If you think that fairness and access to the broadest, deepest pool of talent are good reasons for a firm to promote diversity, you may feel better after aligning your money with your personal values. If you expect a diversity-tilted portfolio to outperform its benchmark, however, you could be disappointed. Believing that diversity is generally a positive force is not the same as knowing in advance whether more diverse firms will generate superior returns in the market. We acknowledge the difference at Aperio, and we believe this acknowledgment distinguishes us from both promoters of “diversity alpha” and naysayers who dismiss incorporating diversity data into portfolio decisions for any reason.

While debates about whether diversity or other environmental (E), social (S), and governance (G) characteristics will generate alpha have a long history, recently launched funds and exchange-traded funds (ETFs) that emphasize gender diversity have been accompanied by a growing body of literature and media headlines suggesting a positive link between gender diversity and financial performance. I encourage investors to view this appealing conclusion with skepticism.

Consider the widely cited McKinsey study "Diversity Matters."¹ Using data on global firms between 2010 and 2013, the study patiently and methodically correlates a standard diversity measure, the Hirschman-Herfindahl index,² to a firm’s financial performance.

Ironically, in its attempt to synthesize its results, the study highlights the precise reason why so many strategies that do well in back-tests flounder when they go live. Correlation can be a weak measure, even when, as McKinsey claims, it is "statistically significant and consistently present in the data."³ In the historical data set McKinsey looked at, companies that committed to diverse leadership had better financial performance, on average. This does not mean diversity led to better financial performance. Perhaps firms tended to diversify their leadership once their financial performance had improved. Or there could have been factors leading to both greater diversity and better financial performance, just as smoking leads to both yellow fingers and lung cancer. As the McKinsey study correctly points out, it can be difficult or even impossible to demonstrate cause-and-effect relationships with empirical studies, but cautious framing of results can help us to avoid overreach.⁴ McKinsey’s statement that the correlation between diversity and performance “indicates that companies that commit to diverse leadership are more successful” is misleading.

I confess that I realized only on a second reading that McKinsey used earnings before interest and tax (EBIT) to measure financial performance. I initially thought the study was meant to measure market return. Could the reason be that the article summarizing the results led with a short, impactful, imprecise sound bite: “New research makes it increasingly clear that companies with more diverse workforces perform better financially”? Perhaps it was because the figures mention “financial performance” in bold print, while the term  EBIT is less prominent. One of many standard accounting ratios, EBIT is used by some active managers and academics as a predictor of market returns. How well that works could be the subject of a future blogpost—I won’t get into that today. But EBIT is definitely not the same thing as market return. In any case, McKinsey’s sound bite went everywhere, including the Wikipedia Gender Diversity page, which I revised as I was writing this note.

Not every ESG study focuses on EBIT. A growing collection of ESG alpha studies coming from both academia and industry generate widely varying results, reflecting different time periods, different data sets, different benchmarks, and different research perspectives.

Market performance of three gender diversity funds (SHE: SPDR SSGA Gender Diversity Index ETF; WIL: Barclays Women in Leadership ETN; PXWIX: Pax Ellevate Global Women’s Index Fund) and their benchmarks (SPY: SPDR S&P 500 ETF Trust; IWV: iShares Russell 3000 ETF; URTH: iShares MSCI World ETF). Calculations used daily data over the period from July 17, 2017, to July 17, 2019. Source: Bloomberg.

Meanwhile, gender diversity funds have delivered mixed results over the past two years. The two US funds we looked at, SHE and WIL, underperformed their benchmarks by 0.7% and 2.7% per year, respectively. The global fund we considered, PXWIX, outperformed its benchmark by 1.5% per year. Admittedly, we are looking at a small number of investments, we did not systematically review all active gender diversity funds, and the two-year time period we considered is short. Things might change. Then again, they might not.

Will investing in gender diversity make you rich? Since tools and data that allow investors to align their portfolios with gender diversity and other personal values are growing in sophistication, the answer is yes if you feel you are richer after having increased your expressive utility. But it is prudent to view any promise of gender diversity alpha with skepticism.

Send questions or comments to  blog@aperiogroup.com.

¹  Results from the original McKinsey & Company study, “Diversity Matters,” published in February 2015, were announced in a brief, nontechnical summary, "Why Diversity Matters," published in January 2015. Both pieces were written by Vivian Hunt, Dennis Layton, and Sara Prince. In January 2018, McKinsey published a follow-up study, "Delivering through Diversity," which arrived at similar conclusions. The follow-up was written by Vivian Hunt, Sara Prince, Sundiatu Dixon-Fyle, and Lareina Yee.

²  The Hirschman-Herfindahl Index is defined here.

³  For an introduction to statistical significance, see en.wikipedia.org/wiki/Statistical_significance.

⁴  Please see Judea Pearl and Dana Mackenzie’s The Book of Why, and my review of it.