Discourse on corporate governance has been evoked since the work of Adam Smith in 1776, who discusses the subject of ownership and control, and Berle and Means (1932), who raise the issue of the principal-agent problem. Although much literature has examined the issues of corporate governance and/or its relationship with some form of firm performance (for example, Baliga, Moyer & Rao 1996; Black 2001; Dye 1993; Fama & Jensen 1983; Haniffa & Hudaib 2006; La Porta et al. 1998; Lipton & Lorsch 1992; Mak & Kusnadi 2005; Martin & Parker 1995; McConnell & Servaes 1990; Mitton 2002; Pathirawasam & Wickremasinghe 2012; Shleifer 1998; Tirole 2001; Yermack 1996), there is a relative lack of research examining corporate governance specifically within the context of developing and testing trading strategy. This is not unexpected. As discussed earlier, the use of corporate governance information for trading
25 UNPRI is an initiative of the UN Global Compact and the UN Environment Programme Finance Initiative. The collaboration with Enhanced Analytics Initiative was announced on 6 October 2008. 26 UNPRI (2008, para. 3) describes extra financial issues as ‘fundamentals that are generally not part of traditional fundamental analysis but have the potential to impact companies’ financial performance or reputation in a material way’. This includes corporate governance.
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strategy is a rather new area of fundamental research. The study by Gompers, Ishii and Metrick (2003) provides a reasonable starting point for a review of research in this field. In their highly influential study, Gompers, Ishii and Metrick (2003) examine the relationship between corporate governance and firm performance in about 1,500 firms, sourced from the Investor Responsibility Research Center (IRRC), during the 1990s. Based on 24 governance variables focusing on anti-takeover provisions, they develop a governance index (G) that is measured as the sum of each binary variable. In defining good and weak governed firms, the authors rate those with stronger rights (democracy firms) with their lower G index (G ≤ 5), while weaker rights (dictatorship firms) are those with a high G index (G ≥ 14). They find that shareholder rights are strongly associated with firm value. As well, a simple trading strategy that buys (sells) democracy (dictatorship) firms yields an abnormal return of 8.5% per annum. The result appears to be in direct contrast to the logic of semi-strong efficient market theory, and suggests that a trader can construct a profitable strategy by screening stocks on the basis of publicly available corporate governance information.
Drobetz, Schillhofer and Zimmermann (2004) find similar results. Focusing on the German stock market, they examine if the differences in governance quality among the firms can explain stock returns. To do this, they construct a corporate governance rating (CGR) of firms based on the responses from their questionnaires. Their CGR comprises of 30 criteria from five categories, namely corporate governance commitment, shareholder rights, transparency, management and supervisory board matters, and auditing. Analogous to Gompers, Ishii and Metrick (2003), Drobetz, Schillhofer and Zimmermann (2004) focus on two portfolios – the principal portfolio (firms with high CGR), and the agent portfolio (firms with low CGR). They employ a simple trading strategy that long (short) high (low) CGR companies. The strategy generates about 12% of annual abnormal returns.
Extending the approach in Gompers, Ishii and Metrick (2003) to European markets, Bauer, Guenster and Otten (2004) use similar screening method. Using CGR by Deminor CGR, which includes most of the firms listed on the FTSE Eurotop 300 for 2000 and 2001, they describe the top (bottom) quintile of firms with the highest (lowest)
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CGR as good (bad) for the European Monetary Union (EMU) portfolio, while for the UK, portfolios are based on quartile cut-off points.27 For the period January 1997 to July 2002, they find that the governance trading strategy produces an annual return of 2.1% (7.1%) for the EMU (UK) portfolio. Like Drobetz, Schillhofer and Zimmermann (2004), however, they only use constant ratings for the period 1997 to 2000 because of the unavailability of CGR for these years. Overall, their results indicate that good corporate governance is associated with higher stock returns and market value.
Whereas previous studies investigate the performance of governance trading strategy in the developed markets of the US and Europe, Chen et al. (2007), Aman and Nguyen (2008) and Bauer et al. (2008) test the relationship between CGI and stock returns in the Asian markets. Using four governance variables (CEO duality, board size, management holdings and block holdings), Chen et al. (2007) focus on the aspect of ownership and leadership structure for firms listed on the Taiwan stock market. Based on their CGI, they divide firms into portfolios of weak, moderate, and strong governance. Examining the period 1992 to 2001, they observe that the portfolio of firms with strong corporate governance earns an annual return of 8.8%, whereas firms with moderate governance only earn 2.02%. Further, the portfolio of weakly governed firms records an annual loss of -6.12%. The results indicate that traders can profit by screening firms with good corporate governance.
Conflicting results, however, are observed in the Japanese market. Aman and Nguyen (2008) investigate their CGI (which is built based on board structure, ownership characteristics and quality of disclosure) over the period 2000 to 2005, and find that firms with weak governance outperform those with good governance. Nonetheless, this is due to the greater risk exposure associated with the former. Overall, they argue that their result is consistent with a semi-strong efficient market. In contrast, Bauer et al. (2008), using the data from GMI, find that a simple zero-investment strategy using a 5% cut-off point produces an outperformance of 8.72% per annum for the period 2000 to 2004, in line with the argument that the market is not efficient. Several factors may have caused these discrepancies, for example, differences in the sample firms or period used,
27 This is different to the absolute index measure as employed in Gompers, Ishii and Metrick (2003). The difference in cut-off points between the EMU and the UK is due to the smaller sample size of the UK portfolio.
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but CGI formulation seems most likely. Indeed, as argued by Bauer et al. (2008), some aspects of corporate governance are not material to shareholders in Japan.
In another major study, Bebchuk, Cohen and Ferrell (2009) build an entrenchment (E) index using a more parsimonious model to Gompers, Ishii and Metrick (2003), focusing only on six provisions out of the 24 used in the G index: (1) staggered board; (2) limits to amend bylaws; (3) limits to amend charter; (4) supermajority; (5) golden parachutes and (6) poison pill. Based on the data from IRRC for the period 1990 to 2003, they find that a simple trading strategy of buying (selling) good (weak) governed firms with E = 0 (E ≥ 5) yields about 7% of annual abnormal returns. In contrast, they observe that the remaining 18 provisions from the G index in Gompers, Ishii and Metrick (2003) are not correlated to abnormal returns.
Most recently, Bebchuk, Cohen and Wang (2013) argue that the returns on the governance trading strategies in Gompers, Ishii and Metrick (2003) (G index) and Bebchuk, Cohen and Ferrell (2009) (E index) are particular to the 1990s period. Re- examining the same rules in the same dataset, they find that the governance trading strategies produce statistically and economically significant results for the first sample period of 1990 to 1999. However, for the second period of 2000 to 2008, the strategies no longer yield abnormal returns. The returns generated by these strategies are not significantly different from zero. Whereas the market seems semi-strong inefficient to process corporate governance information in the 1990s, Bebchuk, Cohen and Wang (2013) argue that the dissipation of returns from the trading strategies is due to the fact that market participants already learn the differences between good and bad governance and invest in it, making the stock prices already reflect this information. They conclude that trading strategies based on the G and E indexes are no longer profitable.
The results from Bebchuk, Cohen and Wang (2013) do not mean any corporate governance trading strategy is totally ineffective and is no longer useful. In fact, their study is restricted to the use of G and E indexes developed by Gompers, Ishii and Metrick (2003) and Bebchuk, Cohen and Ferrell (2009). The use of other governance indicators and/or more sophisticated trading rules (for example, where the trading rule is enhanced using neural networks) may produce an even superior outperformance. Indeed, in reflecting on Bebchuk, Cohen and Wang (2013), Bebchuk (2012) later affirms that
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there are still possibilities to make profit from a governance trading strategy, since there are other governance instruments that are not efficiently priced yet.28 Overall, the above literature review suggests that there are potentials for constructing profitable strategies via screening stocks on the basis of publicly available corporate governance information, which exploits the inefficiency of the capital market.