Hugh Smith, CFA, MBA, works in the financial and risk unit of Thomson Reuters and specializes in wealth and asset management.
It is generally agreed, and bemoaned, that the vast majority of traditional mutual-fund managers fail to outperform their respective benchmarks after fees. The past decade has seen a huge rise in quant funds that 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 there is a simpler answer, and one you wouldn’t find on a company’s balance sheet.
The Thomson Reuters Diversity & Inclusion Index is a simple, market-cap weighted index of the 100 companies globally with the highest Thomson Reuters Diversity and Inclusion Score, which comprises four pillars – diversity, inclusion, people development and reported controversies related to these values. The Diversity pillar is made up of gender and cultural diversity metrics at the board, executive and work-force level, while the Inclusion pillar considers whether companies provide things such as flexible working hours and daycare service, and the percentage of employees with disabilities or special needs.
The index does not consider any financial-related metrics, yet it has outperformed the global stock market (measured by the Thomson Reuters Global Total Return Index) over three and five years on both an absolute basis (annualized return of 14 per cent versus 12 per cent for the benchmark, and 12 per cent versus 10 per cent for the benchmark, respectively) and risk-adjusted basis (annualized Sharpe ratio of 1.34 versus 1.17 and 1.08 versus 0.99, respectively).
Furthermore, the outperformance is consistent, with the index beating the broad market every year from 2013 through 2017. It appears, maybe not surprisingly, that a company with a strong culture of diversity and inclusion, which develops its people and avoids controversies, is a sign of strong management – which leads to stocks that perform well on a long-term basis.
One criticism of environmental, social and governance (ESG) oriented investment strategies is that there are inherent biases against certain countries or sectors that could limit portfolio diversification. For example, a low-carbon strategy would obviously be lighter on fossil-fuel companies than the broad market. Notably, this doesn’t appear to be the case when the diversity and inclusion metrics are used. The oil and gas industry is represented (including Enbridge Inc.), and industrials make up 7 per cent of the Thomson Reuters D&I Index.
From a country perspective, only one country – Switzerland – has a weight in the index that is more than 5-per-cent over or under its weight in the MSCI All Country World Index (ACWI). In general, European countries tend to outperform while their Asian counterparts lag. The top three countries (measured 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-per-cent overweight while the United States is 3-per-cent underweight.
The outperformance of the index might be partially explained by diversity in the work force leading to diversity of thought ultimately leading to stock performance, especially in industries such as health care and technology that are very intellectual-property-intensive and innovation-driven. A recent Goldman Sachs study found that, in terms of the percentage of female employees, over three years the top 40 per cent of companies outperformed the bottom 40 per cent by 11.7 per cent and 9.5 per cent for medical technology and pharmaceutical companies, respectively.
The top company globally is Accenture, incorporated 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 Canadian company is Bank of Montreal, which scores particularly well on the Inclusion pillar. BMO provides flexible working hours, daycare services and programs around HIV/AIDS linked with GBC Health – an organization of companies working to maximize their impact in the fight against the disease.
The paradigm of responsible investing is changing. The classic question has been, “Will investors sacrifice returns in order to invest more in line with their values?" It appears that not only is the answer no, but in fact the opposite may be true. If the past five 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?”
There’s an exchange-traded fund for this index – the recently launched iShares Thomson Reuters Inclusion & Diversity ETF (ticker symbol OPEN) – listed on the London Stock Exchange.
Editor’s note: An earlier version of this article said Accenture's headquarters are in Dublin. They are incorporated in Ireland. This version has been corrected.