Corporate governance as an ingredient of stock market Index

Vivek Sharma 22 August 2014

By creating an index that factors in corporate governance practices of a listed entity, investors can be provided a good alternative to select scrips. This will help in protecting interest of investors in a much better way

Removal of United Spirits Ltd (USL) from NSE's CNX Nifty, the most actively traded index in the India, has brought to fore one of the key variables that all stock market indices fail to capture. The point is that of factoring in corporate governance practices in formation of any Index. Before moving ahead it is pertinent to note that as per media reports, removal of USL from Nifty is not just a periodic exercise, but an outcome of non-reporting of financials by the company. The issue is indeed series and warrants attention. Even otherwise, significance of corporate governance in creation of an index cannot be overlooked.

Let us look at an index like Nifty. It is based on some of the key variables that determine the formation on any equity index. The benchmark considers impact cost, investible weight factor and a listing history as some of the eligibility criteria for formation of Nifty. But there is no mention of corporate governance as a variable in the creation of the index. The same applies to other indices as well. As a result of these criteria, most trader friendly companies become part of the index, leaving behind interest of investors. This is not to say that once companies with high standard of corporate governance are included in the index, the issues related to fraud and cheating will permanently get eliminated. But definitely interest of investors will be protected in a much better way.

Now the most interesting aspect of the issue i.e. how to create an index, which will factor corporate governance practices of the company. While this may be debated, there are exclusive examples in the world that give an insight into this kind of index. Let us look at one such index. Borsa Istanbul has an index, which takes on consideration corporate governance practices. The index is known as BIST Corporate Governance Index (XKURY). As per the website of Borsa Istanbul, “BIST Corporate Governance Index is the index in which the companies that apply Corporate Governance Principles are included. BIST Corporate Governance Index aims to measure the price and return performances of companies traded on Borsa stanbul Markets (except companies in Watchlist Companies Market and List C) with a corporate governance rating of minimum 7 over 10 as a whole and minimum of 6.5 for each main section. The corporate governance rating is determined by the rating institutions incorporated by CMB in its list of rating agencies as a result of their assessment of the company's compliance with the corporate governance principles”.

This experiment is however not just limited to Istanbul. There are at least eight stock exchanges, which have launched indices with corporate governance as the critical ingredient:

While creating these indices, some of the key criteria have been considered. Here is an insight into what Italy and Brazil consider as the criteria for creating indices:

While many of these criteria are part of corporate governance practices that we follow in India, they are not included in any of the benchmarks. As regards the success that these indices have achieved in their respective countries, here is a table which shows that large number of companies have joined these indices, wherever number of companies in an index is not capped.

Small investors often find it difficult to comprehend and gauge corporate governance practices of companies. However, by building an index which factors in corporate governance practices investors can be provided a good alternative to select companies which are high on corporate governance standard. At least time has come to think on these lines.

(Vivek Sharma has worked for 17 years in the stock market, debt market and banking. He is a post graduate in Economics and MBA in Finance. He writes on personal finance and economics and is invited as an expert on personal finance shows.)

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