Human Capital: Investing in Diversity and Inclusion

Human Capital: Investing in Diversity and Inclusion Data Science and Technology

By Elliot Worth| April 14, 2021

The field of human capital is a vast landscape from which investors can glean a significant amount of insight through the ingestion of vendor-collected datasets. It often acts as a supplementary source to company-reported financial information.

The human capital theme spans specific features such as employee history, job listings, compensation, relationships and connections, and corporate governance, to name a few. Content aligned to the personal and professional characteristics of individuals is being used to help investors build out their portfolios and select trading strategies. In this article, we'll focus on this investment workflow.

Introduction

2020 was a truly historic year and offered no shortage of lessons to carry forward into 2021 and beyond. Among the most significant was the need to continue advancing diversity and inclusion efforts-from the workplace, to boardrooms, and to investment management teams. Recent evidence indicates that the corporate world has finally begun heeding the wider public call for greater diversity across all aspects of business. CEOs have been publicly committing to practices that embrace different genders, races, ethnicities, sexual orientations, ages, and professional experiences.

It is now widely accepted that diversity in the corporate world can foster innovation and creativity and improve overall business outcomes. We will look to establish and cite a range of research that provides evidence of investment outperformance because of broader diversity and inclusion. After this, we'll examine some of the quantifiable factors that data vendors have collected and made available in response to the recent needs of the investment community on this subject.

Analyzing Diversity and Inclusion in the Corporate Environment

Without necessarily relying on specific research to draw us to the suggested conclusion, there would likely be a strong consensus agreement that a balanced corporate board and workplace environment offers the greatest potential for outperformance against market peers. Too much or too little of one thing is rarely likely to succeed in today's highly competitive and dynamic spaces.

Recent studies illustrate the benefits of board diversity. For several years, McKinsey & Co. has investigated and extolled the business case for diversity. In 2014, they established their stance with their Why Diversity Matters report and then followed up in 2017 with Delivering Through Diversity, which suggested top quartile companies with gender diverse boards were 21% more likely to achieve higher profits. Most recently, in 2020 their Diversity Wins: How Inclusion Matterspaper confirmed observations that, 'the relationship between diversity on executive teams and the likelihood of financial outperformance has strengthened,' with the likelihood of financial outperformance increasing to 25%.

Similar indicators can be seen by extending the characteristics to cover ethnic and cultural diversity, with McKinsey again making compelling conclusions and illustrating a significant profitability outperformance potential of 36%, up from 33% in 2014.

From an asset management perspective, in 2018 Citywire illustrated that funds managed by mixed-gender teams outperformed both male-only and female-only managed funds with 4.3% higher three-year returns on average. The report also highlighted the huge discrepancy in fund manager gender diversity, with over 88% being male, suggesting slim pickings in the search for mixed-gender fund management setups.

There has been progress. According to Yahoo! Finance, in February 2020 the FTSE 350 was deemed to have finally banished all-male boards with the 30% Club announcing there was now at least one woman on all boards of FTSE 100 and FTSE 250 companies. Globally, however, the pace of change is typically slow and derived from different starting points, perhaps due to underlying cultural or legacy attitudes.

Possibly as a culmination of the COVID-19 pandemic combined with high-profile public events and movements, many businesses have been driven to address disparities that may be evident in the makeups of their boards and overall workplaces. This has been evident from a regulatory standpoint, a result of in-house initiatives and through outside-in employee opinion contributions via websites such as Glassdoor.

On December 1, 2020, Nasdaq filed a request with the U.S. Securities and Exchange Commission, requesting permission to ask all 3,200+ companies listed on the exchange to hold their boards to higher diversity standards. This ruling stated that companies must have at least one woman and one minority director representation, or to publicly disclose why they do not.

If public companies are only moving slowly towards gender equality in terms of representation, then overlaying this data with other measures such as compensation can provide an extended view into equality. In the case of top Nasdaq organizations, while males are receiving on average around 10% higher total compensation, there have been years (2014-2016) where females averaged slightly more.

Introducing Diversity and Inclusion through Vendor Data

With such a groundswell of gender equality movements and an increasing range of quality research that illustrates the potential outperformance of companies addressing diversity imbalances, investors are now seeking access to content that they can incorporate into trading strategies.

A variety of individual-level characteristics are used to determine how diverse and inclusive an organization is. Some are very clearly defined, and others, when added to the contextual mix of more 'traditional' characteristics, provide enhanced insight into the general composition of a board or executive management team. We have defined leading diversity characteristics from vendors in the following table. Investors can use these characteristics to determine corporate-, management-, and board-level factors.

Diversity Characteristics

Characteristic	Description	Interpretation
Gender Equality	Flags or indicators of gender can be aggregated at the board, executive management, or workplace level	Gender diverse ratios of at least 30% female suggest companies adopting a more inclusive workplace environment (especially at the board level), according to McKinsey
Ethnic Minority	Flags or indicators of an individual's ethnicity can be aggregated at the board, executive management, or workplace level	With financial outperformance, based on ethnicity and culture diversity, reported (in the above cited paper) to outpace that based on gender, it could be concluded that a preferable ratio may provide equivalent profitability gains at a value less than 30%
Woman-, Minority-, Veteran-Owned	Any business that is > 51% owned by a non-minority woman or women, one or more veterans, or by one or more minorities	Leadership, increased awareness of risk management and mitigation, tax incentives, new revenue source opportunities, diversification of suppliers, and promotion of innovation and creativity, all conforming to general diversity themes
Nationality	Flag or description to indicate nationality of board members	For global-oriented organizations with a broad sales reach, multinational board composition suggests a higher likelihood of relevant regional or national market or industry knowledge

It is important to extend the theme of diversity and inclusion to other areas of an individual's professional experience. Combining such characteristics with diversity traits can help form a more comprehensive picture of the board's potential to succeed.

Individual Characteristics

Characteristic	Description	Interpretation
Career History	Job history across existing and prior organizations	A diverse range of organizations and roles will ideally be present
Board/Role Tenure	Tenure of existing or prior board-level roles	Consistent tenures of significant periods of term with role advancement indicate a desirable career progression
Age	Age of individual	A diverse range of ages at the board/management level suggests a good mix of experience and acknowledgement of modern practices
Compensation	Total compensation	Identifying executive management teams with a reduced disparity between the CEO and other senior members suggests an effective compensation committee
Independence	Independent director status or may also be derived from historical linkages	Tracking historical linkages may be able to define the suitability of a person's independence rather than purely relying more accurately on the flag/indicator
Education	History of education and qualifications	Industry-relevant education or certifications may indicate enhanced exposure to desired practices and skills
Affiliations	Memberships in trade organizations, etc.	Likely suggest an advanced industry expertise, with a potentially broader network reach

Vendors provide both the ability to create in-house factors based on the above individually-linked scores or flags; pre-aggregated scores/ranks are also available based on the overall board or company. This allows users to adopt a build, buy, or blended approach to provider content based on their needs.

Employing Diversity and Inclusion in the Investment Process: Example Approaches

Now that we have defined the key characteristics, it is worth identifying how these factors can be employed in investment- or signals-based trading and investing strategies. Below are some examples of the potential avenues that investors can use to approach this task.

• Leadership: If you're interested in specific company or fund, find out about the people at the helm. Is there diversity on the management team and the board of directors? Who manages the fund? Does the strategy team include people from various backgrounds with relevant industry or education exposure?
• Reports:Look to industry reports, benchmarks, and indices to gauge social and corporate governance practices. Fortune's Best Companies to Work For® list, Forbes' Just 100 list, the Great Places to Work® (UK) list, and the Human Rights Campaign Foundation's Corporate Equality Index are rich sources of information. For example, Morgan Stanley was recognized by the Money Management Institute and Barron's for its addition of 'Commitment to Diversity and Inclusion' to its core values.
• ESG: Environmental, social, and governance (ESG) investing focuses on companies that adhere to certain standards across these three areas. There are many mutual funds and exchange-traded funds (ETFs) that specifically reflect the 'S' and 'G' principles. For example, the iShares Refinitiv Inclusion and Diversity ETF was launched in 2018 and may provide useful investor insight into the types of corporate characteristics that contribute to its membership.
• Laggard avoidance: At a minimum, investors may choose to screen out companies that don't stress diverse and inclusive values. A variety of data vendors provide both raw and derived calculations on the various topics we have discussed. At the same time, a visit to the company's corporate site should provide an immediate impression on their position (or lack of) through regulatory disclosures, as well as a firm's corporate responsibility and sustainability reports, including diversity and inclusion information.

Conclusion

There can be no doubt that diversity and inclusion as a topic has rapidly gained in prominence and indeed is being referred to as a 'revolution.' This is apparent in the investment world but on a global scale as well; the array of disparity in many walks of life is frequently presented to the public.

Corporations, as we have highlighted, are taking a visible stance; nearly 2,000 global leaders have now signed on to CEO Action for Diversity & Inclusion. As boards shift to a more diverse and inclusive structure, investors-particularly those with access to granular datasets that enable screening out of the laggards-are at an advantage. This is especially evident as the pioneers of the diversity and inclusion movements are being increasingly recognized for their improved financial outperformance.

While the pace of change surrounding diversity likely increases, investors can capitalize by adopting these trends into their investment approaches based on this evolving rebalancing of organizations.

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