When it comes to corporate governance, it pays not to be passive, says Simon Young.

The revelation that Volkswagen cheated on emissions from its diesel engines by employing ‘defeat devices’ to reduce the level of harmful pollutants emitted during testing has shaken confidence in the German car-making giant.

The scandal could see the recall of 11.5 million vehicles globally; environmentalists are up in arms about higher levels of pollutants released into the atmosphere than previously estimated; and regulators, such as the US Environmental Protection Agency, want answers to why a company like VW has willingly cheated the system.

While the reasons for such widespread gaming of the system are far from clear, Volkswagen’s poor record on corporate governance should have triggered alarm bells. Out of the company’s 20-strong Board of Directors, only one was truly independent, without links to either VW or its three largest shareholders.

Independent directors play a vital role in asking management the difficult questions on strategy, audit and performance. Without them a cosy environment can develop, where management is given free rein without the normal checks and balances. Corporate scandals, such as that currently enveloping VW, may not automatically result from such cultures; but investors should not be surprised when they do.

This has particular relevance to the ongoing debate around active and passive investing; specifically why the qualitative analysis of factors such as corporate governance and quantitative assessments of value carried out by active managers do matter. Any investor simply holding a tracker fund of the German large-cap index, the Dax, would have had 4 per cent of their money invested in Volkswagen at the end of March. By the end of September, with its share price dropping 56 per cent due largely to the emissions scandal, VW’s weight in the index was 1.9 per cent and those tracker fund investors would have lost more than 2 per cent of their investment just from this holding.

Tracker funds are valuation agnostic: no consideration is given to whether a share is valued at 10 times or 1000 times earnings. It will be replicated in the tracker fund with the same weighting as it has in the index. This is as true now with the VW situation as it was during another inglorious episode; the tech bubble of 1999-2000. Tracker funds at the time owned the index constituents, despite the emerging reality that a number of internet companies within the index were trading at illogical levels.

The bottom line is that investment managers should pay close attention to issues like corporate governance because there is a high correlation between how a company acts on the inside and its long-term performance. Shortcuts on corporate governance are often symptomatic of shortcuts elsewhere. It is imperative that managers integrate environmental, social and governance analysis into their decision-making, and actively engage or even challenge companies to improve their performance on such issues by using their voting rights and holding regular dialogue with senior management.

When buying a car, it always pays to check under the bonnet first. The same is true of investment. In the context of the active versus passive debate, the VW scandal should be seen as a cautionary tale that demonstrates the value you get from sitting in the driver’s seat rather than being passive passengers along for the ride. .

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