Making The Case For Inclusive Capitalism: An Asset Owner Perspective

This is the second article in a series on building diverse and inclusive investment portfolios. This series is based on a guide for asset owners to increase the racial, ethnic, and gender diversity of their investment portfolios that Blair Smith and Troy Duffie of Milken Institute and I co-authored over the summer with significant input from the Milken Institute’s DEI in Asset Management Executive Council, Institutional Allocators for Diversity Equity and Inclusion and its cousin organizations, including Intentional Endowments Network, Diverse Asset Managers’ Initiative, National Association of Investment Companies (NAIC), AAAIM, Milken Institute, IDiF. The guide is also for consultants who advise them and asset managers who seek to become part of their investment portfolios.

Having introduced the guide in the first article, here we examine the business case for DEI before the remaining four articles in the series detail the 17 practical and evidence-based strategies for building a diverse and inclusive investment portfolio.

Institutional investment teams and committees seeking research on inclusive capitalism can choose from countless studies that detail the benefits of various forms of diversity in specific contexts or circumstances—or the negative effects of a lack of diversity. Gompers, Mukharlyamov, and Xuan (2016) found that investors with the same ethnic, educational, and career backgrounds were more likely to syndicate with each other. This homophily reduces the probability of investment success, and its detrimental effect is most prominent for early-stage investments. A variety of studies show that the cost of affinity is most likely attributable to poor decision-making by high-affinity syndicates after the investment is made. The “birds-of-a-feather-flock-together” approach to collaboration can be costly.

In some settings, greater diversity in the composition of boards and management teams translates to faster growth, wider margins, and improved decision-making. However, this finding is not always replicable, and there is no clear evidence of a constant relationship between increases in ethnic or gender diversity and subsequent improvement in operating metrics. More broadly, existing research suggests that the impact of diversity on company and investment performance depends on context.

Studies of the impact of diversity often begin by pooling different companies or portfolios on the basis of the ethnic or gender composition of the key decision-makers at the company or fund. The pools are then compared cross-sectionally over some fixed time horizon based on fundamentals (sales or earnings growth) or investment performance (internal rates of return, gross return on money invested, or a risk-based return measure).

Even though these studies often reveal that more diverse companies statistically significantly outperform less diverse companies, their design invites accusations of omitted variable bias. In other words, it may not be that diversity explains the difference in performance across companies; rather, it may be that the best companies tend to be more diverse or place greater emphasis on diversity. This subtle distinction helps explain the failure to generalize these findings to alternative samples or to document a precise relationship between diversity and investment returns. However, criticism of existing research on this basis feels like a red herring.

Perhaps diversity is not a “silver bullet” such that a given increase in the ethnic diversity of a management team would predictably accelerate company earnings growth in all circumstances. Studies that purport to prove such a relationship are rightly criticized. However, rather than conclude that diversity therefore exerts no provable impact on performance, wouldn’t it make more sense to explore why many of the best companies place a greater emphasis on diversity? Or how these businesses create the conditions necessary for diversity to yield the hoped-for improvements in decision-making, strategic positioning, and risk management? Company culture seems to play a pivotal role in mediating diversity’s impact. Therefore, the next generation of research must not only regress company or investment-specific data on to diversity metrics, but also identify the “soft” variables that explain the discrepancies bedeviling prior research.

Fortunately, some of this research is already underway. A study by Alex Edmans, professor of finance at the London Business School,4 showed that the 100 Best Companies to Work for in America delivered shareholder returns that beat their peers by 2.3–3.8% per year during 1984–2011 (89–184% cumulative). Although the Best Companies List measures employee satisfaction in general, rather than diversity and inclusion in particular, several of the five dimensions it captures (credibility, fairness, respect, pride, and camaraderie) are linked to diversity and inclusion. In addition, as Edmans noted in his February, 2018, response to the UK Financial Reporting Council’s consultation on the Corporate Governance Code, “Diversity is highly desirable in its own right, and firms should pursue it even in the absence of a target and evidence showing that it instrumentally improves performance. It would be a sad world if the only reason firms increased diversity were to obtain higher performance or meet a regulatory target.”

Let’s briefly examine the legal case for diversity. Some professionals have reported resistance to their deliberate attempts to diversify investment portfolios, capital markets, and corporate executive suites as running counter to their fiduciary duty. This resistance is based on a narrow definition of fiduciary duty. By way of background, the fiduciary duty of loyalty, or acting in the best interest of beneficiaries at all times, is subject to a range of interpretations. On one end of the spectrum, companies and investors presume that diversity depresses maximum benefits and therefore cite fiduciary duty to justify a lack of investment in diverse-owned and diverse-led asset managers. Some investment teams are constrained from surveying the managers in their portfolio for diversity. Some investment teams for state university endowments are prohibited by their legal departments from incorporating non-financial factors, such as diversity, into investment processes or even from identifying diverse managers during manager due diligence.

On the other end of the spectrum, as the Diverse Asset Manager Initiative describes, companies and investors believe that “a lack of diversity undermines the fiduciary responsibility to generate the highest returns because it reflects a failure to fully consider the range of options for generating the best risk-adjusted returns.”

Regarding diversity in investment portfolios, the US Department of Labor recently announced plans to better recognize the important role that environmental, social, and governance (ESG) integration can play in the evaluation and management of plan investments, while upholding fiduciary duty. Regarding diversity at companies, new research by Brummer and Strine shows that corporate fiduciaries are bound by their duties of loyalty to take affirmative steps to ensure that corporations comply with important civil rights and anti-discrimination laws and norms designed to provide fair access to economic opportunity. These authors also explain that corporate law principles, such as the business judgment rule, not only authorize but encourage American corporations to act to reduce racial and gender inequality and to increase inclusion, tolerance, and diversity, given the sound connection between good DEI practices and corporate reputation and sustainable firm value.

The interpretation of fiduciary duty is influenced by the mindset and composition of the investment committee and whether diversity, equity, and inclusion have been included in the investment beliefs. There are organizations that have been intentional about incorporating DEI frameworks to influence the representation of multiple perspectives on their boards.

The next article in this series focuses on the eight practical and evidence-based strategies for incorporating diversity, equity, and inclusion into governance and provides examples of organizations that are leading the charge on adopting them. Stay tuned!