Optimal portfolios vis-à-vis corporate governance ratings: Some UK evidence

Abstract

Socially responsible investments may offer investors higher returns because of the perceived lower risk and thus associated cost (monitoring, litigation, etc.), although it might also be less profitable as posited by proponents of the Efficient Market Hypothesis where higher risk is compensated with higher returns. Corporate governance (CG) - one of the key components in socially responsible investing - has been extensively studied for evaluating its relationship with firm performance. In this paper, we extend prior literature by exploring the investment performances of two distinct portfolios built using strong versus weak corporate governance firms. We contribute by investigating the value of corporate governance (or lack thereof) in formulating portfolios. Using London Stock Exchange data for the period January 2012 through June 2018 and both ends of the quartile spectrum from 2017 Good Governance Report, we optimize each portfolio based on their Sharpe criterion. Our findings offer some practical and theoretical implications. Investors who are conscious about CG and attempt to maximize Sharpe measure by investing in strong governance firms may face lower portfolio risk by foregoing higher returns. Whereas reduction in value-at-risk midway onwards appears to suggest investment in companies with strong CG would less likely to fail in the long run. Volatility and downside volatility results tell similar story. Indeed, from the agency theoretical perspective, companies with strong CG would lead to lower agency cost (and risk) and better firm performance. We find profitable outcomes for both portfolios, although out-of-sample, weak governance portfolio dominates in terms of several key performance metrics.