Mexico Frequency Ranking Country Frequency 20 6 Taiwan 7 17 7 Egypt 6 14 8 Poland 5 10 9 S. Korea 4 8 10 Romania 4 Source: ICPM Survey: * Score is a weighted calculation. Items ranked first are valued five times higher than items ranked fifth (out of five possible).The score is the sum of all weighted rank counts. 33 total responses out of 100 possible. -21- 4. Ownership Engagement and Stewardship Many CG concerns stem from the separation between ownership and control. As first noted over 80 years ago by Berle and Means,21 there is no incentive for small shareholders to monitor corporate management, because the individual owner would bear the entire monitoring costs, yet all shareholders would enjoy the benefits, thus creating a free rider problem. The rise of institutional investors as significant shareholders has the potential to mitigate agency problems (Gillan and Starks 2003). Since all shareholders benefit from the actions of a monitoring shareholder without incurring the costs, only large shareholders have sufficient incentives to monitor due to the size of their holdings. They also have the capacity to affect change because of their voting blocks. 4.1 International standards of ownership and engagement Over the past 15 years, a variety of national and international standards and codes have taken these ideas further, and actively encourage institutional investors to behave as active owners of the companies in their portfolio. This includes the 2004 and 2015 updates to the OECD Principles of Corporate Governance, and the International Corporate Governance Network’s Statement of Principles for Institutional Investor Responsibilities (2013). At a national level a number of countries have issued codes of responsible investment or stewardship, led by the UK’s Stewardship Code (2010). The high expectations for institutional investors to advance corporate governance in their investee companies is based on the assumption that they have more capacity, resources, and incentives to monitor than individual investors. Stewardship essentially becomes its own investment strategy – invest in the entire market, and then engage with companies to improve their governance and increase their valuation. “The longer-term endgame should be to realize value by reducing, or possibly eliminating, this governance discount.”22 The definitions of responsible investment and stewardship continue to evolve. The core principles were already reflected in the updated 2015 OECD Principles of Corporate Governance, which note that “…the effectiveness and credibility of the entire CG framework and company oversight depend to a large extent on institutional investors’ willingness and ability to make informed use of their shareholder rights and effectively exercise their ownership functions in companies in which they invest.”23 The Employee Retirement Income Security Act (ERISA) in the United States de facto obliges institutions subject to it to vote all shares under their management. Stewardship Codes in the United Kingdom, Japan, Malaysia, and (2016, forthcoming) Kenya encourage engagement and voting. In some emerging markets, local pension funds are required to nominate independent directors (Chile), vote their shares (Peru) and disclose their CG policies (Colombia). The basic legal framework also plays a role.24 Investors that are subject to “more stringent fiduciary standards likely have greater preferences for “better” CG 21 As described in Gilson and Gordon (2013) Alsarat and Dallas 2011? 23 OECD (2015), p. 32 24 Bushee, Carter and Gerakos (2009) 22 -22- mechanisms as a defense against investor lawsuits. “25 Bank trusts, pension funds and endowments are more likely to be sensitive to governance than insurance companies and investment advisors. 4.2 Challenges to the stewardship model Although now a recognized international standard, in practice the level of adoption of the stewardship model varies widely in both the developed and emerging market worlds. The expectations of strong institutional investor engagement have only partially been met. Issakson and Celik (2013) note that “one of the most straightforward explanations is simply that a great majority of intermediary investors actually lack the incentives to exercise their ownership functions.”26 Celik and Isaksson (2013) identify four different degrees of ownership engagement and tie the level of ownership engagement directly to the institutional investors’ business model. The four broad degree of ownership engagement the authors identify are: 1. No engagement: The authors summarize investors under this category who neither monitor investee companies directly nor engage in any form of dialogue and do not vote their shares. Exchange-traded funds can fall under this category. 2. Reactive engagement: Described as investors who follow voting practices based on mainly generic, pre-defined criteria, often relying on proxy advisers in guiding their decisions. The level of engagement may be increased when other, active shareholders come forward with specific proposals. Pension and mutual funds who are required to vote their shares often fall under this category. 3. Alpha engagement: Associated with ownership engagement that “seeks to support short or long-term returns above market benchmarks.”27 Activist hedge funds and private equity funds can both employ this strategy, albeit with very different ownership stakes. Hedge funds tend to influence companies through small holdings, at times complemented by derivatives and seek the support of other investors to increase the chances of success of their interventions. Private equity firms aim to achieve similar goals by acquiring large or controlling stakes. 4. Inside engagement: Characterized by “fundamental corporate analysis, direct voting of shares and often assuming board responsibilities.”28 Controlling stakes and long-term engagement are typical features of this engagement level. Closed-end investment companies such as Berkshire Hathaway or some sovereign wealth funds are examples of such engagement. Celik and Isasksson argue that one needs to understand the underlying business models of different investors to understand their engagement level. In an illustrative example, they juxtapose two performance fee-charging hedge funds with a short-term liability structure. Neither faces regulatory requirements to engage in the governance of their investee companies or has any particular social and political objectives. However, they differ in their investment strategy and portfolio structure and consequently, they have completely different levels of engagement. One hedge fund has an active 25 Bushee, Carter and Gerakos (2009), p. 26 Isaksson and Celik (2013), p. 34 27 Celik and Isaksson (2013), p. 27 28 Ibid 26 -23- qualitative strategy with a concentrated portfolio, thus follows what the authors dubbed “alpha engagement”. The other fund employs an active quantitative strategy with a diversified portfolio, showing no interest in the governance details of its individual portfolio companies and instead relying on software to process large quantities of information. Such a hedge funds engagement would fall in the “no engagement” category. Wong (2010) identifies additional structural deficiencies that are a consequence of modern investment management practices. These deficiencies preclude a long-term ownership mindset that is essential for a functioning stewardship model. 1. Inappropriate performance metrics and financial arrangements. The incentives for most asset managers promote trading and short-term returns since compensation is based on the shortterm performance of investments. Long-term commitment and engagement therefore runs against the economic incentives of the principal investor agents. 2. Excessive portfolio diversification. Modern risk management investment techniques employed by institutional investors often result in equity portfolios containing hundreds or even thousands of stocks. This naturally creates difficulties in monitoring and “weaken an ownership mindset.”29 3. Lengthening share ownership chain. Similar to the point raised by Gilson and Gordon, new agency problems arise since in the modern investment world, there are several layers of financial intermediaries between the ultimate beneficial owner of shares and the accompany. This phenomenon, also dubbed ‘separation of ownership from ownership’ creates significant agency and accountability problems. 4. Misguided interpretation of fiduciary duty. Wong argues that across the investment chain, there is “an increasing emphasis on furthering the economic – as opposed to non-financial –interests of clients and ultimate beneficiaries, “leading to an excessive reliance on evaluating investment and other decisions “principally in quantifiable financial terms.” 5. The rise of passive funds. In general, passive funds tend to fully replicate a broad or sometimes specific market index such as the S&P 500 or a sector or specialty index. Exiting individual holdings is not an option in this model. The move of many investors towards indexing is driven by two important factors: (1) it helped investors to dispose of heavy brokerage commissions and advisory fees, and (2) active institutional investors were unsuccessful in beating the market averages over time.30 While the long holding periods of passive index funds should bode well for their stewardship, Wong points that the bulk of passive funds “pay scant attention to corporate governance,” since their marketing focuses entirely on the low cost and close tracking of the respective benchmark. As a result the resources and capacity of many investors for active monitoring and engaging with investee companies are limited. Today, the principal means of shareholder participation by pension funds, mutual funds and insurance companies is through voting their proxies. Since the funds do not have the capacity to analyze their holdings, the use of proxy advisors has grown dramatically in the US 29 30 Wong (2010), p. 407 Isaksson and Celik (2013), p. 32 -24- and Europe. A survey conducted by the Dutch Corporate Governance Code Monitoring Committee in 2011, cited by Isaksson and Celik found that 88% of institutional investors in the Netherlands made use of the voting advice from third parties. Filling the assurance void on corporate governance practices and thereby ‘outsourcing’ the stewardship duties to CG raters like Governance Metrics International and Deminor and proxy advisory firms like ISS and Glass Lewis is now an established practice in developed markets. However, these providers have yet to start comprehensive coverage in emerging markets since it would not be economical from their standpoint. As of March 2013, GMI Ratings was covering 6,100 companies worldwide with its ESG (Environmental, Social, Governance) ratings, 998 of which were in emerging markets, but heavily concentrated in the BRICS markets Brazil, Russia, India, China, and South Africa (Grimminger 2014). 4.3 Stewardship across borders Most of the efforts around stewardship have focused on the markets in the developing world. Much less research has been done on the focus of this paper – the role played by foreign institutional investors in emerging market countries. While the benefits of stewardship are presumably even larger – because of weaknesses in local CG frameworks – the costs are larger as well. A number of factors may make stewardship and engagement more difficult in emerging markets: More limited information. Information disclosure and availability is weaker, making it more difficult for investors to make voting decisions or set engagement priorities. Lack of information providers. The traditional proxy service firms mentioned above are much less present in emerging markets (especially in smaller frontier markets). Higher costs. Costs of voting and engaging are likely to be higher. Reluctance to engage outside of the home market. Investors are likely to be reticent about taking strong positions in countries where they are unfamiliar with local business practices and cultures. Lack of trust and reluctance to engage on the part of companies. Companies are generally less likely to be willing to meet with shareholders that they do not know. 4.4 Stewardship and Engagement: Results from the Survey The survey of ICPM research partners provide a number of important insights into how pension funds are engaging with their portfolio companies in emerging markets. Pension funds are voting and engaging in emerging markets, but to a limited degree, and to a much lesser extent than in developed markets. The main reasons cited appear to be proxy voting issues, lack of available information, and the small size of many positions that makes costly engagement less-than-worthwhile. Below are the four principal findings from on this topic from the survey: Pension funds vote generally their shares in emerging markets companies, but less than in developed markets -25- In emerging markets, cost considerations make funds’ engagement opportunistic and carried out through third parties Three factors appear to account for the lack of voting and engagement: voting problems, lack of information, and the relatively small size of investments in emerging markets. Funds use a variety of approaches to overcome obstacles and obtain information necessary to engage Pension funds vote generally their shares in emerging markets companies, but less than in developed markets Pension funds in the sample vote the shares of their emerging markets portfolio, but generally less so than in developed markets. 56 percent of respondents report that they “always” vote their shares, followed by 11 percent voting “most of the time” and 11 percent “sometimes”. 59 percent of funds report voting less than in developed / mature markets, and 41 percent said it was about the same (with none voting more). When your shares have voting rights, do you vote your shares in your equity investments in emerging and frontier markets? If you vote your shares, does your Fund make the voting decisions itself or is this delegated to another party? Most of the Time 11% Always 56% Delegated but based on clear guidelines 37% Sometimes 11% Seldom 5% Fully delegated 19% Ourselves 44% Never 17% 44 percent of funds report that they vote themselves, 37 percent delegate the voting process, but based on clear guidelines, and 19 percent fully delegate their votes. One respondent noted that “…we instruct our managers to vote according to their policies if we believe they have a good policy and team in place - otherwise we instruct to vote according to their proxy voting agency policy or recommendations.” Another, referencing concerns about costs, notes that “…we have a market value cap on the number of companies we vote outside North America so the emerging and frontier markets only make up a small portion of this international voting list.” A third (in the partially delegated category) adds that “… Investment professionals in the Equities Department use ISS research but apply our own guidelines to each and every vote.” -26- In emerging markets, cost considerations make funds’ engagement opportunistic and carried out through third parties 83 percent of funds reported less engagement with companies in emerging markets relative to developed markets. 56 percent of respondents indicated that they were engaging directly with companies. One fund states that “…based on an earlier prioritization of companies and issues, we engage with companies through different levels of management to voice our concerns over CG and other ESG issues.” However, even those that claimed to engage directly with companies noted that cost considerations drive the degree of communication. One fund noted that “we do [engage], but given location and relatively limited investments, we engage within developed markets much more extensively than with companies in emerging/frontier markets. We rely heavily on foreign investor groups (e.g. Asian Corporate Governance Association) and other local investors for detailed analysis.” Another agrees that they “usually only [engage] in collaboration due to geographical limitations.” A third remarked that they “will meet on roadshows, will also participate in ACGA events” while noting that they “…will also directly travel and meet companies in their home markets. 76 percent of surveyed funds delegate the engagement process to third parties, typically the asset manager. Others included specialist engagement providers (Hermes, BDO) or the index fund provider. If you engage with portfolio companies in emerging and frontier markets, does your Fund do this itself or is it undertaken by another party? Ourselves 24% Other 43% Asset Manager 33% Three factors appear to account for the lack of voting and engagement: voting problems, lack of information, and the relatively small size of investments in emerging markets. Proxy voting, particularly important due to the geographical distance between investors and emerging market companies appears overly complex due to often long custody chains, the lack of vote confirmation and a general lack of accountability, according to a number of responses. One pension fund noted, “Proxy voting is the greatest challenges [we] encounter with respect to our equity investments in emerging markets. We have encountered POA (Power of Attorney) issues, which have prevented us from voting shares in Poland, Hungary, and Brazil. Recalling shares on loan for proxy voting is an issue for proxy voting in China and South Korea. Another issue is the transparency of the "Proxy -27- Voting Pipeline". There is no way for us to audit the proxy voting process end to end to ensure votes were properly instructed”. When asked to rank the five emerging markets where investors find it difficult to vote, the five biggest emerging markets by volume were named most often, reflecting their omnipresence in emerging market portfolios (Brazil, Russia, India, China, and Mexico). However, Brazil and Russia came out on top by a relatively wide margin. Even though the sample size is relatively small, this is still a relevant finding. A number of respondents also mentioned corporate disclosure as well as the relatively low level of quality of governance and financial reporting, and often the complete absence of relevant ESG information as the greatest challenges to monitor, vote and engage with companies in emerging markets. In addition to the difficulties in applying standard proxy voting procedures and lack of quality information, a number of respondents also stated that their emerging market holdings are too insignificant to warrant engagement. “Given location and relatively limited investments, we engage within developed markets much more extensively than with companies in emerging/frontier markets”, stated one of the respondents. Another manager noted “we have a market value cap on the number of companies we vote outside North America so the emerging and frontier markets only make up a small portion of this international voting list.” Funds use a variety of approaches to overcome obstacles and obtain information necessary to engage As noted above, virtually all of the surveyed funds work with proxy advisors such as ISS and specialist engagement providers such as Hermes EOS. Some funds indicated that the coverage they received from proxy advisors was sufficient. But when information is limited, other funds take advantage of a number of options to obtain information about companies as part of their engagement process. Most rely on local institutions and existing relationships for help; only 11 percent report that they “undertake the analysis ourselves. “ In many emerging and frontier markets there may be limited or no proxy advisory services available, or coverage may be limited. In such circumstances and in order to exercise stewardship over your investments does your fund: Invest only in companies in which we can get direct access to management 4% Other 25% Undertake analysis ourselves 21% Rely on a local fund manager to gather any information necessary 32% Use local corporate governance analysis providers 18% -28- 40 percent of respondents noted that they approach governments or regulators to seek additional safeguards, showing the potential such investor interventions can have. Investor groups such as the Asian Corporate Governance Association with a regional focus, or the UN PRIs were cited as platforms investors utilize for collective engagement. One respondent stated that “we tend to pursue advocacy opportunities that focus on shareholder rights and CG (and) pursue company engagements that address ESG risk- such as an ongoing 2+ year engagement with companies that source goods or have factories in Bangladesh.” -29- 5. Conclusions and Implications for World Bank Policy Work The survey generally confirms what was anticipated by the literature review – most of the respondents are factoring corporate governance considerations into their investment decisions, at country and company levels. In addition, governance considerations are today an integral part of the ESG analysis There were a number of important caveats to this general conclusion: Corporate governance shortcomings generally do not prevent an attractive investment Most corporate governance analysis in emerging markets appears to be outsourced Investors continue to find it difficult to quantify corporate governance risks Of note, there is probably some upward bias in the role that governance plays in pension fund decisionmaking, since our survey respondents are not only long term investors but most likely the ICPM members most interested in both governance topics and ESG investing. Likewise, survey respondents generally identified the corporate governance concerns that are emphasized in the international standards. Somewhat surprisingly, core long-term issues like the quality of financial reporting and audit and the level of shareholder rights were ranked the highest at the country and company levels. In their comments, survey respondents also focused on the practical obstacles to voting and engagement with their portfolio companies, especially voting and general assembly procedures are recurring obstacles in many emerging economies In spite of these obstacles, the survey respondents generally vote their shares in emerging markets companies, but less than in developed markets. Engagement (where investors raise concerns directly with boards and management of portfolio companies) happens significantly less than in developed markets. In emerging markets, cost considerations make funds’ engagement opportunistic and carried out through third parties. Three factors appear to account for the lack of voting and engagement: voting problems, lack of information, and the relatively small size of investments in emerging markets. Funds use a variety of approaches to overcome obstacles and obtain information necessary to engage What are the policy implications of these findings? The World Bank’s goals in its work on corporate governance are to bring savers and investors together, in order to increase international portfolio investment, increase access to financing, leading to better firm performance, and more favorable treatment of stakeholders. We also hope to assist all of our client countries to expand inbound portfolio investment over the long term. The ultimate purpose of this study was to initiate a stream of research that can have practical implications for World Bank programs and initiatives. The surveyed pension funds were asked to give their suggestions as to where the World Bank should direct its efforts. The suggestions (presented in the chart below) are notable for their focus on the “fundamentals” of corporate governance – updating company law, increasing the capacity of regulators, increasing disclosure requirements, and updating corporate governance codes. -30- Thinking about the key corporate governance factors that you look at in investing in EME’s, what are the three top corporate governance reform priorities that the World Bank should consider addressing to improve the investment environment in emerging markets? Updating company law to improve shareholder rights 87 Increasing the power and enforcement activity of regulators 70 Increasing disclosure requirements 60 Updating corporate governance codes 55 Improving corporate governance disclosures 48 Improving audit oversight 43 Reforming the courts Other 29 3 * Scores are weighted calculations. Items ranked first are valued eight times higher than items ranked eighth (out of eight possible).The score is the sum of all weighted rank counts. 72 total responses out of 160 possible. There are two general implications of the study for World Bank Group policy work: Corporate governance issues remain important to foreign instructional investors. While the small sample size of the survey precludes definitive judgment, a significant number of institutional investors factor CG into their pre-investment and post-investment decision-making. Governance discounts to investing in emerging markets are significant. The clear policy and research conclusions are that there is important room to improve corporate governance at the country and company level. At the country level, efforts to improve corporate governance by improving law and regulation, enforcement, financial reporting, and audit oversight need to continue. This implies ramping up existing World Bank diagnostic programs (including the Corporate Governance and Accounting and Auditing Reports on Observance of Standards and Codes programs) and capacity building programs to securities regulators and audit oversight agencies to improve enforcement of existing rules. At the company level, more can be done to enhance individual company governance practices and procedures to begin to create market champions of good governance who in turn can have a positive demonstration effect for the market itself in each jurisdiction. The World Bank Group can use its convening power to bring together policymakers and investors to improve engagement and communication. Continued problems with proxy voting (and the challenges of cross-border monitoring and engagement) present a challenge to all stakeholders. The large number of concerned parties (global investors, global custodians, local -31- custodians, proxy voting agencies, regulators, and the companies themselves) with a variety of conflicting interests, make it difficult to resolve problems. The opportunity exists for the World Bank Group and international investor organizations to use their convening power to bring together the stakeholders and try and resolve obstacles to improved engagement and communication. On research, more can be done to gather concrete evidence on company (good and bad) practices that impact investors’ willingness to invest. This can be achieved if coordinated research efforts attempt to include proxy voting firms and local asset managers, which appear to have a better pulse of the corporate dynamics in emerging markets. Regional based hubs of knowledge and information sharing on corporate governance appear to be an effective solution to bridge the information gap. The experience of the Asean Corporate Governance Association appears to be a favorable and useful tool for investors. The possibility to replicate a similar initiative in other regions should be explored. -32- Annex 1: International Data on Institutional Investor Assets and Asset Flows Annex 1: Institutional Investor Assets as a Share of GDP High income: non-OECD Argentina Croatia Cyprus Hong Kong SAR, China Latvia Lithuania Malta Russian Federation Singapore Trinidad and Tobago Uruguay High income: OECD Australia Austria Belgium Canada Chile Czech Republic Denmark Estonia Finland France Germany Greece Hungary Iceland Ireland Israel Italy Japan Korea, Rep. Luxembourg Netherlands New Zealand Norway Poland Portugal Slovak Republic Slovenia Spain Sweden Switzerland United Kingdom United States Lower middle income Armenia Mutual Fund Assets % of GDP 69.2 1.8 (2013) 4.6 (2013) 15.0 (2013) 467.7 (2013) 2.6 (2013) 0.7 (2013) 33.6 (2014) N/a N/a 27.5 (2014) N/a 201.2 17.0 (2012) 46.1 (2013) 26.5 (2013) 73.0 (2014) 16.7 (2014) 2.7 (2014) 35.4 (2014) 2.4 (2013) 31.8 (2014) 49.2 (2014) 51.6 (2013) 2.2 (2014) 15.6 (2013) 19.5 (2013) 616.9 (2014) 22.0 (2013) 11.1 (2014) 17.0 (2014) 22.1 (2014) 5,024.6 (2014) 8.6 (2014) 21.0 (2014) 22.5 (2014) 4.8 (2014) 3.7 (2014) 4.2 (2014) 5.2 (2014) 19.5 (2014) 48.9 (2014) 57.6 (2014) 47.3 (2014) 91.0 (2014) 5.0 0.4 (2006) -33- Pension Fund Assets % of GDP 15.5 9.2 (2007) 21.0 (2014) 37.4 8.5 5.3 8.2 2.5 25.6 17.1 20.6 40.9 102.3 5.8 5.0 76.2 68.3 7.8 75.7 11.9 50.3 0.4 16.4 0.1 4.1 147.2 53.0 50.4 6.2 29.4 7.5 2.4 184.1 17.9 9.5 8.7 9.2 10.5 6.5 11.8 24.9 117.8 104.9 83.2 7.6 N/a (2014) (2014) (2014) (2012) (2012) (2014) (2007) (2014) (2013) (2014) (2014) (2014) (2014) (2014) (2014) (2014) (2013) (2013) (2014) (2013) (2014) (2014) (2013) (2012) (2013) (2014) (2014) (2014) (2014) (2013) (2014) (2014) (2013) (2014) (2014) (2014) (2014) (2013) (2013) (2013) Bangladesh Bolivia Egypt, Arab Rep. El Salvador Honduras India Indonesia Kenya Lesotho Morocco Nigeria Pakistan Philippines Sri Lanka Ukraine Zambia Upper middle income Albania Bosnia and Herzegovina Brazil Bulgaria China Colombia Costa Rica Dominican Republic Ecuador Jamaica Jordan Kazakhstan Macedonia, FYR Malaysia Mauritius Mexico Namibia Panama Peru Romania Serbia South Africa Suriname Thailand Turkey Mutual Fund Assets % of GDP 0.0 (2004) 3.0 (2007) N/a N/a N/a 6.6 (2014) N/a N/a N/a 26.4 (2009) 0.2 (2013) 1.7 (2014) 1.8 (2014) N/a N/a N/a 10.0 3.7 (2013) 3.1 (2011) 46.2 (2014) 1.3 (2014) 6.8 (2014) 0.1 (2013) 4.2 (2014) N/a 0.2 (2013) N/a N/a 1.9 (2012) 0.9 (2007) 32.9 (2013) N/a 9.3 (2014) N/a N/a 3.0 (2013) 2.5 (2014) N/a 41.9 (2014) N/a N/a 2.1 (2014) Pension Fund Assets % of GDP N/a 30.5 (2013) 1.8 (2014) 32.0 (2014) 0.9 (2013) 0.3 (2012) 1.7 (2011) 12.7 (2012) 13.2 (2012) N/a 4.4 (2012) 0.0 (2012) 3.5 (2014) 0.6 (2006) 0.2 (2013) 4.6 (2005) 15.7 0.0 (2013) 0.6 (2011) 14.0 (2013) 8.7 (2013) 0.9 (2012) 20.4 (2014) 11.4 (2014) 8.6 (2014) N/a 21.2 (2012) 34.9 (2006) 11.7 (2014) 6.4 (2014) 57.9 (2014) 1.8 (2012) 13.8 (2014) 74.3 (2012) 8.1 (2012) 19.9 (2014) 3.0 (2014) 0.6 (2014) 40.8 (2011) 10.0 (2006) 6.9 (2014) 2.0 (2014) Source: World Bank, Finstats Database 2016. Latest year available is shown. Data come from a variety of sources and should be compared with caution. -34- Table 2: Net Portfolio Equity Flows to Developing Countries 1995-2014 Billions of USD Total 19952007 2008 2009 2010 2011 2012 2013 2014 Total 19952014 All developing countries 445.2 -39.1 112.0 124.0 3.7 92.5 72.3 92.7 903.2 By Region East Asia & Pacific Latin America & Caribbean South Asia Sub-Saharan Africa Europe & Central Asia Middle East & North Africa 168.0 83.4 90.6 74.0 25.8 3.4 -6.8 -11.1 -15.9 -5.6 -.2 .4 31.6 41.3 24.2 10.8 3.0 1.2 40.7 39.4 29.8 8.2 4.0 2.0 7.1 3.0 -4.3 -1.1 -.5 -.6 35.3 18.6 23.3 9.6 6.9 -1.3 28.8 13.2 20.5 7.0 3.1 -.3 50.5 20.5 13.7 4.5 2.8 .6 355.2 208.5 181.9 107.3 44.9 5.3 By Income Category Middle income 444.9 -39.0 112.0 124.1 3.7 92.1 71.6 91.3 900.6 Upper middle income Lower middle income Low income 332.1 112.8 .3 -21.6 -17.4 -.1 85.0 27.0 .1 83.7 40.4 -.1 3.5 .1 .0 54.0 38.2 .4 45.5 26.1 .6 72.2 19.2 1.4 654.3 246.4 2.5 Top 10 Countries China India Brazil South Africa Turkey 117.6 88.1 67.4 69.4 15.8 8.5 -15.0 -7.6 -4.7 .7 29.1 24.7 37.1 9.4 2.8 31.4 30.4 37.7 5.8 3.5 5.3 -4.0 7.2 -3.8 -1.0 29.9 22.8 5.6 -.7 6.3 32.6 19.9 11.6 1.0 .8 51.9 12.4 11.8 2.6 2.6 306.2 179.2 170.8 79.0 31.5 Nigeria Mexico Thailand Colombia Vietnam 4.0 13.2 28.0 1.7 7.7 -1.0 -3.5 -3.8 -.1 -.6 .5 4.2 1.7 .1 .1 2.2 .4 3.2 1.3 2.4 2.6 -6.6 .0 2.3 1.1 10.0 9.9 .1 3.2 1.9 5.6 -.9 -3.4 1.9 1.4 1.0 4.8 -5.8 3.8 .0 24.9 21.4 20.0 14.2 13.9 Philippines 6.5 -.5 .3 .8 1.0 1.8 .0 1.2 11.2 Source: World Bank, International Debt Tables. 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Butterworths Journal of International Banking and Financial Law, pp. 406-411, July/August 2010 ; Northwestern Law & Econ Research Paper No. 10-28. -39- -40- Annex II: Assets under Management of Surveyed Funds (Billions USD) Home Country Number of Funds Total AUM Average fund size Of which: AUM in listed equity Of which: AUM in emerging markets listed equity Of which: held by tracker / index funds Australia 2 110.5 55.3 48.2 8.20 0.00 Canada 5 286.2 57.2 125.8 18.16 6.70 Denmark 1 28.0 28.0 5.0 0.70 0.20 Finland 1 38.1 38.1 10.2 1.20 0.00 Netherlands 2 218.0 109.0 76.0 8.86 8.86 New Zealand 1 19.5 19.5 8.2 1.10 0.80 Sweden 1 35.0 35.0 15.0 3.70 0.00 United Kingdom 2 101.0 50.5 43.2 7.75 0.01 United States 2 375.0 187.5 170.0 17.60 7.00 Grand Total 17 1,211.3 71.3 501.7 67.27 23.57 Source: WB / ICPM Survey. Excludes 3 funds that had missing AUM data. -41-