Making The Case For Inclusive Capitalism: An Asset Owner Perspective

These color pencils have faces on them. This article is part of a series about building diverse and inclusive investment strategies. This series is based upon a guide for asset managers to increase racial and ethnic diversity in their investment portfolios. It was co-authored by Troy Duffie of Milken Institute and Blair Smith of Milken Institute. We had significant input from the Milken Institute’s DEI in Asset Management Executive Council and Institutional Allocators for Diversity Equity and Inclusion and other cousin organizations such as Intentional Endowments Network and Diverse Asset Management Initiative, National Association of Investment Companies, AAAIM, Milken Institute and IDiF This guide is for asset managers and consultants who want to make it a part of their investment portfolios. After introducing the guide in the first article we will now examine the business case of DEI. The remaining four articles in this series provide detailed information about the 17 evidence-based and practical strategies to build a diverse, inclusive investment portfolio. Research on inclusive capitalism is available for institutional investment committees and teams. There are many studies that examine the positive effects of different forms of diversity in particular contexts. Gompers, Mukharlyamov and Xuan (2016) found investors who had similar educational and career backgrounds were more likely than others to form syndicates. Homophily decreases investment success and is especially detrimental for early-stage investments. Higher diversity in boards and management teams can lead to greater growth, higher margins and better decision-making. This finding is not always reproducible and there isn't any evidence that there is a direct relationship between increased ethnic and gender diversity and improved operating metrics. Research suggests that diversity has a different impact on investment and company performance than previously thought.

Many studies of the impact diversity has on society often start with a pooling of different companies and portfolios based on the ethnic or gender compositions of key decision-makers at the fund or company. These pools are then compared cross sectionally over a fixed time period based on either fundamentals (sales growth or earnings growth), or investment performance (internal rate of return, gross returns on money invested or a risk-based measure). These studies show that companies with more diversity statistically outperform those with less. However, there is a possibility of bias in their design. It may not be the diversity that causes the differences in performance between companies. Rather, the best companies may be more diverse and place greater emphasis upon diversity. This subtle distinction helps to explain why these results are not applicable to other samples or how it is impossible to establish a relationship between diversity investment returns. Criticizing existing research on this topic feels like a red herring. Diversity isn't a panacea. It's possible that an increase in diversity in a management team will not predictably lead to increased earnings growth. These studies are wrongly criticised. It would be more sensible to examine why so many of the top companies are more focused on diversity, instead of concluding that diversity has no proven impact on performance. These businesses can create the conditions that allow diversity to produce the desired results in strategic positioning, decision-making and risk management. The role of company culture is pivotal in determining the impact of diversity. The next generation of research should not only look at data about investments or companies that relate to diversity, but also identify the "soft" variables that are responsible for the discrepancies in prior research. Some of this research is already in progress. Alex Edmans, a professor of finance at London Business School4, found that the 100 Best Companies to work for in America had shareholder returns that were higher than their peers between 1984 and 2011. This was 89-184% cumulative. The Best Companies List measures employee satisfaction, not diversity and inclusion, but many of the five dimensions that it includes (credibility and fairness, respect and pride, camaraderie, integrity, fairness and respect) are tied to inclusion and diversity. Edmans also noted that diversity is desirable as an individual, in response to the UK Financial Reporting Council consultation on the Corporate Governance Code in February 2018. Let's examine briefly the legal arguments for diversity. Some professionals report resistance to their attempts to diversify their investment portfolios, capital market, and corporate executive suites. This is because it runs counter to their fiduciary obligation. This resistance stems from a narrow definition. The fiduciary obligation of loyalty (or acting in the best interests of beneficiaries at all time) is open to many interpretations. Companies and investors on one side of the spectrum believe that diversity reduces maximum benefits. They therefore invoke fiduciary obligation to justify not investing in diverse-owned or diverse-led asset mangers. Some investment teams are restricted from assessing the diversity of their portfolio managers. The US Department of Labor announced recently plans to recognize the importance of ESG integration in plan investment management and evaluation. It will also uphold fiduciary duty. New research by Brummer & Strine reveals that corporate fiduciaries have a duty of loyalty to ensure that companies comply with anti-discrimination laws, civil rights, and other norms that promote equality in economic opportunity. The mindset of the investment committee, as well as whether equity, diversity, and inclusion were included in the investment beliefs, can influence the interpretation of fiduciary responsibility. Next article in the series will focus on eight evidence-based and practical strategies to incorporate diversity, equity and inclusion into governance. It also includes examples of organizations who are already using them. Keep watching!