Incorporate Diversity, Equity, And Inclusion Into Governance

This is the third article in a series on building diverse and inclusive investment portfolios. This series is based on a guide for asset owners to increase the racial, ethnic, and gender diversity of their investment portfolios that Blair Smith and Troy Duffie of Milken Institute and I co-authored over the summer with significant input from the Milken Institute’s DEI in Asset Management Executive Council, Institutional Allocators for Diversity Equity and Inclusion and its cousin organizations, including Intentional Endowments Network, Diverse Asset Managers’ Initiative, National Association of Investment Companies (NAIC), AAAIM, Milken Institute, IDiF. The guide is also for consultants who advise them and asset managers who seek to become part of their investment portfolios.

Having introduced the guide in the first article and examined the business case for DEI in the second article, this series now turns to detail the 17 practical and evidence-based strategies for building a diverse and inclusive investment portfolio.

This article focuses on the first of four pillars on the path to inclusive capitalism: incorporating diversity, equity, and inclusion into governance. This first pillar consists of eight practical and evidence-based strategies for incorporating DEI into governance. Let’s examine each strategy in turn, with examples of organizations leading the charge on adopting them.

Strategy 1: Diversify Investment Committee Composition and Culture. According to Kerin McCauley, senior associate director of the New York University Stern Center for Business and Human Rights, ensuring that investment committees include talented women and people of color—and value their voices—strengthens decision-making and the ability to identify high performance across more diverse networks. In general, investment committees should include at least two diverse members to amplify their voices and offset broader resistance to DEI. The California Public Employees’ Retirement System (CalPERS) board proactively increased its gender diversity, transitioning from one to four female members out of 13 members during the fiscal year 2014–2015.10 Nondiverse committee members should also raise diversity issues, which broadly benefits the investment committee’s work.

A study by the investment management company, Vanguard, found that increasing diversity can enhance an investment committee’s effectiveness. Although cueing a team is likely to reveal differences of opinion, the results indicated that when conflicts arise, simply having a diverse team may improve conflict resolution. The investigators concluded that when compared with uniform groups, diverse committees bring fresh perspectives and often a greater level of deliberation before reaching decisions.

Strategy 2: Train the Investment Team on Diversity. Anti-bias training could be helpful, as could training that frames lack of DEI as a systemic risk. Among companies offering corporate training, Frost Included offers inclusive leadership and unconscious bias training, as well as strategy, data, governance, systems, and leadership analysis and support to build inclusive work environments. Blue Level offers experience-based DEI and anti-racism training.

In a study published in 2017 by the Harvard Business Review, participants were encouraged to “perspective-take” by describing the challenges a marginalized minority might face. In addition, participants were set specific, measurable, and challenging yet attainable goals related to diversity in the workplace. The results showed that both exercises produced positive effects on behavioral outcomes, including showing more support and less disparagement of marginalized minorities. Providing an internal investment team with anti-bias training and increasing the gender and racial/ethnic diversity of the investment committee and investment team could facilitate equitable underwriting.

Strategy 3: Incorporate DEI into Investment Beliefs. Some asset owners name diversity as an investment belief or develop diversity statements. For example, CalPERS lists diversity as one of its 10 investment beliefs. According to Chief Diversity, Equity, & Inclusion Officer Marlene Timberlake D’Adamo, “Diversity of talent (including a broad range of education, experience, perspectives, and skills) at all levels (board, staff, external managers, corporate boards) is important; and CalPERS may engage investee companies and external managers on their governance and sustainability issues, including diversity.”

Strategy 4: Add DEI to Investment Policy Statements. Institutional Allocators for Diversity, Equity, and Inclusion (IADEI) is a consortium of 610 endowments, foundations, pensions, family offices, and other institutional investors that seeks to drive DEI within institutional investment teams and portfolios. A recent IADEI survey found that 91% of asset owners agreed with the business case to incorporate DEI into selection and monitoring of managers. 28% of IADEI members have incorporated DEI language in their investment policy statements (IPS), although such language tends to the general. For example, diversity of ownership and leadership, whether the firm has a compelling DEI initiative and has made progress toward DEI, and the degree to which the firm’s business activities benefit marginalized communities may be noted as considerations in IPS. However, even such nonspecific language can shape investment funnels and the composition of investment portfolios.

Regarding asset owners that are leaders in DEI governance, research by the Intentional Endowments Network notes that DEI language in IPS covers a vast range: Examples include a statement by the Rockefeller Brothers Fund, a leading force in philanthropy, which equates advancing diversity in asset management with its fiduciary duty to preserve its endowment in perpetuity, and the policy of Warren Wilson College, a small, liberal arts school in rural North Carolina, that identifies diversity in management and board membership of portfolio companies as a positive screening tool in the process of identifying investment candidates. For investment committees and investment teams that are not yet ready to incorporate DEI into their IPS, a DEI investment team mission statement is a step forward.

Strategy 5: Design and Implement a Plan to Collect Diversity Metrics. Diversity definitions and thresholds vary across the marketplace. In the early 2000s, asset owners used thresholds ranging from 25 to 51% to determine diverse ownership. This was an apparent trend away from the 51% threshold previously used toward a broader definition of substantially diverse ownership. The Harvard Business School economist Josh Lerner defines diverse-owned asset managers as 25-49% and numerous investors use a 33%+ threshold to define a diverse-owned firm.

Numerous organizations outsource assessment of the diversity of their portfolio to data science organizations such as Lenox Park Solutions. In addition, to ease the burden on asset managers and facilitate peer comparisons, the Institutional Limited Partners Association (ILPA) maintains a standardized diversity reporting framework for institutional investors to use with the asset managers in their portfolios. A common definition of diversity facilitates the measurement of progress in diversity over time, as well as peer comparisons. The current best practice in gauging portfolio diversity is to request that employees of asset managers self-identify.

Diversity metrics vary by region: For example, some asset owners monitor locals versus expatriates in Africa, and First Nations representation is important in Canada. Accordingly, some asset owners measure only gender diversity outside of North America. Asset owners have expressed enthusiasm about the breadth of the facets of diversity covered by the CFA
CFA
Institute’s DEI code and its principles-based approach. More specifically, the code considers generation, citizenship status, and neurodiversity as parts of the spectrum of human attributes, perspectives, identities, and backgrounds.

Asset owners tend to prioritize diversity of ownership for all asset classes and of carried interest allocation for alternative investment managers. They generally gauge the diversity of leadership and the investment team as secondary matters. Some asset owners also assess the diversity of the next layer of leadership and ownership in the firm to discern the diversity of ascending leaders.

Some asset owners describe sourcing asset manager diversity data as the largest challenge to expanding the diversity of their investment portfolios. At least one large asset owner considers the termination of managers for refusing to respond to diversity surveys, and several asset owners plan to be more assertive about asking asset managers to diversify their investment teams within a particular timeframe. Because self-reporting data is the current best practice, manager buy-in is critical. Asset owners report greater resistance to responding to surveys from non-US managers than from US managers.

Several large asset owners reported baseline diversity statistics to their investment committees for the first time in 2021 or planned to do so for the first time in 2022, according to multiple discussions at private convenings of institutional investors.

Strategy 6: Commit to Diversity Pledges. According to an Institutional Limited Partners Association (ILPA) survey, 44% of asset owners have signed DEI pledges, most commonly becoming ILPA Diversity In Action signatories, which requires signatories to (1) have a public DEI strategy or statement and/or communicate a DEI policy to employees and investment partners that addresses recruitment and retention; (2) track internal hiring and promotion statistics by gender and race/ethnicity; (3) set organizational goals for more inclusive recruiting and retention; and (4) request that LPs and GPs provide DEI demographic data for any new commitments or fundraises. The initiative lists nine optional activities that participating organizations can choose to adopt.

Other asset owners have signed the CFA Institute’s new DEI Code, which commits them to (1) promote DEI and improve DEI outcomes; (2) increase measurable DEI results in the investment industry; (3) measure and report on progress in driving better DEI results to senior management, the board, and the CFA Institute; (4) expand the diverse talent pipeline; and (5) design and implement inclusive and equitable hiring, onboarding practices, and promotion and retention practices. A number of UK-based asset owners have signed the Asset Owner Diversity Charter, which commits signatories to include diversity questions in manager selection and ongoing monitoring and to identify diversity and inclusion best practices.

Strategy 7: Report and Disclose Diversity Metrics. A critical mass of the top 25 university endowments publicly disclose data on the diversity of the managers in their portfolios, mostly by congressional request. The Knight Foundation endeavored to measure the representation of women- and diverse-owned investment firms among those used by the country’s top 25 private and top 25 public college/university endowments. The endowments collectively hold $587 billion in assets, more than two-thirds of the nation’s higher education endowment dollars. Only 12 of the 50 eligible endowments provided their asset manager roster and only three made asset manager rosters publicly available on their websites. Knight Diversity of Asset Managers (KDAM) studies show that firms led by white men are significantly less likely to employ diverse portfolio management teams than those owned by women and people of color. Openly reporting and disclosing the diversity of asset managers can accelerate access to women- and diverse-owned firms and encourage diversity within firms owned by white men.

Strategy 8: Incentivize Diversity. The Teacher Retirement System (TRS) of Texas runs one of the largest emerging manager programs in the country, having committed $5.9 billion to 204 emerging managers across 342 investments since 2005. This program was instrumental in catalyzing the success of leading diverse-owned and diverse-led managers such as Vista and generated three-year annualized net return of 12.2% as of June 30, 2022.

TRS has taken a novel approach to incentives in its emerging manager program. Relating its development to an invited peer group, Chair of the Board of Trustees Jarvis V. Hollingsworth explained in an interview: “The entire trust is incentivized to be engaged with the Emerging Manager Program, as the program’s performance is integrated into the Total Plan’s performance. The program is focused on three objectives: performance, diversity, and graduation. The program’s structure allows engagement from the relevant asset classes for each of these objectives. The asset classes form the advisory board for the program, leading to increased collaboration as we continue to search for alpha-generating strategies. The diversity objective is being achieved, as more than half of the program’s assets are with diverse managers. Graduation has been a challenge for many programs, but the trust has implemented an innovative system to aid in this process. Emerging Manager (EM) Select allows the program and the asset class heads to collaborate at an even greater level and objectively identify the best-performing managers in the portfolio. The EM Select portfolio was put in place in 2019 and has already seen two graduations from the managers selected to participate.”

The Road to a Diverse, Equitable, and Inclusive Investment Value Chain

The road to achieving a diverse, equitable, and inclusive investment value chain is long. As the ultimate owners of capital, asset owners have the ability and responsibility to drive DEI within investment management teams and portfolios, and across the asset management industry.

As the landscape of diversity, equity, and inclusion continues to evolve, an open exchange of ideas about best practices for inclusive investing is critical to increasing the percentage of the US asset management industry that is controlled by women- and diverse-owned firms. I welcome comments on best practices and lessons learned on DEI governance, which can inform the work of Institutional Allocators for Diversity Equity and Inclusion to drive DEI within institutional investment teams and portfolios and across the investment management industry.

The next article in this series will detail three practical and evidence-based strategies for sourcing diverse talent and provides examples of leading practices in implementing them.