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FTSE ISS Corporate Governance Rating and Index Series - Measuring theImpact of Corporate Governance onGlobal Portfolios

FTSE Research

Carl Beckley*Director, Research& [email protected]+44 20 7448 1820

Gareth ParkerHead of Index [email protected]+44 20 7448 1805

Jamie Perrett*Senior Index Design [email protected]+44 20 7448 1817

* Key contributors

Bin WuSenior Index Design [email protected]+44 20 7448 8986

Oliver WhittleIndex Analyst

Andreas EliaResearch [email protected]+44 20 7448 8013

ISS Contributors

Stanley J. DubielManaging Director,International Research

Jill E. LyonsExecutive Vice President &General Manager, CorporateServices

+1 301 556 [email protected]

For information on purchasing the data or licensing please contactFTSE Client Services: [email protected] or (+44) 20 7448 1810

1. Executive Summary

FTSE ISS Corporate Governance Index Series

General Corporate governance is now established as a key component of equity risk.However, quantifying this risk within global portfolios has posed a challenge toinvestors. Producing a solution for the global investment community has been themain driver behind the creation of the FTSE ISS Corporate Governance Index (CGI)Series and CGI ratings.

The index and ratings products are the result of extensive feedback obtained duringan industry-wide consultation exercise conducted by FTSE and ISS in 2004.

The ratings allow investors to analyse for the first time corporate governance risk ona company, country and sector basis, while the FTSE Corporate Governance Indexallows investors to track the performance of those companies with good corporategovernance practice.

FTSE’s Research team has undertaken the production of a detailed report andanalysis of both the ratings and the index product, which is available directly fromFTSE or from data vendors worldwide.

CGI Ratings By aggregating company FTSE ISS CGI ratings data within each country, we are ableto give a truly global perspective of corporate governance practices. Closerexamination of the individual countries’ and sectors’ corporate governance scoresshows that:

• the UK and Canada top the list of countries by corporate governance average score;

• the Oil and Gas is the highest scoring Supersector;• when applying the ratings to a selection of local capital market indexes from

around the world, the FTSE 100 has the highest corporate governance rating;• looking at the top vs bottom constituents of the FTSE US Index for each CGI

theme demonstrates the potential relationship between corporate governance and company performance.

FTSE CGI Index Series• By using the FTSE ISS CGI Series, global investors can identify and manage

corporate governance risk within global portfolios;• An inclusion methodology gives the best return while minimizing exposure

to companies with poorer corporate governance, and has therefore been used in the methodology of the FTSE Corporate Governance Index Series;

• The indexes have a low tracking error and the historical performance is in line with the underlying benchmarks.

ConclusionInvestors believe that good corporate governance reduces risk and leads to improvedshareholder value. Historically, it is difficult to quantify improvements in shareholdervalue that is attributable directly to corporate governance improvements and/orgood behaviour. This is due to the lack of consistent comparable data on a globalbasis. In addition, shareholder engagement and activism on corporate governanceissues is a relatively new phenomenon and its impact on corporate behaviour hasonly recently become evident.

However, looking forward, shareholders’ expectations and engagement on corporategovernance issues are only going to grow and companies not fulfilling shareholdersexpectations in this areas are likely to find it increasingly expensive to raise capitaland more difficult to execute corporate strategy.

Contents

1. Executive Summary

2. Introduction2.1 The Importance of Corporate

Governance, William Crist, ChairmanFTSE ISS Advisory Group

2.2 Measuring Corporate Governance,Stanley Dubiel, InstitutionalShareholder Services (ISS)

3. FTSE ISS Corporate GovernanceIndex (CGI) Ratings Data

3.1 Why Create Corporate GovernanceRatings?

3.2 How the FTSE ISS CGI Ratings Work3.3 Country Rankings – Highest and

Lowest Scorers 3.4 Comparison with Domestic Indexes

Worldwide3.5 Distribution of Ratings Within

Countries3.6 Country Dispersion Amongst the Five

CGI Themes3.7 Differences Between Large, Mid and

Small Cap Companies – FTSE All-ShareIndex

3.8 Supersector Breakdown Within CGIRatings

4. FTSE ISS CGI Series4.1 Why Create Corporate Governance

Indexes?4.2 Designing the FTSE ISS CGI Series 4.3 How the Indexes are Constructed4.4 Inclusion Methodology - Why use the

80/20 Method?4.5 Performance 4.6 Risk Analysis

5. Using the FTSE ISS CGI Series

6. ConclusionCorporate Governance Indexing -Just the Beginning

AppendicesA. Adoption of Best Practice Corporate

Governance PracticesB. Risk Analysis – EM Applications Ltd

PAGE 1FTSE ISS CGI SERIES RESEARCH REPORT – APRIL 2005

2. Introduction

2.1 The Importance of Good Corporate Governance

Corporate governance has become an important feature of the investmentmanagement process. It is now recognised as being a key business disciplinewhich can contribute to the financial stability and growth of any corporation, or,if ignored, can lead to the downfall of corporations both large and small.

Today’s global financial markets are characterised by the increased size andinfluence of institutional investors. Their importance as owners of publicly listedcompanies has grown enormously. In 1999 the value of assets owned byinstitutional investors amounted to the equivalent of 144% of the GDP of theOECD countries compared to 38% in 1980. This percentage has continued toincrease since 1999 and almost certainly will continue to increase into the future.Millions of individuals saving for their retirement depend on value created by theprudent and responsible management of their invested assets by largeinstitutional investors. Pension fund professionals and their advisors increasinglyunderstand that improving the corporate governance of companies is animportant means of protecting and enhancing the long-term value of theirbeneficiaries’ equity investments. Poor corporate governance can weaken acompany’s potential and, where there are un-addressed systemic failures, canresult in a dramatic loss of invested savings. As trustees of these investments,institutional investors have a responsibility to use their best efforts to ensure thatthey are at all times “informed” investors.

Class actions and other litigation on the part of shareholders can play a positiverole in bringing discipline to company boards. But more importantly, marketpressures created by governmental rules and regulations and advocacy by privateorganisations seeking to improve corporate governance generally have begun toincrease the voluntary improvement of corporate governance practices in manypublicly listed corporations across the world. New statutory minimumrequirements for corporate reporting and the establishment of principles of goodcorporate governance by large and influential private organisations are generallyconsistent in their aims of providing assurances and protections for allshareholders. This is a global phenomenon.

Academic studies increasingly indicate that investors reward companies whichhave good corporate governance practices by paying a price premium, whichlowers the cost of capital and lowers price volatility. But in order for these newmarket realities to work effectively, investors require accurate and relevantinformation regarding which companies, world wide, actually employ the higheststandards of corporate governance. Although companies have a responsibility toprovide certain financial information to investors, more precise information andinterpretation of corporate governance practices has become important toinvestors and all the intermediaries such as brokers, analysts and fund managerswho play a major role in the world’s capital markets.

The FTSE ISS Corporate Governance Index Series will provide an important toolfor those investors faced with the challenge of meeting mounting client demandfor assessing and evaluating corporate governance risk and performance acrosstheir international portfolios.

William Crist Chairman, FTSE ISS Corporate Governance Advisory CommitteeEmeritus Professor of Economics at California State University,Stanislaus, and former chairman of CalPERS.

• Meeting the mounting demand forevaluation of corporate governancerisk


2.2 Measuring Corporate Governance

Today corporate governance has become a very important topic to investors, firms,and governments. Several key historical events have contributed to the recognition ofthe importance of corporate governance. The most high profile one is the USaccounting and corporate scandal that exploded in 2002. Other events include therecent merger wave, the hostile takeovers in the US in the 1980s followed by hostiletakeovers in Europe in the 1990s, the engagement of institutional investors incorporate governance activities, and the worldwide trend to privatise and liberalisesuch as in Latin America, Western Europe and Asia.

In this new and evolving international environment with a large private sector andglobal integration of world capital markets, corporate governance has become theprominent topic of institutional reform. For governments, encouraging bettercorporate governance practices in policy making enables firms to raise moredomestic as well as foreign capital. For firms, an efficient market will differentiatebetween the firms that embrace best corporate governance practices and those whofind corporate governance a distraction. Therefore firms attempting to drive theircompetitiveness and reduce the cost of capital will adopt best corporate governancepractices. For investors, corporate governance will be put on a par with financialindicators when evaluating investment decisions1 because corporate governance hasa significant impact on equity performance and risk.

Earlier studies of the link between corporate governance practices and firmperformance or value were focused on each specific aspect of corporate governance,such as board composition, shareholder rights, executive remuneration, insiderownership, and takeover defenses. Recently, rating methodologies based on anextensive set of corporate governance indicators have been adopted by researchersto measure and benchmark the quality of corporate governance at the firm level, andthe link between ratings and firm performance or value is investigated. In the US,several such corporate governance ratings have been compiled. Although theunderlying sets of corporate governance indicators used in these corporategovernance ratings differ to some extent, so far, most of the studies have reported asignificant relation between higher ratings and better firm performance, higher firmvaluation, or lower risk2,3,4.

Evidence correlating the relationship between corporate governance and firmperformance or value using similar rating methodologies has also accumulatedrapidly for non-US firms. In Germany, researchers compiled German corporategovernance ratings and found significantly better ratings are linked to higher firmvaluation and better portfolio return for German listed firms5. In Switzerland,researchers compiled Swiss corporate governance ratings and found significantlybetter ratings are linked to higher firm valuation for Swiss listed firms6. In Norway,researchers have compiled Norwegian corporate governance ratings and foundsignificantly better ratings are linked to higher firm value (Tobin’s Q) for Oslo StockExchange firms7. In Korea, researchers compiled Korean corporate governance ratingsand found significantly better ratings are linked to higher firm value (Tobin’s Q) andhigher security prices for Korea Stock Exchange firms8. It is expected that moreevidence on the link between better ratings and better firm performance, higher firmvaluation, or lower risk will be reported9.

To meet the broadening requirements of investors, FTSE Group and InstitutionalShareholder Services (ISS) have identified a set of globally accepted corporategovernance principles. These indicators have been used to rate the firms within theFTSE Global Equity Index Series and create the FTSE ISS Corporate GovernanceIndexes (CGI). This extensive and transparent set of corporate governance ratings willenable investors around the world to analyse corporate governance risk withinglobal portfolios using a set of integrated corporate governance indexes and data10.

Stanley Dubiel, ISS

1. “Global Investor Opinion Survey: Key Findings”, McKinsey &Company (July 2002)

2. “Corporate Governance and Equity Prices”, Quarterly Journal ofEconomics 118, Gompers, Ishii and Metrick (2003)

3. “Corporate Governance and Firm Performance”,http://papers.ssrn.com/sol3/papers.cfm?abstract_id=586423,Brown and Caylor (2004)

4. “What Matters in Corporate Governance?”http://papers.ssrn.com/sol3/papers.cfm?abstract_id=593423,Bebchuk, Cohen and Ferrell (2004)

5. “Corporate Governance and Expected Stock Returns:Evidence from Germany”,http://papers.ssrn.com/sol3/papers.cfm?abstract_id=379102,Drobetz, Schillhofer and Zimmermann (2003)

6. “An Integrated Framework of Corporate Governance and FirmValuation – Evidence from Switzerland”,http://papers.ssrn.com/sol3/papers.cfm?abstract_id=489322,Beiner, Drobetz, Schmid and Zimmermann (2004)

7. “Governance and Performance Revisited”,http://papers.ssrn.com/sol3/papers.cfm?abstract_id=423461,Bøhren and Ødegaard (2003)

8. “Does Corporate Governance Predict Firms’ Market Value? Evidencefrom Korea”,http://papers.ssrn.com/sol3/papers.cfm?abstract_id=311275,Black, Jang and Kim (2004)

9. In general the link between better corporate governance rating and better firm performance or higher firm valuation may be subject to the criticism that firms with higher valuation may adoptgood governance practices, rather than vice versa (the issue of“endogeneity” or “reverse causation” in statistical terminology).On the other hand, studies have reported that, after the issue of“endogeneity” is resolved, the link between better corporategovernance rating and better firm performance or higher firmvaluation still persists.

10. Details of FTSE ISS Corporate Governance Indexes are available athttp://www.issproxy.com/institutional/cgi/index.jsp and athttp://www.ftse.com/corpgov


3. FTSE ISS Corporate Governance Index (CGI) Ratings

3.1 Why create Corporate Governance Ratings?

In recent years, corporate governance has become a recognised component of equityrisk, and is increasingly being used by investment researchers in their day-to-dayanalytical processes. Recent events have sharply focused attention on the way inwhich corporations are managed and led. Most people point to WorldCom as thewatershed when corporate governance became an investment issue, though in ashort space of time Enron became the pinnacle of media headlines. The spending ofTyco’s CEO and CFO has also helped provide the tabloids with an insight into theworld of corporate excess.

This list is by no means exhaustive, nor a US phenomenon, as companies such asParmalat (Italy) and Marconi (UK) have demonstrated, but as each problem hasoccurred investors have become more concerned. The conclusion that is quicklydrawn is that in such cases the share price falls dramatically and investors losemoney. In Figure 1 below, we have taken the rebased share prices of WorldCom,Enron, Tyco and Parmalat, two months prior to any disclosure of corporategovernance failings, and four months post announcements. The loss to shareholderscannot be disputed, however, the concept of corporate governance is much deeperand more subtle than sudden share price declines.

Figure 1: Six Months in the Life of WorldCom, Enron, Tyco, and Parmalat

Source: FTSE Group / FactSet Limited

Shareholders and companies are leveraging corporate governance analysis both as ameans of mitigating risk, and as a route to enhancing value. Poor corporategovernance does not mean that the share price will necessarily disappear. It is morethe risk that poor corporate governance becomes pervasive throughout the firm, andit is this fact that leads ultimately to poor share price performance.


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Tyco (Down 65%)

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On a day-to-day basis the investor is more concerned about this risk effect. A poorcorporate governance culture can carry on for many years, with management alwaysexplaining the company’s underperformance with a myriad of rational reasons;therefore, never having to acknowledge, or worse, being blissfully unaware that theroot cause may be themselves. However, actually quantifying corporate governancerisk has often posed a challenge for investors.

In response to this challenge, Institutional Shareholder Services (ISS) and FTSE Grouphave combined their respective expertise in corporate governance and indexing toproduce an index series designed to provide investors with an instrument that theycan use in everyday assessment of listed companies’ corporate governance practice.

3.2. How the FTSE ISS CGI Rating Works

The CGI rating is the output of a corporate governance rating system that evaluatesthe strengths, deficiencies and overall quality of a company’s corporate governancepractices and board of directors. There is now a general trend towards globalconvergence of corporate governance standards. This trend has been crystallised inthe OECD Principles of Corporate Governance that provide a single set of policystandards, and on which these ratings are based.

Based on ISS’s Corporate Governance Quotient system (CGQ), the CGI Rating Systemuses a comprehensive set of objectives and consistently applied criteria across eachcompany in the FTSE Developed and FTSE All-Share Indexes, a total of over 2,200companies in 24 developed markets. The CGQ database includes underlying datapoints for up to 61 corporate governance variables as shown in Table 1. Some of thevariables are reviewed together under the premise that corporate governance isenhanced when selected combinations of these variables are adopted.

Table 1: Corporate Governance Quotient Global Rating Criteria*

* used as basis of FTSE ISS CGI ratings

Features of the FTSE ISS CGI Series • Over 2,200 companies rated• 24 countries • The ratings data is broken down

into five global themes of corporategovernance

• Companies are rated between 1 (lowest) and 5 (highest)


Board Structure

Board Composition

Nominating Committee

Compensation Committee

Governance Committee

Board Structure

Board Size

Changes In Board Size

Cumulative Voting

Boards Served On - CEO

Boards Served On - Other Than CEO

Former CEOs

Chairman/CEO Separation

Board Guidelines

Response To Shareholder Proposals

Board Attendance

Board Vacancies

Related Party Transactions

Retirement Age for Directors

Board Performance Review

Meetings of Outside Directors

CEO Succession Plan

Board Structure

Outside Advisors Available to Board

Directors Resign Upon Job Change

Director Education

Equity Structure

Features of Poison Pills

Vote Requirements

Written Consent

Special Meetings

Board Amendments

Capital Structure

Takeover Provision Applicable Under State

Law – Has Company Opted Out?

Compensation

Cost of Option Plans

Option Re-pricing

Shareholder Approval of Option Plans

Compensation Committee Interlocks

Director Compensation

Pension Plans For Non-Employee Directors

Option Expensing

Option Burn Rate

Corporate Loans

Audit

Audit Committee

Audit Fees

Auditor Rotation

Auditor Ratification

Ownership

Director Ownership

Executive Stock Ownership Guidelines

Director Stock Ownership Guidelines

Officer And Director Stock Ownership

• The five themes facilitatecomparison between companies


Indicator Score CGI Rating for Each theme

5

4

3

2

1

High Score

Low Score

Theme 5Theme 4Theme 3Theme 2Theme 1

5

4

3

2

1

OverallCompany

CGIRating

Higher StandardCG Practice

Lower StandardCG Practice

For the CGI rating FTSE and ISS have identified a set of five common themes ofcorporate governance using a wide range of accepted standards and codes.

Compensation Systems for Executive and Non-Executive Directors

The structures and schemes that are in place for rewarding the Executive

and Non-Executive Directors.

Executive and Non-Executive Stock Ownership

Alignment of Executive and Non-Executive equity ownership with shareholders’ interests.

Equity Structure

Evaluation of a company’s equity structure with respect to shareholder rights, as well as the existence of

any anti-takeover devices.

Structure and Independence of the Board

The composition and processes of the board, as well as the structure and independence of key standing

committees.

Independence and Integrity of the Audit Process

The audit process and the composition of the audit committee as well as the fees and services provided.

To facilitate analytical comparison, each company is scored in relation to its peersaccording to each of its five themes. Within each theme, companies are ranked bytheir total scores and then allocated a number between one and five. Five isassociated with a high rating, and one is associated with a lower rating with the topperforming quintile given a rating of five, and the lowest performing quintile given arating of one. To create the overall CGI rating the themes are combined andnormalised to create one overall value for each company. Figures 2 and 3 illustratethis process. This overall CGI Rating enables the user to distinguish betweencompanies with varying corporate governance practices.

Figure 2: The Ratings Process for Each Theme

Figure 3: Determining Each Company’s Overall CGI Rating

• UK and Canada top the list ofcountries that score well oncorporate governance

• Scandinavian countries Denmark,Norway, and Sweden have thepoorest ratings


3.3 Country Rankings – Highest and Lowest Scorers

By aggregating company CGI ratings data within each country, investors now have atrue global perspective of corporate governance practices. Analysis of countries’corporate governance practices and their differences are a key feature of the FTSEISS CGI Series.

FTSE Developed Index

The FTSE Developed Index covers large and mid cap companies from the 24 countries defined as

“Developed” by the FTSE Country Classification methodology (www.ftse.com/country). The index

captures over 90% of developed countries’ investable market capitalisation and consists of

approximately 2,000 stocks.

The developed countries are Australia, Austria, Belgium/Luxembourg, Canada, Denmark, Finland,

France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway,

Portugal, Singapore, Spain, Sweden, Switzerland, UK and USA.

FTSE All-Share Index

The FTSE All-Share Index is the benchmark for the UK market. It captures 98-99% of the UK market

capitalisation and consists of approximately 700 stocks. The index is an aggregation of the FTSE 100,

FTSE 250 and FTSE SmallCap Indexes.

NB: 130 of the UK stocks in the FTSE Developed Index are in the FTSE All-Share Index.

Figures 4 and 5 show the top and bottom three CG-ranked countries from the FTSEDeveloped Index.

Figure 4: FTSE Developed Index Highest Rated Three Countries

Country Average CGI Rating

UK 4.75

Canada 4.71

Ireland 4.25

Figure 5: FTSE Developed Index Lowest Rated Three Countries

Country Average CGI Rating

Denmark 1.50

Norway 1.14

Sweden 1.00

The analysis takes the simple average constituent rating within each country index togive one overall country rating. As we can see, the UK closely followed by Canadahas the best CGI ratings, whereas the three Scandinavian countries of Denmark,Norway and Sweden perform relatively poorly.

3.4 Comparison With Domestic Indexes Worldwide

This analysis can also be used to look at the major domestic stock market indexesaround the world as outlined in Figure 6.

Figure 6: Local Market Indexes Based on their CGI Rating

Source: FTSE Group / Bloomberg

To analyse the domestic index CGI rating, we used a market capitalised weightedcalculation. The indexes broadly correspond to their respective country equivalentsfrom the FTSE Developed Index.

3.5 Distribution of Ratings Within Countries

Within countries the distribution of CGI ratings can be both diverse and concentrateddepending on the country analysed. Figure 7 breaks down the distributions betweenthe 1 to 5 ratings of the UK, France, Germany, US, and Japan. As we can see 77% ofFTSE UK constituents have an Overall CGI rating of 5, whereas Japan has just under80% of its constituents with a rating of 2. Both Germany and the US have a normaldistribution of CGI ratings, with 46% and 60% of constituents having a rating of 3respectively. France has the majority of its constituents between a CGI rating of 3 to5. Looking at other countries within the FTSE Developed Index shows that bothSweden and Norway have 100%, and 86% respectively of their constituents with aCGI rating of 1. Canada has the second largest percentage of constituents with arating of 5, with 76%.

Figure 7: Selected Countries from the FTSE Developed Index Overall CGI Rating Distribution

Breakdowns

Source: FTSE Group

• Looking at a selection of localcapital markets the FTSE 100 hasthe highest corporate governancerating

* The higher score for the Hang Seng index is

mainly due to the over 30% index weight of

HSBC. HSBC has been treated in the underlying

analysis of the FTSE Developed Index as a UK

domiciled company and therefore has a better

than average CGI rating in the Hong Kong index.

• The company distribution of CGIratings varies widely betweencountries

• 80% of Japanese companies have arating of 2

• French companies are spread evenlybetween ratings 3, 4 and 5


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CGIR

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CAC 40 DAX Hang Seng* S&P 500 Nikkei 225

54.76

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1.89

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Looking at selected countries within the FTSE Eurozone Index our analysis shows awide dispersion of corporate governance performance across countries in theEurozone. The FTSE Eurozone Index average CGI rating is shown in light blue toenable comparison. Ireland and Greece are at both ends of the spectrum with Irelandcontaining 75% of its constituents within a CGI rating of 4, whereas for Greece two-thirds have a CGI rating of 1.

Figure 8: FTSE Eurozone and Selected Countries Overall CGI Rating Distribution Breakdown

Source: FTSE Group

• From our research, there seems tobe no particular link betweencorporate governance practices andregional consolidation


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3.6 Country Dispersion Amongst the Five CGI Themes

Digging deeper into the CGI rating we can analyse each country’s rating within eachtheme. Figures 9 and 10 break down the FTSE US Index and FTSE All-Share Indexinto each of the five CGI themes, with Table 2 ranking each FTSE Developed countryby the five CGI themes. The US performs quite poorly from the perspective of equitystructure where 75% of constituents have a rating of 1, the remaining themes tendto have a normal distribution. The UK, Ireland, and Japan, all have a high rating forequity structure. A large proportion of FTSE All-Share constituents score a rating of 3for compensation systems.

Figure 9: FTSE US Index – CGI Theme Distribution Breakdown

Source: FTSE Group

Figure 10: FTSE All-Share Index CGI Theme Rating Distribution Breakdown

Source: FTSE Group

• The overall score of each of theindividual corporate governancethemes can vary widely for eachcountry

• Canada performs well, coming topat 3 out of the 5 themes

• 75% of US companies have a ratingof 1 for equity structure


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• CGI ratings have a positive tilttowards large cap companies in theUK

• 76% of FTSE 100 companies have arating of 5 as opposed to 29% forFTSE SmallCap companies


Board StructureRank Country Avg Rating

1 Canada 4.312 UK 4.003 Australia 3.914 Ireland 3.635 Singapore 3.55

Equity StructureRank Country Avg Rating

1 Ireland 4.002 Japan 3.993 UK 3.994 Australia 3.185 Germany 3.04

CompensationRank Country Avg Rating

1 France 4.802 Canada 4.633 New Zealand 3.434 UK 3.385 Germany 3.32

Audit processRank Country Avg Rating

1 Canada 4.032 UK 3.823 Ireland 3.754 USA 3.405 Singapore 3.38

OwnershipRank Country Avg Rating

1 Canada 4.242 Switzerland 4.033 France 3.954 USA 3.455 UK 3.05

Table 2 shows the top five countries for each theme• Canada and Switzerland score particularly well in Ownership, while Canada and

France score well for Compensation.

Table 2: FTSE Developed Index - CGI Rating Theme Breakdown

Source: FTSE Group – data as at 3rd March 2005

3.7 Differences Between Large, Mid and Small Cap Companies –FTSE All-Share Index

Figure 11: FTSE All-Share Overall CGI Rating Distribution Breakdown

Source: FTSE Group

An added dimension has been given by including small cap constituents into theanalysis of the FTSE All-Share Index. The FTSE UK Index (part of the FTSE DevelopedIndex) is based on over 130 large and mid cap stocks but scores more positively thanthe FTSE All-Share (domestic benchmark covering large, mid and small cap). Figure 11demonstrates this difference visually as the distribution of large cap constituents(FTSE 100) within a CGI rating of 5 (76%) is far larger than the 29% of small capconstituents (FTSE SmallCap). Also by taking a mean score that is not taking intoaccount a constituent’s size; the FTSE 100 has a rating of 4.74 compared to the FTSESmallCap’s 4.16. The FTSE 250 Index is spread more evenly between a rating of 5 and4, with a total average rating of 4.38.

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3.8 Supersector Breakdown Within CGI Ratings

We have now looked at the distribution of CGI ratings between countries, but doescorporate governance have an impact on sectors? To demonstrate any differences wehave broken down the FTSE Developed Index into 18 Supersectors based on the FTSEand Dow Jones Indexes Industry Classification Benchmark (ICB - see Figure 12below).

Figure 12: Supersector Average CGI Rating Breakdown - FTSE Developed

Source: FTSE Group

Compared to the differences in country CGI ratings the effects of corporategovernance practice on Supersectors are a lot more closely aligned. For example, thedifference in CGI rating for Oil & Gas, the highest rated Supersector, and Automobiles& Parts, the lowest is only 0.67. The main reason for this is that the country effect isstill a dominant aspect within each Supersector. To get a better understanding ofthese differences, we have analysed one of the Supersectors, FTSE Developed Banks(Figures 13 and 14 below). Figure 13 ranks each country by its overall CGI ratingwithin the Banks Supersector. It is possible to observe a similar pattern to the countryeffects before, as both Canada, New Zealand, and Switzerland have a maximumrating of 5, while Greece, Norway and Sweden each have a minimum rating of 1. Inorder to analyse this more closely, we subtracted each country’s overall CGI rating tounderstand Supersector differences. What we find are relatively smaller differences.For the US and the UK the differences between the respective Supersector and countryCGI ratings are positive, but only marginally different. For New Zealand andSwitzerland these differences are more pronounced. Both Austria and Greece seem tohave a negative effect when taking into account country differences.

Figure 13: Supersector Average CGI Rating Breakdown - FTSE Developed Banks

Source: FTSE Group

• From a global perspective, sectordifferences exist but country biasesstill dominate

• Removing country biases shows thatcertain countries do have a betterrating within sectors

• Both New Zealand and Switzerlandhave a higher Supersector rating inFTSE Developed Banks afterremoving any country effects


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Oil &Gas

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Utilitie

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Teleco

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CGIR

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3.21 3.19 3.113.00 2.96 2.89 2.82 2.80 2.78 2.78 2.76 2.71 2.66 2.65 2.63 2.59 2.56 2.54

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USA

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Spain

Austria

Belgium

/Luxe

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Denmark

Japan Ita

ly

Greece

Norway

Swed

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CGIR

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55.00 5.00 5.00 4.88

4.13 4.00 4.00

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Figure 14: Average CGI Rating Breakdown - FTSE Developed Banks Relative to each FTSE

Developed Country’s Average CGI Rating

Source: FTSE Group

The CGI rating differences of Supersectors within individual countries is very muchdependent on the number of constituents. The greater the number of constituents themore concentrated the individual ratings are. In Figure 15 below, we have broken theFTSE US Index down into its respective Supersectors. The difference between thehighest CGI rated Supersector (Utilities), and the lowest (Media) is 1.2.

Figure 15: Supersector Average CGI Rating Breakdown - FTSE US

Source: FTSE Group

• In the US, utilities has the highestaverage CGI rating, while media hasthe lowest CGI rating


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4. FTSE ISS Corporate Governance Index Series

4.1 Why Create Corporate Governance Indexes and Ratings?

FTSE Group (FTSE), in collaboration with Institutional Shareholder Services (ISS), haveproduced the first global corporate governance indexes for use by institutionalinvestors. Both FTSE and ISS have worked closely using each organisation’s expertisein index construction and corporate governance knowledge.

The FTSE ISS CGI Ratings, that we have already looked at, are a component featurewithin the overall FTSE ISS CGI Series. The ratings allow investors to understandcorporate governance risk on a specific company, country and sector basis, while theoverall index allows investors to view how corporate governance practice impactstheir overall portfolios.

Market research conducted by FTSE and ISS in Q2 2004 confirmed this growinginterest from investors in issues surrounding corporate governance. The majority(88%) of the 117 respondents from the various sections of the investmentcommunity expected interest in corporate governance to increase over the next twoyears. Feedback from the consultation has guided the construction and methodologyof the new index series.

4.2 Designing the FTSE ISS CGI Series

The first step was to decide the universe of stocks which would form the FTSE ISSCorporate Governance Index Series. In order to ensure global coverage, the CGIfamily covers large and mid cap stocks in developed markets. This universe currentlycontains over 2,000 companies. Additionally, for the UK, we used the FTSE All-ShareIndex, which contains large, mid and small cap stocks. This index is the mainbenchmark for UK institutional investors and so was a natural choice to use as thebasis of the FTSE ISS CGI UK. The six indexes that have been created as part of phaseone are detailed in Table 3 below.

Table 3: FTSE ISS Corporate Governance Indexes vs. Respective Benchmarks

* Excludes Investment Companies

Data as at 3rd March 2005

Source: FTSE Group

The objectives of the index series are to:• raise the profile of corporate

governance as an investment risk• encourage the compilation and

dissemination of high quality dataconcerning a company’s corporategovernance practices

• raise the profile of companiesachieving high standards ofcorporate governance

• The index series underlyingbenchmarks are the FTSE DevelopedIndex and FTSE All-Share Index

• Six indexes have been developed inthe first phase, with the objective ofclosely tracking the structure andpattern of the FTSE DevelopedIndex and the FTSE All-Share Index


FTSE ISS US CG Index 412 9,048 9,048 FTSE US Index* 743 12,216 12,216

FTSE ISS UK CG Index 315 2,176 1,140 FTSE All-Share Index* 578 2,713 1,421

FTSE ISS Japan CG Index 353 1,647 172,988 FTSE Japan Index* 479 2,077 218,217

FTSE ISS Developed CG Index 1,350 17,600 17,600 FTSE Developed Index* 2,089 22,828 22,828

FTSE ISS Europe CG Index 347 5,590 4,259 FTSE Developed Europe Index* 502 6,985 5,321

FTSE ISS Euro CG Index 194 2,892 2,203 FTSE Eurozone Index* 277 3,516 2,678

CG Index Stocks Net Market Cap Net Market Cap Benchmark Index Stocks Net Market Cap Net Market Cap (USD Bn) (Loc Curr. Bn) (USD Bn) (Loc Curr. Bn)

4.3 How the Indexes are Constructed

For each of the six indexes ISS collated all of the raw corporate governance scoresfor each constituent. FTSE used this raw data supplied by ISS to produce acumulative score for each constituent. In order to make the scores more user friendlythe cumulative scores are normalised so that all scores fall between 0 and 100. Ascore of 0 represents the lowest corporate governance rating, while 100 is thehighest score that can be attained. This is the CGI Final Score.

Figure 16: The FTSE ISS Corporate Governance Index Series Review Universes

Then for each index the following methodology is applied:

Figure 17: The FTSE Corporate Governance Index Series Construction Methodology

• The design process aims to capture80% of the market cap within eachSupersector

1. In each index universe eachconstituent is classified into its ICB(Industry Classification Benchmark)Supersector. There are 18Supersectors in total.

2. Within each Supersector eachconstituent is ranked by its CGIFinal Score.

3. The constituents representing thetop 80% by investable marketcapitalisation in each Supersectorare eligible for inclusion in theindex.

4. The remaining constituents in thelowest 20% by investable marketcapitalisation are excluded from theindex.

5. The process is repeated for all theSupersectors.

6. The 18 Supersectors are combinedto form the Regional or CountryFTSE ISS Corporate GovernanceIndex.


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Basic Resources

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FTSE Dev. Asia Pacific ex Japan Index

FTSE Japan Index

Following the application of this review procedure the FTSE ISS Developed CGI has1,350 constituents from the original 2,089 and the FTSE ISS UK CGI has 315constituents remaining from the original 578 in the FTSE All-Share Index.

Figure 18: FTSE ISS Developed CGI Country Breakdown Relative to FTSE Developed Index

Source: FTSE Group

Figure 18 above details the FTSE ISS Developed CGI country weightings relative to itsunderlying benchmark the FTSE Developed Index. The largest difference in countryweighting is a fall in weight of the US, compensated by increases in the weight ofCanada, France, Germany, Switzerland and the UK respectively.

On a Supersector level, Figure 19 shows that the FTSE ISS Developed CGI weightingsare relatively unchanged with Banks and Telecommunications seeing a largerincrease relative to FTSE Developed Index, and Financial Services, and Media seeingthe largest decrease in weight.

Figure 19: FTSE ISS Developed CGI Supersector Breakdown Relative to FTSE Developed Index

Source: FTSE Group


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A similar pattern can be found with the FTSE ISS US CGI. A key difference betweenthis index and FTSE US Index is that it is overweight in Industrial Goods and Services,Personal & Household Goods, and underweight in Financial Services, Insurance, andMedia.

Figure 20: FTSE US CGI Supersector Breakdown Relative to FTSE US Index

Source: FTSE Group

4.4 Inclusion Methodology - Why use the 80/20 Method?

An inclusion methodology to create the indexes was chosen after market consultationcarried out by FTSE and ISS in 2004. The majority of clients suggested that for the firstphase of the Corporate Governance Indexes, constituents that tended towards goodcorporate governance practices should be included in the index.

As this consultation was being carried out, FTSE assessed various different methodsof producing an index series for investors which reflected the corporate governanceperformance of the world’s listed companies. The three main options were:

a) to have an inclusion methodology;b) to keep all constituents, but overweight companies with good corporate

governance performance and underweight poorer corporate governanceperformers;

c) to produce best and worst of class indexes with a limited number of stocks.

Weighting vs InclusionThe overweight / underweight methodology produced similar results to the inclusionmethodology. This is because including a proportion of stocks is another way ofradically overweighting them, which then will automatically underweight theremainder. Performance would therefore be more reliant upon the mix of stocks thatare included and excluded from the index. This mix relates to both relative marketcapitalisation sizes and then individual stock performance.

• Methodology Explanation


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Reducing TurnoverThe other issue on deciding the inclusion methodology is that of turnover. Themore constituents that are included in the index the lower the turnover canpotentially be. This has an influence on deciding what level of marketcapitalisation could be included in the index. Including a large amount of marketcapitalisation may have less influence on performance but would theoreticallylead to lower turnover. Including more than 80% would have reduced turnover,but including less would begin to have reverse implications. Having looked at thisissue we felt that an 80/20 split gave the right balance between inclusion andexclusion.

Indeed it is this last point that ensured that at this time our third option ofproducing the best and worst indexes could lead to high turnover.

Inclusion PerformanceOver the long term the differences in performance and volatility between theFTSE ISS CGI and their respective benchmarks were minimal. This confirmed theview that at this point in time corporate governance has a mixed influence onperformance (see below).

4.5 Performance

Investors believe that good corporate governance reduces risk and leads toimproved shareholder value. However, measuring shareholder returns based onchanges in corporate governance practices has been difficult to quantifyhistorically. Prior to the FTSE ISS initiative, there has not been a consistent way ofcomparing corporate governance practices on a global basis and their impact onshare price performance. Availability of this information on a very visible andeasily accessible basis will be a valuable tool to investors in the future.

To date there has been a limited number of high profile investors who haveapplied their corporate governance views to their investment strategies andprocesses. It has taken recent events, such as corporate failures, to bring theseissues into the mainstream for both investors and legislators alike.

Looking at the top vs. bottomconstituents of the FTSE US Index foreach CGI theme demonstrates thepotential relationship betweencorporate governance and companyperformance


Table 4: FTSE US Index Top/Bottom Portfolio Returns

Values in US Dollars from 27th February 2004 to 28th February 2005.


FTSE US Equally Overall CGI Board Structure Equity Structure Compensation Audit Ownership

Weighted

Top Bottom Top Bottom Top Bottom Top Bottom Top Bottom Top Bottom

Performance

1 Year 11.66% 17.24% 7.25% 15.65% 10.46% 15.41% 7.53% 16.50% -1.65% 16.42% 10.23% 15.10% 12.57%

In looking for evidence of any improvements on shareholder value across markets,we have focused on the short term as consistent and timely ratings data is notreadily available. Table 4 shows one year returns of the top and bottom constituentsfrom within each theme of the FTSE US Index. The analysis, based on equallyweighting the portfolios daily using FactSet Software, indicates consistency with theoutperformance of the top constituents, and underperformance of the bottomconstituents against an equally weighted FTSE US Index.

In particular, firms that exhibit poor ratings for the compensation theme thatmeasures the structures and schemes provided to reward the executive and non-executive directors have performed poorly compared to those with the mostappropriate schemes. This theme has a negative performance over this one year timeperiod, and shows the largest difference between top and bottom constituents in theUS Index.

Using a backcast approach (which does not reflect changes in a company CG ratingas this information is not available to us), the FTSE ISS CGI Series tracks itsunderlying benchmark indexes very closely. This is helped by its sector neutralapproach, and by removing only 20% of the underlying market capitalisation.

As a result of using this methodology, we would expect to see similar historicalcorrelations and performance as the underlying benchmarks. The backcasts are basedon a current set of constituents for each index and are calculated backwards for aperiod of five years. As this methodology does not take into account constituentchanges throughout time we have applied the same methodology to their relativeunderlying benchmarks to remove any calculation biases. The output of this analysisis shown in Figures 21 and 22, and Table 5.

Figure 21: FTSE ISS Developed, Europe, and Eurozone CGI vs. Underlying Benchmarks


Performance based on backcasted data


FTSE ISS Developed CGI (USD)

FTSE ISS Europe CGI (USD)

FTSE Developed Europe Index (USD)

FTSE ISS Euro CGI (USD)

FTSE Eurozone Index (USD)

FTSE Developed Index (USD)

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• Given the level of specificinformation available at present,there is no definitive link betweencorporate governance and stockreturns, although over a reasonabletime period we believe thatgovernance factors should showthemselves in investment results

Figure 22: FTSE ISS US, UK, and Japan CGI vs. Underlying Benchmarks


Performance based on backcasted data

The evidence of a clear link between corporate governance standards and share priceperformance is mixed, given the historical issues highlighted above. The FTSE ISS UKCGI outperforms its equivalent FTSE index over one and three years, and the FTSE ISSDeveloped CGI, FTSE ISS Japan CGI, and FTSE ISS US CGI outperform theirequivalents over a five year period. Each index is closely correlated to its underlyingbenchmark index. Over a five year period the tracking errors are higher within theindividual country indexes, while the regional indexes of FTSE ISS Developed, FTSEISS Europe, and FTSE ISS Euro CGI show a five-year tracking error of 1.09%, 0.79%,and 1.32% respectively.

The performance analysis on the US above is only a starting point, and by no meansconclusive over differing time periods. In our research so far we have not found adefinitive link between corporate governance and stock returns, but as time goes bywe can assume that a more cohesive engagement by shareholders from around theworld will come into play, and over reasonable time periods, we believe thatgovernance factors should show themselves in investment returns.

Table 5: FTSE ISS Corporate Governance Index Series Performance Breakdown

Asterisks (*) denote Backcast Indexes

Source: FTSE Group / FactSet Limited - data taken from 30th September 1999 to 30th September 2004


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FTSE ISS FTSE FTSE ISS FTSE FTSE ISS FTSE FTSE ISS FTSE Japan FTSE ISS FTSE FTSE ISS FTSE USDeveloped Developed Euro CGI Eurozone Europe Developed Japan Index* (JPY) UK CGI All-Share* US CGI Index* CGI (USD) Index* (EUR) Index* CGI (EUR) Europe CGI (JPY) (GBP) (GBP) (USD) (USD)

(USD) (EUR) Index* (EUR)

Performance

1 Year 14.64% 15.37% 14.47% 14.86% 14.82% 14.86% 8.34% 8.81% 14.16% 12.08% 10.36% 11.81%

3 Years 14.44% 15.67% -9.86% -9.68% -10.94% -10.56% 10.50% 10.51% -1.69% -2.59% 6.14% 8.50%

5 Years -7.01% -7.58% -21.18% -21.02% -19.96% -19.21% -19.21% -19.84% -16.67% -15.22% -8.13% -8.71%

Correlation

3 Year 0.9995 1.0000 0.9995 1.0000 0.9996 1.0000 0.9980 1.0000 0.9962 1.0000 0.9985 1.0000

5 Year 0.9979 1.0000 0.9991 1.0000 0.9991 1.0000 0.9943 1.0000 0.9944 1.0000 0.9926 1.0000

Tracking Error

3 Years 0.47% - 1.08% - 0.56% - 0.95% - 1.39% - 0.84% -

5 Years 1.09% - 1.32% - 0.79% - 1.77% - 1.63% - 2.09% -

Volatility

3 Years 14.94% 14.84% 23.84% 23.03% 19.18% 19.00% 14.95% 15.06% 15.98% 16.02% 15.42% 15.31%

5 Years 15.73% 16.08% 23.25% 22.35% 18.53% 18.38% 16.57% 16.37% 15.39% 15.27% 16.13% 16.74%

FTSE ISS US CGI (USD)

FTSE ISS UK CGI (USD)

FTSE All-Share (USD)

FTSE ISS Japan CGI (USD)

FTSE Japan Index (USD)

FTSE US Index (USD)

4.6 Risk Analysis

Investors currently look upon corporate governance as a risk factor as opposed to areturn factor. The main investment risk factors are well known and well researched.Investors understand risk in relation to currency, countries, sectors and macro economicand fundamental effects. It is fair to say that these risk factors have a profound effecton stock returns that can be measured. As a risk factor, corporate governance is not aswell researched. However, it is our belief that as corporate governance analysisbecomes more readily available on a global basis, it will assert itself more.

To help provide a better understanding of the differences between the FTSE ISS CGISeries and their underlying benchmark indexes, we have used the risk analyticssoftware of EM Applications (see also Appendix B).

This risk analysis highlights the FTSE ISS CGI Series features, which may causedifferences in relative performance. Given the tight sector constraints used in theconstruction of the indexes, it is not surprising that the expected relative volatilitybetween the FTSE ISS CGI Series and broader indexes (tracking error) is significantly lessthan 2% in all instances based on the software run. Further dissection of the source ofthese tracking errors is only possible using a highly sensitive modelling process, butshould still be considered indicative as opposed to definitive.

All indexes are constructed using a sector-based selection process and still contain alarge diversity of holdings. Owing to this we find that:• Multi-regional indexes are more likely to perform differently based on country

sensitivities as opposed to sector-based or stock specific imbalances• Lacking any regional diversity, single country indexes are more likely to diverge

based on specific holdings or fundamental factors (valuation attributes) such assize or yield

Fundamental valuation data was imported into the risk model and mapped againstthe existing risk factors. Valuation attributes for indexes are measured in the weightedstandard deviation from the mean of the universe of FTSE ISS CGI companies. Thisallows us to understand the contribution to total tracking error due to the relativeimbalances in any of the eight valuation attributes:• Overall CGI Rating with constituents:• Investable market capitalisation (US Dollars)• Dividend yield• Audit Process Rating• Board Structure Rating• Compensation Rating• Equity Structure Rating• Ownership Rating

Further work has been completed in order to ascertain whether CGI ratings are usefulas descriptors for risk. Canonical Correlations give an indication of the best fit of theCGI rating to modelled risk factors. A score above 0.30 is considered statisticallyuseful. The high Canonical Correlations in Table 6 below based on a world risk modelof 2,211 companies indicates that CGI ratings do have relevance as risk attributes.

Table 6: Significance of Valuation Attributes

Canonical Correlation to Correlation to Correlation Market Cap Log Market Cap

Board Structure 0.64 0.13 0.09Equity Structure 0.77 -0.22 -0.47Compensation 0.52 -0.03 -0.12Audit Process 0.60 0.12 0.07Ownership 0.43 0.09 0.19Overall CGI 0.54 0.04 -0.08

Source: EM Applications Ltd

• Statistical correlations on over2,200 global companies indicatethat CGI ratings have relevance asrisk attributes

• Canonical correlations give anindication of the best fit of the CGIrating to modelled risk factors


Given that the frequency market capitalisation appears as a significant risk factorwithin the risk reports that have been run, there was a possibility that the CGIratings might be a function of the market capitalisation and thereby correlated. Thecorrelation data presented in Table 6 shows that there are very low correlations tomarket capitalisation overall and only the equity structure rating has any significantcorrelation to log market capitalisation.


Risk Summary

Top Line At 0.67% the FTSE ISS Developed CGI Index has the lowest tracking error relative to its

broader index and a Beta of 0.99. Given the low relative volatility, even a very small

beta difference swamps the analytics meaning that almost all the top risk factors are

underweight positions. This is also the most diversified CGI assuring that company risks

do not dominate.

Country Only the USA stands out on the risk concentration report accounting for 16% of the

relative risk. Even at 51% of the portfolio, and 2% underweight, it still contains stocks

accounting for 85% of the total risk of the index.

Sector Low relative importance and excluding Beta it drops to background levels.

Valuation A very large number of holdings helps assure balanced relative valuations and low

associated risk.

Company Almost all of the top risk contributing stocks are from the US representing a broad

diversity of sectors.

FTSE ISS US CGI

Risk Summary

Top Line The lowest single country tracking error at 1.18%, which is not surprising given this

index contains the largest number of holdings for any single country index. Also the

lowest Beta for any corporate governance index with a 0.98 Beta representing nearly

9% of the risk relative to the broader index. The primary drivers of risk are the relative

imbalances in valuation attributes that the two indexes exhibit.

Sector Only the Media Supersector stands out as a significant contributor to overall risk, the

overall portfolio has only a small sector misalignment.

Valuation Dominated by the relative valuation differences with market capitalisation standing out.

Even though the themes of board structure and audit process are not correlated to

market size, they are also significant sources of risk. Oddly, equity structure provisions

for the same group are just marginally of lower quality and also account for a

significant fraction of risk.

Company All of the top 5 risk contributors are underweight positions, which is not surprising

given the relatively low Beta.

FTSE ISS UK CGI

Risk Summary

Top Line The highest single market tracking error of 1.42 dominated by company risks and a

small market bet of a 0.99 Beta. Nearly half of the companies have been excluded,

creating the smallest, most concentrated single country corporate governance index.

Sector The sector dependent construction of the index appears to have hedged out any

significant sector exposures.

Valuation Although this index has a large 0.5 standard deviation difference in market

capitalisation, this imbalance does not correlate to the overall relative risk and accounts

for a relatively small 4% of tracking error.

Company The exclusion of AstraZeneca, Shell and Barclays represent over 70% of the relative risk

between the two Indexes. Of the top 5 securities, Vodafone is the only overweight

representative.

• Detailed Risk Breakdown


5. Using the FTSE ISS CGI Series

By applying ISS corporate governance ratings into indexes, a product has beenspecifically engineered to operate in today’s complex and varying market conditions.Significantly, it is particularly pivotal with regard to:• company analysis• portfolio management and stock selection• index-linked financial products• customising your existing benchmark

Company analysisThe index is a consistent yardstick for measurement of governance practices inalmost 2,200 companies across 24 markets. The baseline standard facilitatesnumerous comparison criteria, including:• sector• cross-sector• country• regional

Portfolio management and stock selectionThrough the index, managers are able to evaluate corporate governance risk ofindividual companies and rating data within their portfolio. Institutional investorscan choose either to use the standard FTSE ISS CGI indexes or to have FTSE create acustomised benchmark to fit the fund’s specific needs.

The analysis can be used to manage the level of corporate governance risk byreweighting portfolios and/or eliminating the highest risk companies. The portfoliocould then be benchmarked to an index comprising companies that have the bestcorporate governance standard within their sector.

Basis for index-linked financial productsThe indexes are designed to be used as the basis for structured products and funds.

With recent high profile scandals resulting from poor corporate governance practices,retail and institutional investors are looking for opportunities to invest in productsthat factor in corporate governance criteria and performance.

To discuss these options further please contact your local Sales Representative:

• Investors are now able to take intoaccount these important investmentfactors on a portfolio basis for thefirst time


Email [email protected] [email protected] +86 10 6515 9265Boston +1 617 306 6033Frankfurt +49 (0) 69 156 85 143Hong Kong +852 2230 5800London +44 (0)20 7448 1810 +44 (0)20 7614 8500Madrid +34 91 411 3787New York +1 212 641 6166 +1 212 354 3054 Paris +33 (0) 1 53 76 82 88Rockville +1 301 556 0500San Francisco +1 415 445 5660Shanghai +86 21 3401 5526Tokyo +81 3 3581 281 +81 3 5275 7821Toronto + 416 364 9000US Toll Free +1 888 747 FTSE +1 866 ISS PROXY

Contact FTSE Group ISS

6. ConclusionCorporate Governance Indexing - Just the Beginning

Both FTSE and ISS see the indexes created so far as the first step towards a globalcorporate governance standard. As corporate governance develops into a moreestablished financial measure, it is expected that more work will be required to ensurethe index series meets market requirements. Many countries around the world are atthe very early stages of looking at corporate governance, implementing legislation oracceptable codes, it is a long process. Many parts of the investment community areonly now beginning to accept corporate governance as an investment criteria and riskfactor.

From the index and data perspective, as corporate governance becomes moreembedded in people’s thoughts and business processes, the available data willimprove, which will add stability to the indexes.

FTSE also wants to add further corporate governance indexes to the series in phases.These future indexes will be created, based on feedback from users. For example,there has been interest expressed in creating indexes covering emerging markets.Obviously obtaining the information on which these new indexes would be basedand verifying the accuracy of the data will be challenging.

It is logical to assume that the main use of the CGI ratings will be as a measure ofthe company itself. However, by including these ratings in a index structure, theratings can be used to determine the corporate governance rating for the index itselfor importantly the corporate governance rating of a manager’s portfolio.

The investors’ perspective will become more important. For instance, investors areusually content if the manager is getting good returns in excess of the benchmark.However, if the manager is consistently underperforming the market and the portfoliois invested in poor corporate governance companies (ie the CGI rating of the portfoliois low so there is a high corporate governance risk) some serious questions may beasked.

Indexes can also be compared for their relative CGI rating within a country, regionand of course sector. For the first time sector allocation based upon CGI ratings willbe possible and stock selection based upon that particular stock’s CGI ratingcompared to its peers, or the sector’s average.

By introducing the CGI ratings and the FTSE ISS CGI Series investors are now abletake into account these important investment factors on a portfolio basis for the firsttime.

• As Corporate Governance becomesmore embedded in businessprocesses the available data willimprove, which will add stability tothe indexes

• Investors are now able to take intoaccount these important investmentfactors on a portfolio basis for thefirst time


Appendix A

Adoption of Best Practice Corporate Governance Practices

To illustrate the extent to which the FTSE ISS CGI ratings differentiate betweencompanies that are transparent in their disclosures and adopt sound corporategovernance practices from firms that lack transparency and fail to meet best practicestandards, we looked at two distinct subsets of companies: companies with higherCGI ratings (ranked in the top quintile/quartile) and companies with lower CGIratings (ranked in the bottom quintile/quartile). This information looks at all firms inthe FTSE ISS CGI universe, by country, and in the FTSEurofirst 300 Index.

We then selected a few of the corporate governance rating criteria from the 61variables used in the CGI rating process, and examined the level of adoption in eachsubset. Because CGI ratings are generated on a relative basis, the subset of firmswith best ratings do not necessarily adopt the best practice standard for each ratingvariable.

What we find is that the percentage of companies adopting best practice corporategovernance standards within the subset of firms with the higher CGI ratings issignificantly higher than that within the subset of firms with the lower CGI ratings.


CGI Universe

Theme Rating Criterion Top-CGI-quintile Firms Bottom-CGI-quintile Firmsof CGI Universe of CGI Universe Difference

Audit Audit committee comprised solely of independent outsiders /

Audit committee comprised solely of independent outside

directors and board can hire its own advisors 64.3% passed rating criterion 4.0% passed rating criterion 60.3%

Board Remuneration committee comprised solely of independent

outsiders / Remuneration committee comprised solely of

independent outside directors and board can hire its own

advisors 62.7% passed rating criterion 4.0% passed rating criterion 58.7%

Board Nominating committee comprised solely of independent

outsiders / Nominating committee comprised solely of

independent outside directors and board can hire its own


Compensation Options grants align with company performance and the

burn rate is reasonable 61.5% passed rating criterion 14.6% passed rating criterion 46.8%

Ownership Directors are subject to stock ownership requirements 54.7% passed rating criterion 1.4% passed rating criterion 53.3%

FTSE ISS CGI SERIES RESEARCH REPORT – APRIL 2005

Australia

Theme Rating Criterion Top-CGI-quartile Firms Bottom-CGI-quartile Firmsof Australia of Australia Difference

Audit Audit committee comprised solely of

independent outsiders /

Audit committee comprised solely of

independent outside directors and board can

hire its own advisors 68.2% passed rating criterion 13.3% passed rating criterion 54.8%

Board Chairman and CEO are not separated but

there is a lead director / Chairman and CEO

are separated 80% passed rating criterion 23.1% passed rating criterion 56.9%

Compensation No interlocks among remuneration

committee members 54.5% passed rating criterion 28.9% passed rating criterion 25.6%

Ownership All directors with more than one year of service

own stock 56.5% passed rating criterion 23.3% passed rating criterion 33.2%

Equity Structure Shareholder may act by written consent 90.5% passed rating criterion 19.1% passed rating criterion 71.4%

Canada

Theme Rating Criterion Top-CGI-quartile Firms Bottom-CGI-quartile Firms

of Canada of Canada Difference

Audit Policy disclosed regarding auditor rotation 100% passed rating criterion 3.4% passed rating criterion 96.6%

Board Remuneration committee comprised solely of

independent outsiders / Remuneration

committee comprised solely of independent

outside directors and board can hire its own


Board Board controlled by a supermajority of

independent outsiders (75% < IO <= 90%) /

Board controlled by a supermajority of

independent outsiders (IO > 90%) 53.0% passed rating criterion 17.6% passed rating criterion 35.4%

Compensation Options grants align with company

performance and the burn rate is reasonable 50% passed rating criterion 4.3% passed rating criterion 45.7%

Equity Structure No pill & no blank check preferred 86.7% passed rating criterion 7.7% passed rating criterion 79.0%

France


of France of France Difference





hire its own advisors 85.7% passed rating criterion 0% passed rating criterion 85.7%


there is a lead director /

Chairman and CEO are separated 64.3% passed rating criterion 0% passed rating criterion 64.3%

Board Board guidelines are included in each release of

the proxy 85.7% passed rating criterion 35.7% passed rating criterion 50.0%

Compensation Directors receive all or a portion of their fees in stock 60% passed rating criterion 15% passed rating criterion 45.0%

Ownership Executives are subject to stock ownership guidelines 57.1% passed rating criterion 0% passed rating criterion 57.1%


Germany


of Germany of Germany Difference

Audit Policy disclosed regarding auditor rotation 91.7% passed rating criterion 3.9% passed rating criterion 87.8%

Audit Consulting (audit related and other) fees are

less than audit fees /

Fees paid to auditors are strictly audit fees 75% passed rating criterion 3.8% passed rating criterion 71.2%





Board CEO is not listed as having a "related-party

transaction" in the proxy statement 75.0% passed rating criterion 25.0% passed rating criterion 50.0%

Compensation No option repricing within last three years 100.0% passed rating criterion 37.5% passed rating criterion 62.5%

Hong Kong


of Hong Kong of Hong Kong Difference






Board Board guidelines are included in each release

of the proxy 83.3% passed rating criterion 17.4% passed rating criterion 65.9%



Chairman and CEO are separated 77.8% passed rating criterion 34.8% passed rating criterion 43.0%

Compensation Company does not provide any loans to

executives for exercising options 62.5% passed rating criterion 20.8% passed rating criterion 41.7%

Ownership Officers + directors ownership as % of shares

outstanding is > 5% and <= 30% 25.0% passed rating criterion 8.2% passed rating criterion 16.8%

Japan


of Japan of Japan Difference



Fees paid to auditors are strictly audit fees 28.9% passed rating criterion 3.7% passed rating criterion 25.2%






Board No former CEO on the board 77.6% passed rating criterion 45.6% passed rating criterion 32.0%

Board Board size is >=9 and <=12 43.0% passed rating criterion 21.6% passed rating criterion 21.4%




Singapore


of Singapore of Singapore Difference








Fees paid to auditors are strictly audit fees 83.3% passed rating criterion 6.6% passed rating criterion 76.7%

Board Nominating committee comprised solely of


Nominating committee comprised solely of





Remuneration committee comprised solely of




outstanding is >= 1% and <= 5% /

Officers + directors ownership as % of shares


United Kingdom


of United Kingdom of United Kingdom Difference

Audit Policy disclosed regarding auditor rotation 68.2% passed rating criterion 9.9% passed rating criterion 58.3%



Remuneration committee comprised solely of





Chairman and CEO are separated 68.2% passed rating criterion 31.0% passed rating criterion 37.2%


performance and the burn rate is reasonable 55.8% passed rating criterion 15.6% passed rating criterion 40.2%

Ownership Executives are subject to stock ownership

guidelines 40.6% passed rating criterion 4.0% passed rating criterion 36.6%


FTSEurofirst 300 Index

Theme Rating Criterion Top-CGI-quintile Firms Bottom-CGI-quintile Firms

of FTSEurofirst 300 of FTSEurofirst 300 Difference






Board Nominating committee comprised solely of


Nominating committee comprised solely of



Board CEO is not listed as having a "related-party

transaction" in the proxy statement 76.8% passed rating criterion 19.6% passed rating criterion 57.2%

Compensation Repricing prohibited 75.0% passed rating criterion 1.7% passed rating criterion 73.3%

Ownership Executives are subject to stock ownership guidelines 75.0% passed rating criterion 0.8% passed rating criterion 74.2%

US


of U.S.A. of U.S.A. Difference

Audit Fees paid to auditors are strictly audit fees 85.0% passed rating criterion 4.7% passed rating criterion 80.3%






performance and the burn rate is reasonable 61.3% passed rating criterion 9.5% passed rating criterion 51.8%

Ownership Directors are subject to stock ownership

requirements 88.5% passed rating criterion 7.5% passed rating criterion 81.0%

Equity Structure Company has a shareholder-approved poison

pill but is not authorized to issue blank check

preferred /

No pill, but company is authorized to issue

blank check preferred /

No pill & no blank check preferred 94.6% passed rating criterion 18.3% passed rating criterion 76.3%

Appendix B

Risk Analysis – EM Applications Ltd

EM Applications Ltd produces standard risk models, as well as custom models forspecific applications, and multiple assets types. The standard models are derived froma proprietary application of the EM (“Expectation Maximisation”) algorithm,covering all countries and regions around the world and are based on 200 weeks ofun-weighted returns data, generating 20-factor models.For the risk analytics produced within this report we employed 5 standard equity riskmodels with 99.8 % constituent coverage (99.95% by market capitalisation) beforecapturing the remaining securities within the risk model:• The Europe risk model was used in the analysis for the FTSE ISS Europe CGI, and

FTSE ISS Euro CGI• The Japan risk model was used in the analysis for FTSE ISS Japan CGI• The USA risk model was used in the analysis for the FTSE ISS US CGI• The UK risk model was used in the analysis for the FTSE ISS UK CGI• The World risk model was used in the analysis for the FTSE ISS Developed CGI

The risk reports used within this report have been simplified for general distribution.For further details on the modelling process please contact Michael Tanaka from EMApplications Ltd on +44 (0)20 7397 8395 or visit www.emapplications.com


Figure 23: Risk Concentration

Figure 24: Country Risks


USA

Marke

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Active Weight

Marginal Risk

% of Risk

Figure 25: Sector Risks

FTSE ISS UK CGI



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-9

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FTSE ISS US CGI




-7

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-8

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”FTSE” is a trade mark of the London Stock Exchange Plc and The Financial TimesLimited and is used by FTSE International Limited (“FTSE”) under licence. “ISS” is atrade mark of Institutional Shareholder Services Inc (“ISS”). The FTSE CorporateGovernance Index Series is calculated by FTSE in conjunction with ISS and inaccordance with a standard set of ground rules. All rights in the FTSE ISS CorporateGovernance Index Series vest in the ISS and in FTSE jointly. Neither ISS nor FTSE

shall be liable (including in negligence) for any loss arising out of, reliance on or useof the FTSE ISS Corporate Governance Index Series. All information is provided forinformation purposes. Distribution of FTSE ISS Corporate Governance Index Seriesvalues and the use of the FTSE ISS Corporate Governance Index Series to createfinancial products requires a licence with FTSE.

FOR MORE INFORMATION ON THE CORPORATE GOVERNANCE RATINGS AND CGQ CONTACT ISS AT [email protected]

OR YOUR LOCAL OFFICE: US HEADQUARTERS, ROCKVILLE +1 301 556 0500 US TOLL FREE +1 866 ISS PROXY

TOKYO +81 3 5275 7821 NEW YORK +1 212 354 3054 TORONTO + 416 364 9000 LONDON +44(0)20 7614 8500

BEIJING +86 10 6515 9265 BOSTON +1 617 306 6033 FRANKFURT +49 (0) 69 156 85 143

HONG KONG +852 2230 5800 LONDON +44 (0)20 7448 1810 MADRID +34 91 411 3787 NEW YORK +1 212 641 6166

FOR FURTHER INFORMATION VISIT WWW.FTSE.COM, E-MAIL [email protected] OR CALL YOUR LOCAL FTSE OFFICE:

PARIS +33 (0) 1 53 76 82 88 SAN FRANCISCO +1 415 445 5660 SHANGHAI +86 21 3401 5526 TOKYO +81 3 3581 2811

ftse iss corporate governance rating and index series - … · andreas elia research analyst...

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