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Diversity can pay — but women aren't 'pixie dust'

Investors hoping to beat the market by focusing on diversity need to dig deeper than a simple metric such as the number of women on a board.

When combined with the right leadership or deployed under certain conditions, diversity is strongly correlated with improved profits. But the empirical, peer-reviewed research tells a nuanced narrative about the relation between diversity and market returns.

Millions of dollars are pouring into investment products that incorporate environmental, social and governance, or ESG, factors. ESG includes everything from climate change to compensation to board composition, and evidence shows that U.S. investors are paying increasing attention to ESG or sustainable investing.

Gender diversity has been a big part of the broader ESG conversation. One of the most prominent studies on board diversity and financial performance was published by consulting firm McKinsey & Co. in 2015. It found that women on boards increased a company's likelihood to post above-average financial returns by 15%; racial diversity on boards translated to a 35% greater chance.

Oft-cited studies from Catalyst, a nonprofit focused on gender equality in the workplace, and Credit Suisse produced similar findings: The Catalyst study from 2004 found that companies with the most women produced higher financial metrics such as return on equity. And the Credit Suisse study from 2014 found that companies with more women in senior roles delivered higher stock market returns.

Companies are using these studies to market products designed to meet the growing demand for ESG-friendly investment strategies. State Street Global Advisors Inc., for example, discusses the McKinsey study in promotional materials for its much-publicized gender diversity index exchange-trade fund. Launched in March 2016, the 'SHE' ETF had about $364 million in assets under management at Nov. 30.

But academics who have studied the impacts of diversity warn against oversimplifying the issue.

"I find it a bit surprising that firms putting forward these reports would think women are like this pixie dust that you can just throw into a board and say, 'Ah, now we'll do better,'" said Corinne Post, an associate professor of management at Lehigh University. Post and Kris Byron, a Georgia State University professor, conducted a meta-analysis of 140 academic studies that have explored the question of gender diversity and financial performance. A meta-analysis combines the findings of many studies to produce a more robust finding of whether a particular relationship exists.

The study finds female board representation tends to correlate with higher profits but better equity performance can depend on the situation. Female board representation tended to lead to better stock returns in countries that already have strong gender parity, such as Norway or Sweden. And diverse companies' stock returns were stronger in countries with strong shareholder protections such as the legal right to sue board directors for failing to fulfill fiduciary responsibilities.

"It's very consistent with other small group research that suggests the effects of diversity are basically: It depends. If you have a context that is supportive of diversity, you're going to have more positive effects," Byron said. "If you have a woman on the board but then you don't pay a lick of attention to her, you don't think she's legitimate, I don't think she's going to have that much of an influence."

Several academic studies that examine the impacts of a broader ESG focus on performance reach a similar "it depends" conclusion.

A study by Harvard University researchers used a matrix of ESG factors established by the Sustainability Accounting Standards Board, a nonprofit that pushes for standardized ESG disclosures. SASB has established a number of sustainability factors, such as diversity or biodiversity impact, and classified each factor as material or immaterial depending on industry. For example, a company's water management policy would be material for an energy company but not for a bank.

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The researchers — Mozaffar Khan, George Serafeim and Aaron Yoon — found that companies performed best when focusing on material factors. If a company was highly invested in all sustainability factors, its stock returns beat the market average by 1.50% on an annualized basis. However, if the company was highly invested in material factors but not in immaterial factors, it did even better, beating the market by a whopping 4.83%.

By elevating material factors and de-emphasizing immaterial factors, the paper echoes the Post-Byron study: ESG can beat the market, but a focused approach performs best. Per SASB, "diversity and inclusion" is just one of many factors and is immaterial for certain industries, such as healthcare and transportation.

The study's authors say that does not mean healthcare companies should be less diverse. Rather, it suggests diversity may be less of a priority for healthcare companies trying to maximize shareholder value.

"You cannot be everything to everybody, and you cannot do everything perfectly," Serafeim said. "You need to have a strategy. You need to have a plan and in order to be able to execute on your strategy, you need to pick the investments you're willing to make and really concentrate on them."

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A couple of international studies further underline how ESG investing success requires the right context. A meta-analysis co-authored by a Deutsche Asset Management fund manager and professors from Hamburg University in Germany found ESG investing was most successful in emerging markets. The analysis showed 65% of ESG-investing studies for emerging markets between 1970 and 2014 showed a positive relationship between ESG values and performance: The meta-analysis included studies that focused on corporate profits as well as ones focused on equity performance. By contrast, studies in Europe's developed economies were only 26% positive.

The meta-analysis also found that studies focused on individual companies that prioritized ESG tended to be more positive than studies examining portfolios focused on ESG. Gunnar Friede, the senior fund manager for Deutsche, said portfolio management fees sapped some of the performance and ESG portfolios tended to overlap the broader market.

Another meta-analysis on ESG funds' market performance was more skeptical. Co-authored by European professors Christophe Revelli and Jean-Laurent Viviani, it examined 120 studies that looked at the performance of ESG funds. The study found a slight positive correlation but could not rule out the possibility of zero or negative correlation.

"Our conclusion states, finally, that there is no real difference of performance between [ESG] and mainstream investment," Revelli wrote in an email. But Revelli added that an ESG focus can help fund managers identify potential opportunities.

Revelli's research echoes that of other academics. There is alpha to be found when using ESG, but investors and fund managers need to go beyond merely identifying ESG-focused companies: Is the ESG focus relevant for the company's core mission? Are diverse opinions being heard, or is the company's diversity commitment a form of tokenism?

"Diversity is work, hard work," said Alice Eagly, a psychology professor at Northwestern University who has studied diversity and feminist theory. "People have to re-learn some of the aspects of social interaction. You have to learn how to include [diverse employees] in a positive way, and it takes a lot of special conditions so that creativity can flow from diversity. … You can't just pour in some women and profits soar."