The business case for diversity among corporates at board and management levels is compelling, according to Research Affiliates, but the investment case requires more work to measure the excess returns from having a culture that embraces diverse and dissenting views.
The Californian-based smart-beta manager, which partners with others to implement its strategies, says in a recent report, ‘The Challenges of Diversity Investing’, that investors who seek to promote diversity and its business benefits would be well served to combine diversity with known drivers of excess returns.
The report says that research shows that cognitively diverse groups have higher levels of collective intelligence than non-diverse groups. This results in greater creativity and innovation as well as more effective corporate leadership.
However, the narrower investment case for diversity is less clear-cut, because researchers lack the necessary data to determine whether a link exists between diversity and portfolio performance.
The authors say: “We can test the relationship between observable measures of diversity and cross-sectional firm characteristics, but it is much more challenging to test the robustness of whether more diverse firms are better investments in a portfolio context.”
An additional challenge is that the corporate advantages associated with greater diversity are dependent on an inclusive culture, they say. Corporate culture, however, is exceedingly hard to measure, particularly on a large scale across thousands of firms around the globe.
“Therefore, the ability to ascertain with any degree of definitiveness if diversity attributes are priced in, or if they should lead to otherwise unanticipated excess returns, is limited at this time.”
But the growing attention paid to gender diversity in recent years has led to more transparency among investee companies, more research and better reporting of gender statistics.
“With time, the data and the research will extend past gender into other areas of diversity, such as race, ethnicity, age, and cognitive differences, providing more insight and direction for investment strategies. In the meantime, investors who seek to promote diversity as a social choice as well as for its broad business benefits may prefer to rely on investment strategies that pair diversity with known return-driving metrics in the pursuit of investment performance.”
Cognitive diversity – going beyond gender – is an antidote to ‘groupthink’, an example of which is a committee invariably agreeing with the views of a forceful or non-inclusive chair. Two issues companies have to overcome, though, is their hiring practices and the implementation of a safe environment where people can present alternative views.
The report says that the academic evidence that boards with a more diverse composition tend to be more profitable is actually mixed. But, once again, the research is partly inconclusive because of the difficulty in making comparisons between, say, a board with a 50:50 gender split and an all-male board.
This is because the 50:50 board is more likely to contain directors who are younger and with multiple degrees, but with less experience. Even though Research Affiliates’ studies and observations point to a link between gender diversity and corporate profitability, they say causality from the one to the other is not clearly shown.
“Nonetheless, given the notorious instances in which poor decisions in the absence of cognitive diversity and a culture of expressing dissenting views led to unfortunate outcomes, it is understandable that investors might prefer to trust their investment dollars to more cognitively diverse companies,” the report says.
“We encourage investors who seek to promote diversity and its benefits to use investment strategies that combine diversity with known sources of excess returns in pursuit of their deal objectives.”
It seems we are not likely to see a smart-beta strategy based solely on diversity from Research Affiliates anytime soon.
The report was written by Katrina Sherrerd, Research Affiliates’ chief executive, Jonathan Treussard, director and head of product, and Lillian Wu, vice president, product management.
– G.B.
