The Corporate Library’s Governance Ratings and Equity Returns

Kimberly Gladman, CFA, Ph.D., Director of Research and Risk Analytics

Execu�ve Summary
A recent study of investment applica�ons for The Corporate Library’s governance ra�ngs shows outperformance
in 2003-2010 for three hypothe�cal por�olios benchmarked to the Russell 1000. The highest level of
outperformance—275 annualized basis points—was found for the por�olio applying the strictest governance
screens. Performance a�ribu�on indicates that 121 basis points of the annualized outperformance for this
por�olio was stock-specific and hence directly a�ributable to the ra�ngs. Approximately 74 addi�onal basis
points resulted from differen�al industry weigh�ngs produced by the applica�on of ra�ngs standards to
each company on an absolute (not “best-in-class”) basis. Por�olio standard devia�on was comparable to the
benchmark, and tracking error was 3.3 percent. The por�olio outperformed the benchmark in over 60 percent
of the test months, and had an informa�on ra�o exceeding 0.8.

Growth of $1 Billion Invested

The chart below shows the growth of $1 billion invested in each of the three por�olios vs. the Russell 1000 (in
blue), with the por�olio using the strictest governance screens shown in dark red.

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© 2010 The Corporate Library
 The Corporate Library’s Governance Risk Ra�ngs
The Corporate Library’s governance risk ra�ngs seek to iden�fy companies where a divergence between the
interests of management and shareholders may be placing investment value at risk. The ra�ngs process has
two parts. First, a database algorithm scores each company’s governance by assigning or deduc�ng points
for a range of data items related to board composi�on, execu�ve compensa�on, takeover defenses, and
accoun�ng compliance. Second, a ra�ngs analyst researches each company and adjusts the automa�c scores
where appropriate. To ensure consistency across �me and among analysts, a detailed protocol containing
extensive decision rules guides this qualita�ve research. On a quarterly basis, The Corporate Library’s senior
staff, including specialists in board prac�ces, takeover defense, and compensa�on, review and if necessary
suggest amendments to this research protocol. It thus represents the firm’s evolving collec�ve intelligence and
expert opinion on how best to iden�fy governance-related investment risks.
The ra�ngs process is en�rely bo�om-up and evaluates each company individually (not on a “best-in-class”
basis). As a result, if what The Corporate Library believes to be poor governance prac�ces are widespread
in a par�cular industry, a large propor�on of the companies in that industry will receive low ra�ngs. The
Corporate Library’s ra�ngs are from A to F, corresponding to a scale from low to very high risk. This overall
ra�ng is comprised of individual component ra�ngs for board, compensa�on, takeover defense and accoun�ng
compliance, which are also expressed in le�er grades corresponding to risk levels. Board and compensa�on
scoring components together make up the majority (about 80 percent) of the overall scoring system.

The Quan�ta�ve Services Group Study

Commissioned by The Corporate Library and conducted by Quan�ta�ve Services Group, the current study
covered the period from July 2003 to February 2010 and modeled three por�olios. All por�olios were based
on the Russell 1000 but excluded the following companies: 1) those whose overall governance The Corporate
Library rated D or F (the green “TCL” line in the chart above); 2) those rated D or F in overall governance
as well as both board and compensa�on (this “Long Only Inclusive” por�olio is represented by the bright
red “LOI” line); and 3) those rated D or F in either overall governance or board or compensa�on (this is the
“Long Only Exclusion” por�olio, represented by the dark red “LOE” line above). For each case, the simula�on
assumed market-cap weigh�ng, quarterly rebalancing, and reinvestment of dividends at each quarter-end. It
also incorporated market-impact transac�on costs for a por�olio size of $1 billion. The third por�olio showed
strongest outperformance and is the main focus of this report. In what follows, it will simply be referred to as
“the por�olio.”

Por�olio Characteris�cs
On average, the por�olio excluded about half the benchmark names and had annual turnover of 65 percent,
corresponding to an average holding period per company of 1.5 years. In comparison to the benchmark, the
por�olio had a somewhat smaller weighted average market-cap ($42 billion vs. $79 billion) and a slight growth
�lt (P/E ra�o of 20.3 vs. 18); it was also persistently underweight in financials and energy and overweight in
technology stocks. These differen�al factor exposures were much diminished when the por�olio was compared
to the benchmark on an equal-weighted basis, demonstra�ng that the market-cap weigh�ng played a large
role in their crea�on.

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© 2010 The Corporate Library
 Performance
Annualized performance for the por�olio was 6.91 percent, compared to 4.16 percent for the benchmark,
producing an annualized outperformance of 275 basis points and cumula�ve outperformance approaching 25
percent. Standard devia�on was 22.29 percent (vs. 21.84 percent for the benchmark). Tracking error was 3.3
percent, the informa�on ra�o was 0.82, and outperformance was seen in 61 percent of test months. Forty-
four percent, or 121 bps, of the 275 annualized bps of ac�ve return was stock-specific, and another 74 bps are
a�ributable to the financial industry underweight produced by the applica�on of ra�ngs standards to each
company on an absolute (not “best-in-class”) basis.

Conclusion
Previous research on the rela�onship of governance ra�ngs systems to investment performance has shown
mixed results, and the significance of par�cular governance features to equity returns is widely debated. The
current study, however, suggests that The Corporate Library’s ra�ngs system—focused on the iden�fica�on of
agency problems rather than supposed best prac�ces—can contribute significantly to alpha genera�on.

For more informa�on

• Request the full study here or call (207) 874-6921
• Request a free trial of Board Analyst® and gain access to The Corporate Library’s Risk Ra�ngs
• Speak to The Corporate Library team about how you can incorporate our Risk Ra�ngs into your
investment decisions: click here or call (207) 874-6921

The Corporate Library

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© 2009 The Corporate Library, LLC. All rights reserved. No part of this publication may be reproduced, republished, altered, posted, transmitted,
or distributed without written permission from The Corporate Library, or, in the case of photocopying, under the terms of a license issued by The
Corporate Library.

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© 2010 The Corporate Library