Advancing social equity through your investments

Building a truly inclusive society will require concerted action across governments, nonprofits, corporations, and investors.

Opportunities to integrate racial-equity criteria across asset classes are growing, with research showing that such approaches can potentially achieve market-rate investment returns.

1. Supporting diverse-owned or diverse-run asset managers;
2. Seeking investments in companies that are creating products and solutions directly addressing the needs of disadvantaged communities;
3. Looking at the diversity and inclusion records of publicly traded companies across industries;
4. Minimizing or avoiding exposure to companies with lagging racial-equity records or whose products and services disproportionately affect disadvantaged communities;
5. Exercising active shareholder dialogue to seek to improve company outcomes across social criteria.

Impact reporting can help monitor and strengthen the impact of each of these approaches.

By building your portfolio to support companies that take a stand for diversity and show accountability for their actions, as well as supporting diverse-owned firms, some investors are playing a critical role in helping to right historical imbalances. Here’s a closer look at these investment approaches. 

While investors increasingly think about a range of social criteria, including the diversity of corporate boards, employees, and senior leaders, fewer investors intentionally integrate diversity of ownership with how investment managers allocate their assets. Some institutions, such as endowments and foundations, have focused specifically on “emerging managers,” a term which can carry many different definitions but is meant to designate promising, often diverse-owned asset managers with more limited track records and fewer assets under management.

Morgan Stanley has highlighted diverse-owned asset managers since 2015 and has worked to evolve due diligence processes to remove barriers and increase opportunities for these managers with the firm.

Research shows that diverse-owned asset managers are responsible for less than 1.5% of assets under professional management in the US.¹ Why are so few assets managed by diverse firms? One possibility is that some investors—individuals, families, and institutions, as well as the advisors that serve them—harbor implicit bias when selecting asset managers. This finding was the result of a study led by the investment firm Illumen Capital and Stanford University’s SPARQ, a self-described “do tank” that helps policymakers, educators, and nonprofit leaders apply social-psychology insights and methods to their work.²

Of note, the performance of diverse-owned asset management firms isn’t statistically different from the industry as a whole, according to a study conducted by Professor Josh Lerner of Harvard Business School, et al., and published by the Knight Foundation and Bella Research Group.³ This study also found that many strategies managed by diverse-owned firms performed in the top quartile of mutual funds, hedge funds, and private equity funds.

When building a portfolio across asset classes, some investors consider actively allocating capital to funds that invest in companies providing solutions to alleviate social disparities and help disadvantaged communities. This includes identifying products and services creating positive outcomes for communities of color in sectors such as health care, education, energy, affordable housing, and more.

For example, some investors support affordable housing and schools or provide access to lower cost clean energy in diverse communities through tax-exempt bond funds. In addition, some investors support companies creating products and services related to financial inclusion to help close the wealth gap or improve health-care outcomes for communities of color as part of an equity fund.

Investment funds that factor a holistic set of environmental, social, and corporate governance (ESG) considerations into their investment selection process often include racial-equity criteria. For example, as part of social considerations (the “S” in ESG), companies may be evaluated on whether they have diverse representation across employees, as well as policies that support attracting and retaining diverse employees, which can boost talent retention and drive innovation.

As some sustainability investors seek to reward companies with a more diverse workforce, research increasingly shows that this can potentially lead to materially positive financial outcomes. For example, companies in the top quartile for ethnic and cultural diversity on executive teams were, according to a leading consulting firm, 33% more likely to outperform the national industry financial benchmark. What’s more, the study found a persistent penalty for diversity laggards. Companies in the bottom quartile of diversity exhibited a 29% lower chance of beating the benchmark.⁴

Some sustainable investors have long acknowledged that most companies, even those performing better than their peers, have work to do in achieving balanced representation across race and ethnicity at all levels of their organizations. Sustainable and impact investment firms can also engage shareholders to foster more dialogue, activate proxy voting and file resolutions directly with the companies they own around racial-equity issues. Shareholder engagement can be an important tool to measure which managers in your portfolios actively engage with the companies they own to influence behavior over time.

For decades, some investors have been focused on avoiding companies that aren’t advancing racial equity. For example, in the 1980s and 1990s, socially responsible investors, including large religious institutions, used their capital to pressure companies to divest from operations in South Africa to protest apartheid.

Today, some investors seek to avoid companies engaged in sectors and industries that disproportionately impact communities of color—for example, the private prison industry or civilian weapons manufacturers. Some investors develop custom, separately managed accounts or apply overlay restriction screens on top of traditional investments to avoid these industries.

Racial-equity investing can be activated across both equity and fixed-income allocations. Morgan Stanley strategists believe that some investors will position their portfolios to take advantage of more emerging opportunities for racial-equity investing, supported by a better understanding of the business case.

The source of this article, “Advancing Racial Equity Through Your Investments,” was originally published on July 21, 2022.

Sources:

1. Josh Lerner, et al., “Knight Diversity of Asset Manager Research Series: Industry,” December 7, 2021, The Knight Foundation and Bella Private Markets.
2. “Race Influences Professional Investors’ Financial Judgments,” August 27, 2019, Proceedings of the National Academy of Sciences (PNAS).
3. “Knight Diversity of Asset Manager Research Series: Industry,” Josh Lerner, et al., the Knight Foundation and Bella Private Markets, December 7, 2021.
4. Sundiatu Dixon-Fyl e, Kevin Dolan, Vivian Hunt, and Sara Prince, “Diversity Wins: How Inclusion Matters,” McKinsey & Co., May 19, 2020.