January 27, 2022

By Jay Chaudhuri

Last November, the Massachusetts Pension Reserves Investment Board (“MassPRIM”) approved $1 billion in investments for emerging and diverse managers over the next two years. MassPRIM’s announcement represented part of the fund’s broader $96 billion strategy to meet its FUTURE initiative, which seeks to substantially increase allocation to diverse and emerging managers to at least 20 percent of assets under management. The FUTURE initiative was created to help MassPRIM meet diversity goals originally established in a bill championed by Massachusetts State Treasurer Deborah Goldberg, who chairs MassPRIM. Treasurer Goldberg said that “by investing $1 billion into emerging-diverse program, [PRIM] is taking important steps in addressing the inequities endemic in the financial sector.”

Goldberg’s FUTURE initiative is the most recent example of public employee pension funds’ leadership and prioritization of diversity in investments. Efforts by public funds to diversify investment managers can be traced to early adopters like the New York Common Retirement Fund (“NYSCRF”), the California Public Employees Retirement System (“CalPERS”), and the California State Teachers’ Retirement System (“CalSTRS”). The emerging managers program established by the $248 billion NYSCRF in 1994 has $6.7 billion in commitments, for example.

Efforts by both public and private institutional investors to improve their records of hiring diverse asset managers appeared to gain new urgency following the nationwide protests over racial inequality sparked by the murder of George Floyd by a Minneapolis police officer.

In October 2020, Illinois State Treasurer Michael Frerichs led a national effort urging Russell 3000 companies to disclose racial, ethnic, and gender data about their board of directors. In September 2020, Connecticut State Treasurer Shawn Wooden partnered with the Ford Foundation to put together a coalition of CEOs “to advance social change, racial justice, and greater economic prosperity for all.”

On the private investment side, Vanguard said in December 2020 that it would vote against directors who do not push for more racial and gender diversity on their company’s boards. In December 2021, BlackRock, the world’s largest asset manager, announced that its 2022 proxy voting guidelines would push U.S. companies to “aspire to 30% diversity” on their boards of directors and encourage them to include least two women directors and at least one director from an underrepresented group on their boards. BlackRock defined underrepresented groups as those including “individuals who identify as Black or African American, Hispanic or Latinx, Asian, Native American or Alaska Native, or Native Hawaiian or Pacific Islander; individuals who identify as LGBTQ+; individuals with disabilities; and veterans.” That same month, Goldman Sachs updated its proxy policies to say it expected large corporations—those listed in the S&P 500 and FTSE 100—“to have at least one diverse director from an underrepresented ethnic minority group on their board” and all public companies with boards larger than 10 members to include at least two women directors. And in his 2022 letter to portfolio company boards, State Street Global Advisors (“SSGA”) CEO and President Cyrus Taraporevala reiterated SSGA’s “belief that strong, capable, independent boards exercising effective oversight are the linchpin to create long-term shareholder value.” Announcing an enhancement to State Street’s gender diversity policy, Taraporevala said SSGA was prepared to vote against board leaders if their companies did not have at least one female director by 2022 and 30 percent female representation in 2023. He also repeated SSGA’s pledge to expand its diversity focus to include race and ethnicity, pledging “voting action against responsible directors” of S&P 500 and FTSE 100 companies that do not have a “person of color” on their boards or failed to disclose information about their boards’ racial and ethnic makeups.

Despite the historical efforts by pension funds to diversify investment managers and the more recent developments of both public and private institutional investors to diversify company board of directors, however, some institutional investors remain reluctant to embrace the concept of diversity. The argument falls back to economist Milton Friedman who argued in a 1970 New York Times article that the social responsibility of businesses should focus on increasing profits, not “providing employment” or “eliminating discrimination.” More recently, The Wall Street Journal’s editorial board referred to such diversity initiatives as “virtue signaling at the expense of someone else.” In other words, they believe diversity falls outside an institutional investor’s fiduciary duty to maximize risk-adjusted returns for its beneficiaries.

Yet there are several strong arguments that pension funds can square their long and established pursuit of diversifying investment managers while meeting their fiduciary duties.

First, extensive research suggests that corporate diversity results in better financial performance. The Carlyle Group, a private equity manager, found a positive correlation between board diversity and profits among the companies it holds in its investment portfolio. The Carlyle Group’s study, which examined the last three years of financial results, showed that companies with at least two diverse directors out-earned less diverse companies by 12 percent per year on average. Using 2019 data, meanwhile, Global management firm McKinsey & Company (“McKinsey”) found that companies in the top quartile for racial and ethnic diversity on executive teams were 33 percent more likely to have above-average profitability than companies in the bottom quartile. Consulting firm FSG recently conducted a six-month study of 12 leading companies and found these companies generated new sources of growth and profit by advancing racial equity.

Second, evidence suggests that diversity creates better governance and informs better decision-making. Research indicates that diverse groups perform better than like-minded groups because such diversity results in more careful information processing that’s absent in homogenous groups.

Diversity has another benefit, too: diverse firms can help mitigate risk. Studies have found that diverse board of directors, particularly those with gender diversity, approve less financially risky policies than homogenous board of directors. Furthermore, diversity can help reduce litigation risks. In 2020 alone, the United States Equal Employment Commission secured $440 million from victims of discrimination. Such discrimination can also harm the reputation of a company or institutional investor.

Finally, public pension funds can factor diversity as part of their fiduciary duty. The most recent guidance comes from the U.S. Department of Labor’s October 2021 proposed rule on duties of prudence and loyalty for investments. In the Department’s proposed rule, fiduciaries may give “appropriate consideration” of environmental, social, and governance (“ESG”) factors for investments when carrying out a risk-return analysis. Specifically, the proposed rule cites workplace diversity and inclusion as an example of ESG factors. The Department’s proposed rule then cites 15 different studies in which diversity has a material impact on employee recruitment and return, performance and productivity, and litigation. Among the studies and reports cited are the McKinsey and FSG ones discussed above.

For years, some scholars and others adhered to the idea that increasing diversity doesn’t meet fiduciary standards because it sacrifices beneficiaries’ financial interests in the name of a purely “social” goal. However, public pension funds like NYSCRF, CalPERS, and CalSTRS have long demonstrated the opposite: that institutional investors with more diverse staff, boards, and investment managers can make more money over the long term. As the country grapples with continuing gaps in opportunity for underrepresented populations, the need for diversity seems even more evident. As most recently demonstrated by MassPRIM’s FUTURE initiative, a well-designed program that considers diversity no longer raises any real fiduciary questions. Those questions have been answered by the Department of Labor’s proposed rules and associated studies. Now, the real question becomes whether more institutional investors will follow the lead of these public pension funds.