ImpactAlpha, August 13 – It’s not a pipeline problem.
Of the $69.1 trillion in assets managed by mutual funds, hedge funds, real estate and private equity funds, less than 1.3% is managed firms owned by women or people of color.
Investors inside pension funds, endowments, foundations and sovereign funds have long explained the industry’s lack of racial and gender diversity by saying there simply are not enough high-quality fund managers from historically disadvantaged groups. That has led to any number of “emerging managers” initiatives to stock the pipeline.
A new study of how investors evaluate funds and allocate capital suggests a more persistent and systemic explanation for the homogeneity of the investment managers selected by such asset allocators: implicit racial bias.
The capper in the new data: It is the highest-performing managers of color, not the lowest, that are most harmed by racial bias. Experiments involving 180 asset allocators found a clear bias against funds led by high performing Black males, even when all other aspects of the hypothetical funds are identical – and the discrepancy was more pronounced among the best-performing funds.
“We put to sleep forever in this paper the idea that it’s only a pipeline problem,” says Illumen Capital’s Daryn Dodson, who co-authored “Race influences professional investors’ financial judgment” with Stanford SPARQ. Illumen, based in Oakland, is an impact investing fund of funds with specific strategies for overcoming racial bias among fund managers. SPARQ is a Stanford “do tank” that investigates disparities in criminal justice, economic mobility, education, and health.
The study provides evidence for a phenomena that many investment professionals have long suspected. The biases of asset allocators, Dodson says, “inhibit them from seeing the value of the investments because of the person presenting the opportunity to them.”
The study used a form of “paired testing” that has long been used to identify racial bias in housing. Researchers recruited asset allocators to participate by challenging them to compete with an artificial intelligence-based algorithm in the manager selection process. In reality, the researchers were testing for the presence of bias.
Researchers presented asset allocators with one-page summaries of prospective fund managers’ team credentials, track record from previous funds, and investment strategies. The researchers varied the one-pagers in only two ways: quality of the fund manager and race of the managing partner, Black or White.
The results signal asset allocators have trouble gauging the relationship between competence and performance of racially diverse teams. The gap was strongest among higher-performing funds. Among identical high-performing funds, asset allocators rated those led by White managers more favorably than those led by Black managers. In looking for high performance, allocators “may fall back on pattern-matching strategies and mitigate risk by sticking with familiar options,” and continue to invest in White and male-led teams, say the researchers.
Put another way, having a strong track record is inconsistent with stereotypes about funds owned by people of color. Lower-performing funds led by people of color may not challenge such stereotypes and, in effect, may get a pass.
Among the weaker performers, the allocators actually preferred the Black-led teams. This, say the researchers, may suggest either allocators were penalizing low-performing teams led by White males – who are stereotyped as competent – or took moral comfort in giving higher ratings to lower-performing Black-led teams.
The study found that implicit racial bias is pervasive enough that investors inside pension funds, endowments, foundations and sovereign funds may be violating their fiduciary duties by underinvesting in high-performing funds led by people of color. The effects of allocation decisions are felt all along the chain of investing, and throughout society.
That cognitive biases can lead to suboptimal business and policy decision making is not new (see, Thinking Fast and Slow by Nobel Laureate Daniel Kahneman). But to date, there’s been no systematic investigation of specific racial biases in investment decision making.
The study suggests that by systematically undervaluing racially diverse high performers, asset allocators may be exposing their portfolios to uncompensated risk and leaving returns on the table.
Companies concentrating on racial equity have created new business value and improved their bottom line, Prudential Financial’s Lata Reddy said in a statement. Black and Latino Americans represent nearly $3 trillion in combined purchasing power. The study highlights “the tangible business value represented by diverse teams, which, when left unrecognized, leaves profit and opportunity on the table,” she added. Prudential was the study’s lead sponsor.
By not properly valuing people of color, big asset allocators are limiting the available universe of funds and managers, said Ashby Monk, who heads the Global Projects Center at Stanford and helped design the study. “Which means, you’re limiting your ability to generate high risk-adjusted returns.”
Nobody is going to look at the results of the study and say, “This bias is delivering us some meaningful alpha,” says Monk. “No. Everybody’s going to say, ‘this bias is limiting our ability to access the entire market and assess it properly.’”
Monk says asset allocators, as part of their fiduciary obligation, should use this type of finding to say, “are we doing this? Because if we’re going this then we’re not getting the full return potential of our investments.”
“We’re living in a society where we’re absorbing images and ideas all the time that influence who we are and how we see the world, even when we’re not aware of it,” said Dr. Jennifer Eberhardt, who led the Stanford SPARQ research team and chronicles the pervasiveness of racial bias in America in Baised.
Illumen and SPARQ are still exploring how exactly to reduce bias in investing. Monk says the investment industry needs the same type of process changes underway in corporate hiring practices, university admissions and other industries.
Dodson’s Illumen has put bias reduction at the center of its investment thesis. Illumen invests in White or Black fund managers targeting financial inclusion, education, health and wellness and cleantech and sustainability. Dodson then works with the managers to reduce racial bias over 10 years in key decision-making areas: investment processes, hiring and promotion practices and board construction of the underlying fund portfolio companies.
“Impact investors have spent R&D on lots of things in the sector – to build tools for impact measurement frameworks or strategies to unlock the greatest financial contributions to solve the hardest problems of our time,” says Dodson. “One of those problems that was underinvested in and was ripe for creating the largest impact, was this seemingly unnatural occurrence (of homogeneity) within the financial markets.”
Many institutional investors, if they have a solution at all, still focus on the pipeline problem. Ford and Knight Foundations have dedicated a portion of their endowments for diverse fund managers. Kellogg Foundation’s mission-investing strategy intentionally backs fund managers of color and seeks investments that systematically reduce bias in the financial system. Kellogg and Prudential have carve outs for first-time and emerging minority and women-owned investment firms.
The results of the Illumen/SPARQ study suggests such programs aren’t sufficient to boost diversity in investing. Even if a first-time managers get a boost, bias seems to increase as managers of color achieve stronger credentials.
Kellogg has sponsored a separate report, “It’s About Time: A Call to Advance Racial Equity in the Investment Industry,” from Confluence Philanthropy. The report suggests four high-level actions including clear commitments to institutional learning and change, mandates and data to increase transparency and fostering new connections.
“Racial equality is linked to commercial performance,” says Stanford’s Monk. “If we can get these investors to consider people on equal footing, then we’re going to see more people of color being funded and having capital allocated to them.”