Investing in Good Governance

by Lucian A. Bebchuk

New York Times
September 12, 2012

Can investors generally beat the market by concentrating their portfolios on companies that practice good corporate governance? There is evidence that good-governance features included in standard governance indexes do improve the performance of companies – but that their significance is already reflected in market prices.

In a well-known study issued a decade ago, Paul Gompers, Joy Ishii and Andrew Metrick identified a trading strategy that would have produced abnormally high returns in the 1990s. The strategy was based on an index, the G-Index, consisting of 24 governance provisions that weaken shareholder rights.

In a subsequent study, Alma Cohen, Allen Ferrell and I showed that, among the 24 provisions, only six – including staggered boards, poison pills and supermajority requirements – really mattered. As a result, we constructed an E-Index based on these six “entrenching” provisions.

Those studies showed that buying shares in the 1990s of companies that scored well on the governance indexes and shorting companies that scored poorly would have beaten the market. The correlation between governance and stock returns has attracted interest from researchers, and the G-Index and E-Index have subsequently been used in hundreds of studies by financial economists.

In a recent study that will be published by The Journal of Financial Economics, Alma Cohen, Charles Wang and I document that the correlation between governance and stock returns in the 1990s did not persist in later years. This correlation disappeared because markets learned to distinguish between good-governance and poor-governance firms (as defined by the governance indexes) and to price the difference into stock values.

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