Diversity & Inclusion Criteria Can Be Powerful Investment Tools…When Responsibly Implemented ~ Wealth Management

An edited version of this article was originally published by WealthManagement.com
Written by Betsy Moszeter

In corporations, heterogeneous leadership teams have been shown to create fewer governance controversies, have higher rates of creating leapfrogging innovations, are more customer-centric, more likely to capture new markets, and have higher sales growth rates than homogeneous teams.

So why isn’t analysis of homogeneity vs heterogeneity of Executive Teams and Boards of Directors included in all investment research processes? Perhaps because the investment industry itself is so homogeneous. Per Morningstar, “in the U.S., women make up just 10% of fund managers.”

Lack of diversity of financial services professionals should be discussed more and in deeper ways, and—importantly—remediated in practice, because of the well-documented fact that heterogeneous teams outperform homogeneous teams, across disciplines, and not by an insignificant amount. In asset management specifically, heterogeneous teams construct better portfolios.

However, it can be hard to recognize virtues one does not practice. There are gender-focused and diversity-aware investment portfolios available, but many can be found wanting. To avoid the similarity bias that exists throughout the investment industry, how can prudent portfolio managers factor leadership team diversity into investment processes?

First, appropriately prioritize criteria. The biggest determinant of a company’s—therefore a stock’s—growth expectations is product and service mix. What do they make? How/why will it take market share from its peers? How fast are revenues growing? From where around the globe are revenues receives? A prudent investor should analyze that set of variables first, then move down to the next level of analysis if the answers to this first set are sufficiently strong.

Second, ask: “Who’s at the helm?” Is it an Executive Team and Board of Directors with sufficient diversity of gender, experience, education, age, race, geographical backgrounds, etc. to give an investor confidence they are best equipped to manage the company through an environment of rapidly accelerating change?

Third, ask the question again, “Who’s at the helm?” and evaluate with rigor. Analysis of tokenism vs sufficiency is critical. It’s not sufficient to count one person of color and/or one woman on a team to say it’s not homogeneous and has an elevated chance of outperforming. Looking at gender criteria alone, Kramer, Honrad and Erkut found that as a leadership team crosses a critical threshold of at least three women “difficult issues and problems are considerably less likely to be ignored or brushed aside, which results in better decision-making.” Those companies with at least three women on their Boards of Directors suffered materially fewer governance controversies.

In the Credit Suisse “CS Gender 3000: The Reward for Change” report, an important section focuses on “outperformance of the 50% club” highlighting impressive findings, including: “for companies where there are over 50% females in the top echelons…lower leverage, higher dividend payouts, and higher return on capital employed lend support to the idea that diversity implies better returns for lower risk.” The financial metrics achieved by companies with a sole woman in leadership are not nearly as impressive as those with three or more women and other diverse members. Further, the most spectacular financial successes were achieved by companies with the ideal 50:50 women:men ratio in leadership. Again, tokenism is insufficient to yield meaningful results, so a prudently managed gender-lens portfolio must have higher inclusion thresholds than a sole woman in leadership.

Having said all that: it can be difficult to know what portfolio construction parameters are being used from marketing language. Using gender-lens portfolios as an example, websites and fact sheets often use phrases like “addresses gender disparities,” or “higher representation of women…” But the prospective investor is left to ask, ‘how exactly does the portfolio address gender disparities?;’ ‘“Higher representation of women” relative to what? Does that mean higher than zero?’ Does that mean that counting a sole woman on the Board of Directors is sufficient to be included in the portfolio? Sadly, the answer is usually Yes.

So, what’s an investor to do? Ask questions! If you are interested in selecting a portfolio with strong diversity-inclusion factors, and you cannot tell exactly what criterion the managers have used or why they believe their criterion are the most material factors, contact the investment company and ask exactly those questions. In addition, ask broad questions like, “Please tell me which holding in the portfolio has the lowest representation of people of color (and/or women, etc) in leadership, and why it is included in the portfolio.” Answers to questions like that can quickly tell an investor if their values, assessment of materiality, and vision of a prudently invested portfolio are in line with the portfolio manager.

When included as a component in a holistically-designed investment process, thorough analysis of leadership team diversity can be a powerful tool to identify strong corporate performers, and thus to increase a portfolio’s capability of preserving and growing clients’ wealth. Pink-washing and tokenism aren’t as likely to pay off. Nor is evaluating diversity of a leadership team without first understanding what the company’s product and service mix is and how/why that is superior to its peers.

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Nothing in this article should be construed to be individualized investment advice. Please see additional important disclosure information here: https://greenalphaadvisors.com/about-us/legal-disclaimers/