The World Bank and IFC have just completed a major study ofCorporate Governance-based Indices (CGIs) in eight countries, concluding that they they can have significant impact on raising the bar for corporate governance. They are usually created by stock exchangs and arebased on standards set forth in stock exchange corporate governance codes. (Note: Japan has no corporate governance code, and no CGI.)
IFC- Study of Stock Exchange Indices-2013
The eight indices that were examined are:
Brazil BM&FBOVESPA Special Corporate Governance Stock Index (IGC)
China Shanghai Stock Exchange (SSE) Corporate Governance Index
Italy Borsa Italiana FTSE Italia STAR
Mexico Mexican Stock Exchange (BMV) Indice IPC Sustentable
Peru Lima Stock Exchange (BVL) Good Corporate Governance Index
South Africa Johannesburg Stock Exchange (JSE) Socially Responsible Investment (SRI) Index
South Korea Korea Stock Exchange (KRX) Korean Corporate Governance Index (KOGI)
Turkey Istanbul Stock Exchange (ISE) Corporate Governance Index
A review of the experience of the eight CGIs studied shows that they are having a strong impact ina number of areas:
Indices are growing and attracting companies across index types. All indices in the study thatare not capped have shown strong growth, often in only a few years. This is particularly true forthe listing tiers in Brazil and Italy, but also for the ISE CGI in Turkey and the SSE CGI in China.
This shows that companies see the value in adopting more stringent governance requirements thanare required in the regular market. The growth of the JSE SRI Index in South Africa, based on the
automatic evaluation of the main index at the JSE, indicates that companies are improving theirpractices to be part of the index.
CGIs offer tangible benefits as research and policy tools. In markets where information on thegovernance practices of companies is scarce, companies selected to be in an index can be a usefulstarting point for investors choosing stocks. More importantly, raising the governance bar via theintroduction of new market-driven index requirements can have an immediate effect on companies’governance practices and can offer alternative avenues to attract foreign capital.
Some indices outperform, while most indices mirror, the broader market. Almost all indicesstudied closely track the main benchmark index of their markets. This mainly reflects the largeoverlap in constituents between the main index and the CG and ESG indices. It also shows the lack
of depth in capital markets in most of the countries in the study, where a few blue chip companiesmove the market. These blue chips are also the natural constituents of CGIs since they usually havegood governance practices. Brazil’s BM&FBOVESPA CGI is the only CGI that has significantly
outperformed the market over time. This shows both the success of the index in differentiating itselffrom the main market and the greater depth of capital markets in Brazil.
Besides these observations on the impact of CGIs, this study attempts to address three key questions:
1. What are the key drivers for stock exchanges to launch CGIs?
2. What are the critical building blocks in the construction of a CGI?
3. What risks do investors face when investing in CGIs?
Based on the review of experience and performance of the eight CG and ESG stock exchangeindices studied, a number of conclusions can be reached:
1. Key drivers for launching CGIs
Indices can elevate a country’s overall corporate governance environment. Weaknesses ina country’s CG framework, such as lack of shareholder protection and weak requirements forindependent directors, are some of the main reasons behind the creation of CG and ESG indices.
Evaluation criteria often address the most salient issues facing a country in this area.Indices can offer companies an opportunity to differentiate themselves and can increasetheir access to capital. Creating an index or listing tier of excellence in corporate governanceallows companies to differentiate themselves from other companies in the market. At its 10-yearanniversary, the Italian STAR showed that SMEs in the index were able to increase their liquidityand access to foreign capital. Brazil’s Novo Mercado not only attracts the bulk of new listings in theBrazilian market but also significantly outperforms the broader market index. This is also true forindices incorporating broader ESG issues, as the premium paid
for companies in South Africa’s JSE SRI Index demonstrates.
Indices based on listing tiers offer a higher degree of
commitment to governance issues than indices with a rating
threshold. Since adherence to all of the tier’s listing rules
becomes a binding contractual obligation, listing tiers offer a
higher level of commitment than indices based on meeting a
rating threshold, where a company is never required to score 100
percent compliance with the index criteria. The attractiveness of
the listing-tier approach is highlighted by the strong growth of
Brazil’s Novo Mercado and Italy’s STAR.
The success of Italy’s STAR underlines that CGIs are also
an option for segments in markets where overall corporate
governance is already considered strong. By focusing on the
particular governance challenges of SMEs, the Borsa Italiana
created a listing tier that offers clear benefits for both companies
and investors as is evident from the performance of STAR.
When indices are based on a rating threshold, automatic
evaluations have a stronger potential impact on CG practices
than voluntary applications. Corporate governance indices
can be an efficient policy tool for improving CG practices. In
this context, automatically evaluating listed companies has a
stronger reputational effect than letting companies voluntarily
apply. Experience with voluntary application in Peru and Turkey
shows that only companies assured of qualifying for the index
will apply, while companies with bad CG practices can pretend
not to be interested in joining the index. Automatic evaluations,
on the other hand, offer no such option. If a company in the
evaluation sample is not part of the index, it is because the
company’s practices were not good enough to meet the index
threshold. This offers a stronger incentive for companies to
improve their practices.
2. Critical building blocksof an index
Stock exchanges tend to select governance criteria that are
objective and measurable, and are often based on national
corporate governance codes. The governance criteria used
for listing-tier rules and index evaluation tend to be concrete
and measurable, which is critical for supporting the evaluation
process, the supervision of companies, the potential exclusion
of companies that do not meet the criteria, and the overall
credibility of the index. A majority of criteria focus on the
role of the board of directors, such as number of independent
directors, existence of committees, and separation of CEO
and chairman. National corporate governance codes play an
important role as source for the criteria used in the indices, and
indices contribute to better application of codes. If the index
criteria are based solely on the corporate governance code,
however, they can be only as strong as the underlying principles
of the code. This can present a challenge, as in the case of Peru,
where the Code’s independence definition for directors is weak.
Market-based criteria are important for the marketability
of the index but may hurt its policy impact. Ensuring the
availability of a sufficient number of shares for trading is of
critical importance for a CGI to be marketable, especially in
markets with concentrated ownership structures. Applying
free float and/or liquidity criteria in the index can achieve this
goal. However, in markets where liquidity is concentrated in a
few stocks and free float is limited, the number of companies
eligible for inclusion in an index can be severely reduced, as
is the case in Mexico. It thus diminishes the potential of an
index to broadly influence corporate behavior, if companies
not meeting free float and liquidity criteria are not part of the
governance evaluation. On the other hand, it can motivate
tightly controlled companies to make more shares available for
trading. Market-based criteria can also skew the evaluation,
since highly traded companies tend to be the blue chips of
the index and are likely to have higher governance standards.
Definitions of free float can also be problematic, since little
changes can trigger big consequences, as can be seen from the
recent changes in Mexico.
Stock exchanges outsource the evaluation process for
indices based on a rating threshold to avoid conflicts of
interests with client companies. For indices based on a rating
threshold instead of compliance with special listing rules, the
evaluation of companies by the stock exchange can present a
potential conflict of interest, since the companies are also the
clients of the exchange. All exchanges, with the exception of
China’s SSE, consequently outsource the evaluation to external
providers. Nevertheless, with the exception of Peru and Turkey,
the evaluation is paid for by the stock exchanges to ensure an
independent evaluation process.
Most of the stock exchanges disclose index criteria and
methodology. Transparency about index evaluation criteria and
methodology is an essential building block for a CGI, and all
indices, with the exception of China’s SSE index, disclose both.
However, effective communication goes further than mere
disclosure and includes easy accessibility of information. Only
the exchanges in Brazil, Peru, and South Africa link directly to
criteria and methodology from the index pages on the stock
exchange websites, and only Brazil and South Africa offer the
information in English.
Disclosure of rating results is rare. The disclosure of rating
scores and evaluation reports is important for investors, and
it also adds to the index’s credibility. Nevertheless, of the six
threshold-based indices, only the Korean and Turkish exchanges
disclose the rating grades. Turkey discloses the full evaluation
Exclusion of companies from indices occurs mainly during
annual reviews and rarely occurs because of a failure to
meet governance criteria. Evaluation of companies against
index criteria is an annual affair in all indices and listing tiers
with the exception of Brazil, where compliance is monitored
continuously, and exclusion for a violation of listing rules
may occur immediately. To protect the index from the risk of
reputational damage, stemming from a scandal at a constituent
company between the evaluation cycles, all indices with the
exception of Peru have an option for immediate exclusion of
a company. Such an exclusion outside of the review cycle has
occurred only once in the eight indices. Even during the annual
review, virtually all exclusions are due to failure to meet marketbased
criteria or because companies have simply delisted.
This pattern could suggest reluctance by stock exchanges and
evaluators to exclude constituent companies for governance
reasons. It could, however, also indicate the success of the
indices in permanently elevating the governance practices of its
3. Risks for Investors
CGIs offer a unique challenge for investors’ expectations,
as the underlying governance criteria do not always follow
international standards. For example, while all indices
require the presence of independent directors on the board,
the definition of independence and the required number of
independent members differ substantially among the indices
and vis à vis international practices.
Asymmetry of information can create false expectations.
Investors may believe that they understand the CG criteria of an
index based on notions from markets that they are familiar with,
but the criteria employed in the indices can be very different.
Equally important is the process of company evaluation and
supervision of the index employed by the stock exchange.
Investors need to make an effort to fully understand the
intricacies of each index to ensure that their initial expectations
The more transparent the index, the lower the information
asymmetry investors face. Transparency about the set-up of the
index, including its rating criteria, methodology, and disclosure
of evaluation results, is critical in allowing investors to ensure
that the index meets their expectations.