Macro-Level Governance and International Portfolio Performance

Abstract

This paper compares the performance of “good governance” and “poor governance” portfolios at the country level for a time period spanning 1 January 1995 until 31 December 2002. Comparison between the two portfolio types are made on the basis of an equally weighted and value weighted constructions. Results indicate that “good governance” portfolios outperform “poor governance” portfolios for both return and risk measures. For value weighted portfolios, “good governance” exhibited by far superior performance as compared to “good governance” equally weighted portfolios. More strikingly we find that value weighted portfolios substantially outperformed the Morgan Stanley Composite World Index and the equally weighted portfolios tracked the World Index quite effectively especially with regard to our passive international investment strategy.This country-level evidence is consistent with research that has been conducted at firm-level that supports the notion that good governance leads to superior investment performance. However investing at the country level offers the advantage of improving the risk-return trade-off of portfolios through international diversification.The results have policy relevant implications for fund managers as they can achieve superior returns by passively investing in value weighted investable country indices in countries with good macro governance environments and consistently beat returns on World Market portfolio. However, the results of this study also suggest a time-varying level of importance placed upon governance as a driver of international stock market returns which is more marked after emerging market crises. In other words, the premium paid for good governance may have already dissipated at the country level. Finally, Morgan Stanley may consider producing a “good governance” value weighted index as a benchmark which potentially could encourage countries to enhance their governance environments to be included in the index.