Can Diversity and Inclusion Help Investors Beat the Market?

November 11th, 2018 | Hugh Smith

“The majority of traditional mutual fund managers fail to outperform their respective benchmarks after fees” is mentioned so frequently today it is almost ubiquitous. The last decade has seen a huge rise in quant funds which scour every quantitative piece of information from company financial statements to try to find factors that might allow them to beat the overall market.

But perhaps, as illustrated by the Thomson Reuters Diversity & Inclusion Index, there is a simpler answer, and one you wouldn’t find on a company’s balance sheet.

The Diversity & Inclusion Index is a simple, market-cap weighted index of the 100 companies globally with the highest Thomson Reuters Diversity and Inclusion Scores. This score is made up of 4 pillars — diversity, inclusion, people development and reported controversies related to these values. It does not consider any financial-related metrics, yet the index has outperformed the global stock market over a 3 and 5-year timeframe, on both an absolute and risk-adjusted basis. Furthermore, the outperformance is consistent, with the index beating the broad market every calendar year from 2013 through 2017.

It appears, and maybe not surprisingly, that a company with a strong culture of diversity and inclusion, which develops its people and prevents controversies, is a sign of strong management — which leads to stocks that perform well on a long-term basis.

One common criticism of ESG indices, or generally investing with an ESG orientation, is that there are inherent biases against certain countries or sectors and could thus be less diversified. For example, a low carbon index strategy would be lighter on fossil fuel companies than the broad market. This doesn’t appear to be the case when diversity & inclusion metrics are used. The oil & gas industry is represented (including Enbridge), and industrials make up 7% of the index.

From a country perspective, only one country — Switzerland — has a weight in the index that is more than 5% over or under its weight in the MSCI ACWI (all country world index). In general, European countries tend to outperform while their Asian counterparts lag. The top 3 countries, measured by their weight relative to their weight in the MSCI ACWI, are Switzerland, Germany and Ireland, while the two most underweight are Japan and China. In North America Canada is 2% overweight while the US is 3% underweight.

The absolute outperformance of the index might be explained by diversity in the workforce leading to diversity of thought, ultimately leading to stock performance, especially in industries like healthcare and technology that are very IP- and innovation-driven. A recent Goldman Sachs study found that considering only percentage of female employees would have led to 11.7% and 9.5% outperformance respectively for medical tech and pharmaceutical companies (top 40 percentile over bottom 40 percentile over 3 years). The portfolio diversification (sector and country) outlined above then (partially) explains why the Diversity & Inclusion Index also outperforms on a risk-adjusted basis.

The top company in the index globally is Accenture, headquartered in Ireland (although this is mostly for tax reasons, the majority of its revenues come from North America). Accenture has also scored a perfect 100 on the Human Rights Campaign Foundation’s Corporate Equality Index since 2007. The top company in Canada is BMO, which scores particularly well on the “Inclusion” pillar. BMO provides flexible working hours, day care services and programs on HIV/AIDS. The proportion of companies in the banking services industry that provide these are 25%, 15% and 6% respectively.

The paradigm of Responsible Investing (RI) is changing. The classic question of, “will investors sacrifice returns in order to invest more in line with their values?” is perhaps not only irrelevant, but directionally incorrect. If the last 5 years are any indication, maybe the question should be “why wouldn’t investors increase their returns by considering non-financial metrics that are statistically linked to stock performance?”

Disclaimer
The views and opinions expressed in this article are solely those of the authors and do not necessarily reflect the view or position of the Responsible Investment Association (RIA). The RIA does not endorse, recommend, or guarantee any of the claims made by the authors. This article is intended as general information and not investment advice. We recommend consulting with a qualified advisor or investment professional prior to making any investment or investment-related decision.

Author

Hugh Smith

Investment Management Specialist
Thomson Reuters