Forensic governance: Detective work focused on corporate risk can help protect shareholder value
Forensic accounting plays a vital role in assessing governance quality—a key consideration for global investors.
- Emerging markets, due to their often less-developed regulatory regimes, may leave investors more exposed to governance risks than developed markets, making typical approaches to assess governance practices inadequate for companies. As such, specialized governance research becomes even more valuable.
- While developed markets, including Europe and the U.S., typically have stronger governance and regulatory standards, proper oversight of a company’s management is essential, irrespective of jurisdiction.
- By focusing on six primary factors to assess corporate governance quality—related parties, forensic accounting and audit, legal and regulatory, history and structure, board structure, and management practices—Fidelity’s corporate governance and forensic research helps identify factors that, if missed or ignored, could result in significant loss in shareholder value.
- Strong corporate governance helps protect shareholder rights, the interests of a company’s providers of capital, and other stakeholders.
- Fidelity’s Governance and Forensic Accounting (GFA) team’s proprietary framework and custom models help flag potentially problematic corporate behavior to sort out the leaders from the fraudsters.
A solid corporate governance process is a core and critical component of the global equity research process. Aligning the investment process with this governance focus offers a research edge in all markets, particularly emerging and developing markets, that can be more exposed to risk. Further, research shows that companies demonstrating strong governance standards and practices have exhibited better equity performance in both the U.S. and other developed markets.1
“Corporate governance is an integral part of the investing process.”
Praveen Sangana, Head of Governance and Forensic Research
What is corporate governance?
Corporate governance refers to a set of practices designed to resolve potential conflicts between management incentives and the interests of other stakeholders—including minority shareholders and other providers of capital. The purpose of corporate governance is to help build an environment of trust, transparency, and accountability necessary for fostering long-term investment, financial stability, and business integrity, thereby supporting stronger growth and more inclusive societies, according to the G20/OECD corporate governance principles.2
Its role in asset management is to seek compelling investment opportunities to generate alpha while safeguarding client’s investments.
Why it matters?
Simply, governance is financially material. Governance research is a tool that may correlate with returns, which makes it a key consideration for global investors. Without a specialized governance research process to evaluate factors, significant loss in shareholder value could result. Transparency and accountability are sought within a framework of research observations and shareholder action to help protect shareholder rights.
Fidelity's research in recent years provides compelling evidence showing a clear link (high correlation) between governance quality and returns, showcasing a clear benefit.
How it works?
Our Governance and Forensic Accounting team’s proprietary framework and custom models help flag potentially problematic corporate behavior. The six-point framework aims to uncover potential risks by assessing it to the four most common corporate governance issues.
- Reliability: Honesty among management and strong stewardship of capital.
- Fairness: Equitable treatment of all shareholders by management.
- Effective Supervision: An independent and effective board of directors.
- Transparency: Timely and reliable disclosure, including hidden shareholder risks.
As an example, one important part of the governance framework is evaluating the board structure. In addition to leadership competency, accountability and transparency are critical factors that signify potentially good governance. Their policies address potential conflicts of interest among stakeholders, have diverse and independent boards, offer compensation incentives that align managers’ interests with those of shareholders, and have sound capital allocation policies.
| Corporate Governance Issues | Fidelity’s Framework |
|---|---|
| Reliability | 1. Management practices and background |
| Fairness |
2. Ownership structure and history 3. Related parties and conflicts of interest |
| Effective supervision |
4. Board structure and practices 5. Forensic accounting and audit |
| Transparency |
6. Legal and regulatory |
Source: Fidelity Investments, as of December 31, 2023
1. Fidelity Investments, MSCI
2. OECD (2015), G20/OECD Principles of Corporate Governance, OECD Publishing, Paris. http://dx.doi.org/10.1787/9789264236882-en
Forensic governance: Detective work focused on corporate risk can help protect shareholder value
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Fidelity does not provide tax or legal advice. Employee benefit plans may wish to consult with their ERISA counsel regarding the evaluation of investment or investment courses of action that incorporate nonpecuniary factors.
Investing involves risk, including risk of loss.
Diversification and asset allocation do not ensure a profit or guarantee against loss.
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Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
Generally, among asset classes stocks are more volatile than bonds or short-term instruments and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Although the bond market is also volatile, lower-quality debt securities, including leveraged loans generally offer higher yields compared to investment-grade securities but also involve greater risk of default or price changes. Foreign markets can be more volatile than U.S. markets due to increased risks of adverse issuer, political, market, or economic developments, all of which are magnified in emerging markets.