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Does Diversity Improve Financial Performance?

Particularly in the current political environment, there has been increased interest in expanding diversity on corporate suites and boards. Does diversity impact performance, however? Is there a business case to be made for broadening the backgrounds of decision-makers in the VC world?

One argument for yes …

Research by the Harvard Business Review (“The Other Diversity Dividend,” July-August 2018) suggests that there is. The researchers looked at the financial performance of VC firms’ investments against the profile of the firms’ partners—their ethnicity, gender, school backgrounds and work histories. Presumably, because all VC firms have the same goal regardless of the partners’ backgrounds—that is, to maximize return—those backgrounds should not drive partners to make financially suboptimal decisions.

The article concludes that: “Diversity significantly improves financial performance on measures such as profitable investments at the individual portfolio-company level and overall fund returns. And even though the desire to associate with similar people—a tendency academics call homophily—can bring social benefits to those who exhibit it, including a sense of shared culture and belonging, it can also lead investors and firms to leave a lot of money on the table.”

Homophily is a striking feature of the VC world. Investors in VC firms are largely similar: only 8 percent of investors are women, 2 percent are Hispanic, and less than 1 percent are black.

However, the HBR article indicates that homophily within firms comes at a cost: “Along all dimensions measured, the more similar the investment partners, the lower their investments’ performance. For example, the success rate of acquisitions and IPOs was 11.5% lower, on average, for investments by partners with shared school backgrounds than for those by partners from different schools. The effect of shared ethnicity was even stronger, reducing an investment’s comparative success rate by 26.4% to 32.2%.”

The difference appears to be the diversity of perspectivesthat comes from the diversity of backgrounds.

And one argument for no …

On the other hand, a study conducted by Josh Lerner, a professor of investment banking at Harvard Business School, and the Bella Research Group for the John S. and James L. Knight Foundation seems to contradict those findings. This study, “Diversifying Investments: A study of ownership diversity and performance in the asset management industry,” examined the 2017 performance of woman- and ethnic minority-owned investment companies including mutual funds, hedge funds, private equity funds, and real estate investment management, and it found that there was no substantial difference in performance for these companies and those that were not woman- or ethnic minority-owned.

An investment vehicle was “broadly defined as owned by women or an ethnic minority if they held at least a quarter of the business.” Lerner’s study did show that women and ethnic minorities are particularly underrepresented among investment company owners.

  • It could identify only 136 mutual fund companies owned by women and 126 mutual fund companies owned by ethnic minorities, controlling only 1.5% of all assets under management (AUM) for this asset class.
  • Of 1,126 hedge funds sampled, the numbers were 51 and 100, respectively, controlling less than 1% of AUM.
  • Of 2,814 private equity funds, the numbers were 146 and 106, respectively.
  • The study could identify only 17 women-owned real estate management firms and 21 minority-owned firms, controlling 2% of AUM.

Within this small universe, however, diverse ownership appears to have no material effect on performance, with the possible exception of minority-owned private equity funds. The authors write:

  • “Our results [for mutual funds and hedge funds] conclude that even controlling for risk, the results are the same—[there is] no significant difference in performance for women and minority- owned firms.”
  • For private equity, the data show “there was no consistent difference in performance between diverse and non-diverse firms relative to public markets.”
  • For mutual funds, again, “we find no evidence that women or minority ownership affects the returns of U.S. mutual funds.”

However,mixed evidence did suggest that minority-owned private equity funds might outperform their non-minority-owned peers. Moreover, “[i]n private equity, both women-owned and minority-owned firms are overrepresented among top quartile performers.” In short, with the possible exception of private equity firms, for the majority of investment companies, the data do not show that diverse ownership improves performance.

Additional questions

The Financial Times (“FT: Harvard study questions benefits of fund manager diversity,” January 27, 2019), reported on the study, and the responses to it.

The findings surprised some fund executives who have championed women and ethnic minorities in the investment industry. Kathryn McDonald, head of sustainable investing at Axa Investment Managers’ Rosenberg Equities division, pointed to “real economic arguments” in favour of diversity. “We see the benefits on a daily basis of employing colleagues from different backgrounds. [This] percolates into problem-solving processes which have proved very beneficial for clients,” she said.

It notes that a study of 16,000 fund managers by media group Citywire last year (“Alpha Female 2018)  found that mixed-sex fund management teams delivered a 0.5% better return over three years than all-male teams and a 4.3% better return over three years than all-female teams.

Thus, the question remains open. The Lerner report states:

The biggest barrier to research on diverse ownership or management is the lack of data, as most data providers for the asset management industry do not track diversity in a systematic way. The report relies on the most comprehensive data sources available, but to encourage further research on this topic, improved data on the composition of firm ownership and management is required.