Diversity issues have exploded into the global zeitgeist over the past few months as Black Lives Matter protests have rocked cities around the world. From an investment perspective, diversity is an interesting concept. There have been a lot of studies into the diversity of gender and race on company performance with, well, diverse results.
On the negative side, more diversity can lead to less communication, increases group conflict, lower satisfaction and increased staff turnover.
There are theories of tokenism that suggest that when minorities first enter an occupation that increased visibility creates expectations that are difficult to perform. Or that stereotypes increase the pressure on minorities leading to underperformance.
The stock price arguments focus on time-series analysis, showing that adding women to a board does not, on average, influence stock performance positively. In some studies, the share price is actually negatively affected, even while profitability is unaffected.
On the positive side, group diversity increases network connections, resources, creativity, and innovation.
Creativity and innovation are particularly important from an investment perspective because they contribute to a company’s ability to create and maintain a competitive advantage. Which in turn is fundamental to the sustainability of a company’s returns.
Evidence for this case comes from cross-sectional (rather than time-series) investment studies. These show that companies with more diversity have share prices that perform better.
First, I need to give you some background on how we treat ESG (Environmental, Social and Governance) investing.
From a quantitative perspective, corporate governance is a factor that outperforms. i.e. companies with good corporate governance tend to perform better than those with weak corporate governance.
But, as with all quantitative measures, it comes with some significant caveats.
For governance scores, I prefer to use them as a negative screen rather than a positive one. i.e. bad governance can make a quality score worse and therefore the company needs to be cheaper before I buy it. But I'm not choosing to buy a company with 42% gender diversity over the one with 39% on that measure alone. Many of the governance scores are like that – there is a definite "bad" option, but there is little sense trying to rate the difference between two good options.
We don't use social measures much. I find them too arbitrary. Reading about how a company rates on social impact can sometimes have the same intellectual rigour I expect to see in my horoscope.
We treat ethical as an opportunity set problem. There are 1,600 stocks in the MSCI World Index – a common investing benchmark containing only very large companies. If you:
You are asking fund manager B to beat fund manager A with one hand tied behind their back.
The good news? Reducing the opportunity set that a fund manager has doesn't affect performance too much – especially if you are only cutting out a few sectors. There are plenty of periods where fund manager B will outperform.
The bad news? If fund manager A and B have the same skill, you have to expect the ethical one, in the long run, to have worse performance.
Many ethical funds have an all in or out strategy. i.e. you either get all the ethical exclusions or none. Some people think tobacco is horribly addictive and unethical, but gambling is each person's own choice. Others have exactly the opposite view. For most ethical funds you can either have both sectors or neither, regardless of your view.
Our goal is to give every investor the broadest possible opportunity set. So we run every investor and superannuation client through a separately managed account where they can make these choices for themselves from over 30 different options:
We find about 2/3rds of our investors choose to exclude at least one sector. But the benefit of individual exclusions is that our Tobacco-less investor still has 99% of stocks in our portfolio and our Gamble-free investor has (a different) 99% of stocks. Each has the broadest opportunity set available.
Positive investing is difficult – finding stocks that are good quality and cheap is hard enough. If you find a stock with very positive ethical characteristics that is only average quality and the stock is very expensive should you buy it anyway, expecting a poor return?
There are better arguments made to exclude stocks that don't align with your values. However, don't congratulate yourself too much.
If there is a cause you are genuinely passionate about and you want to support companies in that area, there are four monetary ways you can support that cause, in order of most helpful to least helpful:
For me, more innovation and creativity trump any negative effects of increased diversity.
I also find the tokenism and stereotype arguments disingenuous. These may be issues in the initial years but are not reasons to avoid diversity forever.
I find the difference in the share price performance studies understandable. If companies with more diversity are more innovative, then companies with more diversity will tend to perform better. Which the cross-sectional studies show.
I don't think this is incompatible with the time-series findings. i.e. that adding a woman to a board doesn't improve share price performance. I suspect those studies are over-estimating the power of a single director in a 10+ person board. And there are a lot of companies where the entire board has little control over the direction of the company, let alone a single director. To put it another way, a diverse board and management is a sign of an innovative and creative company. Adding more women to a board will not immediately (or maybe ever) make a company more innovative.
I am also keeping in mind that all the focus on diversity might also create false signals going forward. It may be harder to see genuinely diverse and innovative companies vs the ones with token appointments and a politically correct front.
In the past, we have treated diversity as a measure of governance. A relatively minor warning signal in our overall assessment of the quality of a company.
And we are not looking to change that. Diversity still appears to be a good (but far from infallible) indicator of more innovative companies.
However, increasingly we are finding for some clients a lack of diversity in companies is more important than that.
So, we have also added diversity as an ethical exclusion, giving investors the option to strike companies from their portfolio that don't have enough gender diversity in their board and management team.
My goal as a fund manager is to invest in companies that I think have an appropriate mix of quality and value. An important part of that is considering the potential impact on share prices of companies in ethically dubious industries, which I try to do without too much moral judgement.
In a world of cancel culture, I don't think fund managers should be making non-investment "cancel" decisions on behalf of clients. I do however think people should be empowered to make the ethical decisions for themselves both in superannuation and in ordinary investments.
If you do "tick the box" to exclude stocks with diversity issues from our portfolios, keep in mind that this is only a small step.
In fitting with our philosophy, if diversity is something you feel strongly about then you should also be asking yourself whether there is a better way to help:
Don't get me wrong, I want you to avoid buying shares in companies where you don't agree with the ethics.
But if you truly want to make an impact, don't stop there.
Damien Klassen is Head of Investments at Nucleus Wealth.
Follow @DamienKlassen on Twitter or Linked In
The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Nucleus Advice Pty Ltd - AFSL 515796.
