Articles

GMI Ratings Study Finds that Major Market Indices Expose Investors to Elevated ESG and Accounting Risk

In Investor Empowerment on December 12, 2012 by Global Index Group

December 11, 2012 in GMI Press Releases

New York – December 11, 2012 — GMI Ratings, the leading provider of research on environmental, social, governance (ESG) and accounting-related risks affecting the performance of public companies, released today the results of a study assessing the risk characteristics of major market indices based on ESG and forensic accounting criteria.

Focusing on Nasdaq 100, S&P 500, FTSE 100 and MSCI World indices, the study compared the distribution of ESG and forensic accounting (AGR®) risk ratings for companies in these indices with the normal (expected) distribution of scores in the same region. The study found that the distribution of ESG and AGR risk in these indices varies materially from the normative risk distribution in the broader universe of stocks.

James A. Kaplan, GMI Ratings chief executive, said: “These findings shed new light on the implications of an investment manager’s decision to benchmark portfolio performance against a major market index. Institutional investors typically use index benchmarks as a way to measure their contribution to performance. However, our findings suggest that widely followed indices such as S&P 500 can also expose investors to above-normal concentrations of ESG and accounting risk.”

Kaplan added: “Beyond quantifying the risk characteristics of these indices, this research has a larger significance in the evolution of extra-financial research. So far, the financial community has mainly started to apply extra-financial research to the analysis of individual stocks. The findings below point to the importance of applying these novel measures more broadly – not only to indices but also to asset classes and industry groups.

Key Findings: ESG Risk

Twenty-five percent of companies in the Nasdaq 100 index – and 40% of S&P 500 companies — have lowest-quintile ESG ratings, compared to 20% for the normative distribution. By contrast, companies with top-quintile ESG ratings are under-represented in these indices.

Twenty-eight percent of companies in the MSCI World Index have lowest-quintile ESG ratings, compared to 20% for the normative distribution. Companies with top-quintile ESG ratings are under-represented in MSCI World, but by a narrower margin (18% vs. 20%).

In the FTSE 100 index, the study found a much more favorable distribution of ESG risk compared to the normative set. Companies with lowest-quintile ESG ratings only account for 3% of FTSE 100 – 17% below the norm. By contrast, companies with top-quintile ESG ratings are widely over-represented in FTSE 100 (55% vs. 20%).

Key Findings: Accounting (AGR®) Risk

Thirty-six percent of companies in the Nasdaq 100 index – and 30% of S&P 500 companies — have lowest-quintile AGR ratings, compared to 20% for the normative distribution. By contrast, companies with top-quintile AGR ratings are under-represented in these indices.

Twenty-three percent of companies in the MSCI World Index have lowest-quintile AGR ratings, slightly above the normative distribution. Companies with top-quintile AGR ratings are under-represented in MSCI World by approximately 6%.

In the FTSE 100 index, the study found a slightly more favorable distribution of AGR risk compared to the normative set. The favorable variance is much less pronounced compared to FTSE 100’s ESG risk characteristics.

Conclusion

Kaplan concluded: “These are important findings, in our view, that point toward new applications of extra-financial research to the practical concerns of mainstream institutional investors. Just as it adds depth to issuer-specific analysis, extra-financial research yields insights into investment risk on a broader scale – across indices, industries, regions. Whatever the purview of investment analysis, it remains clear that novel measures of risk and value are steering decision-makers toward a fuller understanding of the changing character of capital markets.”

Articles

Event Driven Reconstitution

In Investor Empowerment on December 11, 2012 by Global Index Group

While at Russell Investments, I developed the Russell Family of Indexes to be more representative as a proxy for the US Market. These benchmark indices and now the newer “rules-based strategies” reconstitute their membership on fixed calendar dates each year. This approach seemed appropriate if the index’s strategy is aimed at measuring a particular market segment. However, if your “rules based strategy” is meant to generating excess returns flowing from content and/or an overlay, this calendar directed reconstitution might actually impact possible future alpha.

Recently, Global Index Group (GIG) signed an agreement with GovernanceMetrics International (GMI), a leading forensic accounting and governance-monitoring firm. As a result of intense analysis of GMI data, GIG has developed a new methodology for reconstituting rules-based strategies based on information-based content.

Our proprietary system is called Event Driven Reconstitution™. It selects the timing of reconstitution of rules-based strategies based on the timing of the information content generation.  This new method provides a number of benefits versus calendar driven reconstitution.

As we often heard while at Russell, having only one annual reconstitution can allow the index to drift away from its stated goals for capitalization, valuation and such. And in some cases, the selected index members can be of the wrong cap size or valuation sector until a scheduled reconstitution.  This is a more serious problem when the criteria are designed to increase returns of the index.

So if you are trying to measure small cap Brazilian equities, one might as well reconstitute the index to capture the changes in market cap on fixed calendar dates. On the other hand, if you are trying to capture the information content of a security rating system, then one should time the reconstitutions to match the operational timing of the security rating system, so as to provide the greatest impact of that content analysis.

GIG has moved to Event Driven Reconstitution for its various products based on GMI ratings. In particular, the GIG White Swan Index uses Event Driven Reconstitution for its reconstitution process. The GMI ratings come out four times a year, but they do not neatly follow a quarterly timing pattern. Using a fixed date calendar driven reconstitution process, the index would frequently end up with stale content driving the membership of the index. This is not in keeping with the purpose of the rules-based strategy or in the best interest of those looking for a timely representation of GMI’s forensic accounting and governance ratings.

An example of such a benefit is Netflix and its sharp decline in 2011. Given the forensic accounting signals that Netflix was using overly aggressive accounting practices, the GIG rules moved Netflix from the White Swan index to the Black Swan index effective April 7, 2011. Shortly thereafter, Netflix stock peaked on July 13, 2011 at $298.73 per share. Netflix stock bottomed out on November 35, 2011 at $63.86 per share. A fixed calendar date reconstitution would have benefited from avoiding most of the decline, but also would have experienced unnecessary timing risk for almost three months.

Netflix

The objective of the GIG White Swan Index is to avoid as many Black Swan negative events as possible. Event Driven Reconstitution improves the odds of the White Swan index avoiding Black Swans.  Event Driven Reconstitution improves the GIG White Swan Index.

Articles

Black Swans and Forensic Accounting

In Investor Empowerment on November 27, 2012 by Global Index Group

The Accounting and Governance Risk (AGR) rating produced by GMI Ratings are designed to estimate the risk of securities fraud and/or litigation.  Yet, the AGR ratings have done a good job of generating positive equity returns relative to a broad market index.

This short article shows that most of the strong performance comes from avoiding “black swan” events. While the system is not perfect, it has been sufficiently robust to drive strong historical returns to equities.

 

Articles

GMI Analyst: ESG and Accounting Metrics for Investment Use – Asset Turnover

In Investor Empowerment on October 30, 2012 by Global Index Group

October 2012 in GMI Ratings

Asset Turnover is the ratio of a company’s sales to its assets, and is commonly used to assess how efficiently a company uses its assets to generate sales. When Asset Turnover is unusually low it is frequently due to the valuation of the assets being too high. This can occur when Goodwill and Intangibles that are the products of acquisitions build up on a balance sheet, or when management delays writing down other assets whose value may have deteriorated for any number of reasons. GMI Ratings’ Asset Turnover metric flags companies where this issue may warrant heightened investor scrutiny.

Articles

GMI Ratings’ Richard A. Bennett and Paul Hodgson among the 100 most influential professionals in governance

In Investor Empowerment on October 29, 2012 by Global Index Group Tagged: , ,

October 25, 2012 in GMI Press Releases

New York — October 25, 2012 — GMI Ratings, the leading provider of research on environmental, social, governance (ESG) and accounting-related risks affecting the performance of public companies, announced today that Richard Bennett, Chairman of GMI Ratings, and Paul Hodgson, GMI Ratings’ Chief Research Analyst, have both been included in the NACD Directorship 100’s most influential people in the boardroom and corporate governance community. Each year, NACD Directorship identifies the most influential people in the boardroom community, including directors, corporate governance experts, journalists, regulators, academics and counselors. The list offers a balance between those who do actual board work and those who influence how that work is done. There are four categories in the list of 100: hall of fame, directors, governance professionals and institutions, and people to watch. Mr. Bennett and Mr. Hodgson have both been included in the governance professionals category, and this is the fifth year running that Mr. Bennett has been included in the list. More complete coverage is due to appear in the November/December 2012 issue of NACD Directorshipand a full list of the honorees is available here.

“I am honored to be included once more,” said Mr. Bennett, “alongside such august company in this year’s NACD Directorship 100. And I’m especially pleased to be included this year with my long-time colleague, Paul Hodgson. Much more than individual achievement, this recognition is a testament to the influence and impact GMI Ratings continues to have in corporate governance and accountability around the globe.”

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About GMI Ratings

GMI Ratings is an independent provider of research and ratings on environmental, social, governance and accounting‐related risks affecting the performance of public companies. The firm’s ESG ratings for nearly 5,500 companies worldwide incorporate 120 ESG KeyMetrics™ to help investors assess the sustainable investment value of corporations. The firm also provides Accounting and Governance Risk (AGR®) ratings and corresponding litigation probabilities for approximately 18,000 public companies worldwide. AGR metrics reflect the accuracy and reliability of a company’s financial reporting. Clients of GMI Ratings include leading investment managers, asset owners, insurers, auditors, regulators and corporations seeking to incorporate accounting and ESG factors into risk assessment and decision‐making. A signatory to the Principles for Responsible Investment (PRI), GMI Ratings was formed in 2010 through the merger of GovernanceMetrics International, The Corporate Library and Audit Integrity. In the 2012 Independent Research in Responsible Investment (IRRI) Survey conducted by Thomson Reuters Extel and SRI‐CONNECT.com, GMI Ratings was named “The Best Independent Corporate Governance Research Provider”. For more information please visit http://www.gmiratings.com.

Articles

GMI Ratings and Global Index Group agreed to produce Governance Indices

In Investor Empowerment on September 24, 2012 by Global Index Group

Today, GMI Ratings announced it is licensing its forensic accounting and corporate governance metrics to Global Index Group in order to build Governance Indices. The GIG/GMI High Governance Index (GIGHGI) is the first product available. The index consists of large cap US companies that GMI has rated as relatively low risk of securities litigation or SEC enforcement actions. GIGHGI has outperformed the S&P 500 by about 1.5% per year since 12/31/2004.

Articles

Fitch Blasts S&P

In Credit Ratings on April 11, 2012 by Global Index Group Tagged: ,

Fitch Ratings lost to S&P the business of rating a recent mortgage bond deal by Credit Suisse Group. Now, Fitch has issued a press release saying the S&P’s rating on this issue were too high and investors should beware of using the S&P rating to evaluate the creditworthiness of the issue.

In essence, Fitch is accusing S&P of offering a high rating to get the business from Credit Suisse. This is an accusation frequently made by academics and bond buyers, but having an issuer pay rating firm make the accusation is noteworthy.

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