In Defense of Inclusive Capitalism: An Asset Owner’s Perspective

This is the second in a series on building a diversity and inclusion portfolio. This series builds on a summer guide for asset owners to increase the racial, ethnic, and gender diversity of their Diversity Equity and Institutional Allocation Agency and its ilk, including Intended Giving Network, Diverse Asset Managers Initiative, National Association of Investment Companies (NAIC), AAAIM, Milken Institute, IDiF. The guidance also applies to advisors advising them and asset managers seeking to become part of their portfolios.

Following on from the guide introduced in the first article, where we examine the business case for DEI, the remaining four articles in the series detail 17 practical, evidence-based strategies for building a diverse and inclusive portfolio .

Institutional investment teams and committees looking for research on inclusive capitalism can choose from a myriad of studies detailing the benefits of various forms of diversity in specific contexts or situations — or the downsides of a lack of diversity. Gompers, Mukharlyamov, and Xuan (2016) find that investors with the same ethnic, educational, and occupational backgrounds are more likely to associate with each other. This homogeneity reduces the probability of investment success, and its adverse effects are most prominent in early-stage investment. Various studies have shown that affinity costs are most likely attributable to high-affinity syndicates making poor decisions after investing. A “birds of a feather flock together” approach to collaboration can be costly.

In some cases, a more diverse composition of boards and management teams can translate into faster growth, greater profit margins, and better decision-making. However, this finding was not always replicable, and there was no clear evidence of a sustained relationship between increases in racial or gender diversity and subsequent improvements in operational metrics. More broadly, existing research suggests that the impact of diversification on firm and investment performance depends on context.

Studies of the impact of diversity often begin by pooling different companies or portfolios based on the racial or gender makeup of their key decision makers. Pools are then compared cross-sectionally over a fixed time frame, based on fundamentals (sales or earnings growth) or investment performance (internal rate of return, total return on invested capital, or a risk-based measure of return).

Although these studies often show that more diversified firms are statistically significantly better than less diversified firms, their designs have drawn accusations of omitted variable bias. In other words, diversity may not explain differences in performance among firms; instead, the best firms may be more diverse or value diversity more. This subtle distinction helps explain the failure to generalize these findings to alternative samples or to document the precise relationship between diversity and return on investment. Yet critiques of existing research on this basis feel like red herrings.

Perhaps diversity is not a “magic bullet” such that a specific increase in the racial diversity of management teams predictably accelerates corporate earnings growth in any case. Studies aimed at proving this relationship have been rightly criticized. However, rather than concluding that diversity therefore has no demonstrable impact on performance, wouldn’t it make more sense to explore why many of the best companies place greater emphasis on diversity? Or how do these firms create the necessary conditions for diversification to yield the desired improvements in decision making, strategic positioning, and risk management? Company culture appears to play a key role in mediating the effects of diversity. Therefore, next-generation research must not only regress firm- or investment-specific data to diversity indicators, but also identify “soft” variables that explain differences that have plagued previous studies.

Fortunately, some of this research is already underway. According to a study4 by Alex Edmans, professor of finance at the London Business School, between 1984 and 2011, the 100 best companies to work for in the US outperformed their peers by 2.3% per year in return on shareholders -3.8% (89-184% cumulative). Although the Best Companies list measures overall employee satisfaction rather than diversity and inclusion specifically, several of the five dimensions it covers (credibility, fairness, respect, pride, and camaraderie) Dimensions are related to diversity and inclusion. Moreover, as Edmans noted in his February 2018 response to the FRC’s consultation on corporate governance principles, “diversity in itself is highly desirable and companies should pursue it even without purpose and evidence.” Showing that it helps improve performance. It would be a sad world if the only reason for companies to increase diversity was to achieve higher performance or meet regulatory targets.”

Let’s briefly examine the legal case for diversity. Some professionals reported resistance to their intentional attempts to diversify portfolios, capital markets, and corporate executive suites as a violation of their fiduciary responsibilities. This resistance is based on a narrow definition of fiduciary duty. As background, the fiduciary duty of loyalty, or always acting in the best interest of the beneficiary, has been interpreted in various ways. On the one hand, firms and investors believe that diversification reduces best interests, thus citing fiduciary duty to justify the lack of investment in diversely owned and diversely led asset managers. Some investment teams are limited from investigating the diversity of managers in their portfolios. The investment teams of some state university endowments are prohibited by their legal departments from incorporating non-financial factors (such as diversity) into the investment process and even from identifying diversity managers during manager due diligence.

On the other hand, as described by the Diversified Asset Managers Initiative, firms and investors believe that “a lack of diversification undermines the fiduciary duty to generate the highest returns because it reflects a failure to adequately consider generating optimal risk-adjusted returns.”

With regard to portfolio diversity, the U.S. 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 planned investments, while maintaining fiduciary responsibility. With regard to corporate diversity, new research by Brummer and Strine shows that corporate fiduciaries, bound by their duty of loyalty, take active steps to ensure that companies comply with important civil rights and antidiscrimination laws and norms designed to provide fair access to economic opportunity. These authors Also explained that corporate law principles, such as the business judgment rule, not only empower but encourage U.S. companies to take action to reduce racial and gender inequalities and to increase inclusion, tolerance, and diversity because of good DEI practices and a well-connected corporate reputation and sustainable corporate value.

Interpretations of fiduciary duty are influenced by the mindset and composition of investment committees and whether diversity, equity, and inclusion are embedded in investment beliefs. Some organizations have been interested in adopting the DEI framework to influence the representation of multiple perspectives on their boards.

The next article in this series focuses on eight practical, evidence-based strategies for integrating diversity, equity, and inclusion into governance, and provides examples of organizations that have pioneered these strategies. stay tuned!