FTSE Russell Convenes | Episode 4, Season 1

Machine Learning: The evolution of governance through AI

December 14, 2021

In the latest segment of the series FTSE Russell Convenes, we talk to Professor Isil Erel, the David A. Rismiller Chair in Finance at the Fisher College of Business of the Ohio State University, about corporate governance and how AI can help augment human judgement to identify diverse boards and management by avoiding biases.

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FTSE Russell is an index provider and research houseunder the LSEG umbrella.They specialize in convening the best ideas on evolvingmarket trends and helping to developstrategies for global investors.In this series, we look at the evolutionof the biggest of today's trends.When it comes to ESG investing, too many peoplefocus on the environmental and social, when oftenthe governance can be even more impactful on the futureof the company and your return on an investment.So in this interview, I talk to Ishael Errell,the David A.Today Rissmiller chair in finance at The Ohio StateUniversity about how governance is changing and how AI isaffecting that change.Isel, thank you so much for takingthe time to speak with us today.It's my pleasure Jamie, thanks for inviting me.So before we talk specifically about the waythat corporate governance is changing, can you help usjust define what you mean by corporate governanceand what you define as corporate culture?Of course.If you don't mind, I will go back a while,like about 25 years, 250 years actually.I will go back to Adam Smith, 1776.He wrote his famous book, Wealth of Nations,actually he published it in 1776, and he's the founderof modern economics and among other things he alsotalked about corporate governance.And a typical way we define corporate governanceis that management should represent the bestinterests of the shareholders.And a typical way they do so is through their representationin the boardroom, through board of directors.But as also voiced out by Adam Smith, we know that managementaffects the selection of board of directors tremendously.Either directly, you know, CEO's picking theseboard of directors, or indirectly,through CEO's influence on the nominating committees.So, did this250-year-old corporate governance problem disappear?No, I can give you many examples.We still have this issue around selecting boardof directors.So, this is a little introductionto the kind of main issue, main concernof our corporate governance, which is selecting boardof directors.So, let's dig into that a bit.So, what are some of the things that shareholders may getwrong when it comes to selecting a board of directorsthat, you know, AI could improve on?One thing that we fail on, that the machines can help uswith, is just like putting our biasesaside, right?Like, you know, so cleaning the noise and,you know, and putting our, like, implicit or explicit biasesaside and picking the best for our company.And what we argue is that, you know, machines can help us withthat because what algorithms do is that they sift throughthe data and look at various characteristicsof individuals, boards, and firms and see what kindof combinations, like in nonlinear ways,interactive ways, we can create to pickbetter performance.And as researchers, actually, we cannot do that because Idon't know what attributes are interacting wellwith other attributes.But machines, algorithms can tell usabout that.And going back to your question, you know, it's very hardfor the management to assess that as well, right?Like, you know, whether this part of the boardof this director will go with this directoror with these firm characteristics,especially putting their biases aside.And, you know, of course, at the end there,the board's job is to monitor the CEO,and we have a huge conflict of interest there.So at the end, what we find is that, youknow, the directors that the management choosesare more likely to be male, they are more likely to havea large connection of board seats,and they are more likely to have a finance background as well.So these are overrated characteristicsaccording to the algorithms.And actually, this is what institutional investorshave been telling firms for generations.So if your board of directors from your friends in the countryclubs, then you overlook diversityand better monitoring as well.We need to get more women on boards,we need to get more people from diverse backgroundson boards because there's too much focus on menfrom a certain industry really.Yes.So I was going to ask you about these algorithms becauseto a lot of us they seem like a dirty word because weassociate algorithms with social media trying to sellus things that we don't want to buy.So, does there need to bea perception change about, you know, the algorithmsare actually a real force for good,particularly when it comes to the boardroom and selectingmanagers?So, it depends on your purpose.Hiring decisions are, in fact, prediction decisions, right?You are trying to predict whether this person, a boardof directors or an athlete or somebody else,will be performing well or not.And we know from econometrics statistics that machine learningwould be the best in predicting performancerather than other methods.Can I challenge that?Of course, go ahead.I mean, like, if I was going to hire someone for a jobto work with me, and I have ten candidatesand ten resumes, I think I just need to be inthe room with someone else and just get a senseof what they're like and, you know, to get, if there'sa sort of chemistry there.Are you actually saying that the chemistry that's thereis what gives us the bias and makes us perhapsmake the wrong decision and actually we should tryand be sort of unemotional about how wemake these choices?This is an excellent question.I'm so glad you asked this, Jamie,because a typical question that we get is whether wewould like to replace human judgment.And the answer is definitely no.But you can help a lot.So I talk with nominating committees for the top companiesand they always say they are given 25-30 candidatesto interview.If I can help reduce this number to five with my algorithms,that would be a great help.In this way, we can include someobjective judgments into their subjective judgment.But in that, I agree that the decisionshould be yours in picking your help.And actually, I was just thinking if you'relooking for a role, you may only have timeto read a hundred resumes because you just don't have timein your hands.But if you can use machine learning, you can look ata million and narrow it down to the best 50 and pickfrom there.Definitely.That's why we got calls from executive search firms.I think this is the direction that they are going as well.Again, I'm not saying that we should replace human judgment,but we can augment it with the help of the algorithms.That's what we argue.So, Echelle, can you talk a little bitabout the world today?And are companies and corporates,you know, employing AI to help them make better decisions?We are not there yet, fully.The main problem is the data, I think, you know, so wehave to collect and store data better.And then we have to learn how to use the data better.But I believe that that's thedirection to go, especially in hiring decisions.And I see more and more startups popping up on this topicas well.Great.Well, our audience is certainly going to be interested in what'sthe future of corporate culture, but they're also investors.So are there any sort of things that you should saythat investors should look for when it comesto corporate culture?And feel free to use any examples of the big tech or anybig companies where you think, I can spot in this companythat something's not right in terms of the makeupof the board of directors versus what somethingshould look like.Are there any wrongs and rights that you can help peoplelook for?You know, corporate governance is very important, and wehave been saying this for a long time.Investors do care about diversity morenow.We talked about selecting women on boards.I just want to correct that.I do not necessarily want to say that women should be on allboards.I'm talking about diversity in general and how all thesecharacteristics of board members or employeesin general can complement each other.One other thing that we should think about isthe other stakeholders.Now we are talking about growing the pie in terms of creatingshareholder value.It used to be the case that we were thinking we should justincrease the stock value and you know care about the shareholdersbut now we know that other stakeholdersare important as well like the customers or employeesand with this you know world of information technologynow and they voice out their views very easily.And you've got access to that data now as beforehandperhaps you did and it's much more accessible how employeesfeel about their job etc.Definitely and around the world as well the world is gettingsmaller right like with improvementsin information technology and if we can just make allthese different stakeholders happy it will increaseour shareholder route as well.Now there is so much powerful researchshowing that that shareholders should care about what customersand other stakeholders like employees think aboutthe companies as well.So, corporate governance is changing towardsthat direction.So, Işel, if I understand what you're saying about the onsetof AI making these boards more diverse,which is obviously what these companies need, is the onsetof ESG investing a sort of tailwind to that movementand accelerating that movement?Definitely.You know, if you think about ESG,G is the governance and theyare after better governance I'm happy that all theseshareholders are becoming more and more activists on allthree parts of ESG and as we improve more on E and S side, Ithink it will help on governance as well, definitely.So, can you tell us just a little bit,you said you've been going around and teaching and givingtalks, what's sort of the reactionbeen to some of the talks you've been giving?We've published this paper in a top journal and,you know, people even ask us whether we would like to kindof commercialize this and have a start-up out ofthis.So there's huge interest in...We will look out for your consultancy businessas it starts.We will see.Well, Ixchel, it's been so fantastic chattingto you.Thank you so much for your time.It's my pleasure.Thank you.Thank you.Sustainable investing and the role of ESGin corporate culture was something that was certainlytalked about for 10 years.But it didn't really translate into investmentopportunities.Now, due to the rise of indices allowing more direct investmentinto ESG and sustainable themes, capital allocationsare accelerating these trends, creating opportunitiesthat are only going to get bigger and more diversein the future.If you'd like to read more on this topic,please go to footsyrussell.com forward slash researchwhere you'll find much more information.

Video recorded on June 3, 2021 at FTSE World Investment Forum

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