Alpha Wounds: A Lack of Diversity in the Human Resources Portfolio

For the last several months, I have discussed reasons why active investment managers underperform their passive investment manager competition. Alpha wounds discussed so far include navigating toward benchmarks instead of away from them — shame on you active managers! — and the use of inappropriate measures of success – shame on you investment industry adjuncts! This month I turn to a problem hiding in plain sight: the lack of diversity in the human resources portfolio of active managers.

The Importance of Diversification

What is one of the absolute hallmarks of good investment management regardless of whether you are an active or passive manager? Diversification. How important is diversification to investment management? Let’s check in with several sources, shall we?

From Investopedia, in the article “The Importance of Diversification“:

. . . diversification is the most important component of reaching long-range financial goals while minimizing risk.

Wow! Perhaps the author of that article is being too enthusiastic. What does a less sanguine source of investment wisdom, the US Securities and Exchange Commission (SEC), say about diversification?

The Magic of Diversification. The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.

That bolded emphasis on “The Magic of Diversification” comes from a deadly serious regulator. Perhaps there is something to diversification in managing portfolios for success. So it is imperative that investment managers diversify across all of their assets if they want to have “the most important component” and “the magic.” Since the “active” in active investment management comes from human minds doing the analysis and making the investment decisions, these are clearly the most important assets at such firms. But what do we find?

Instead of human resources portfolio diversification, we find bland sameness and concentration. Chances are that the manager at an active mutual fund is a Caucasian male, educated in finance at one of a handful of elite global institutions, by a not much larger group of elite professors, and with an equally narrow point of view about how to perceive the world. In other words, at active investment management houses, their most important asset is not diversified at all. Want proof?

No Gender Diversification

My colleagues at Morningstar here in the United States publish a report each year about gender diversity in investment management. Here is a sample of what they found recently:

• Less than 10% of all US fund managers are women.
• Women exclusively run roughly 2% of the industry’s assets and open-end funds.

In response to the lack of gender diversity in asset management, a partner at Heidrick & Struggles, an asset management headhunter, said in the Financial Times, “It is almost indisputable that having diversity of thought within any business — particularly when you are [trading securities] or putting together a portfolio — is critical to ensuring you are aware of any biases.”

No Racial Diversification

Sadly, there is very little formal data about the number of non-Caucasians in investment management. One source, again here in the United States (sorry to my non-US readers), is the gigantic pensions manager, CalSTRS, which publishes an annual Diversity in the Management of Investments report. The manager says specifically, “Diversity in the management of investments is interwoven in the investment business goals and is consistent with the objective of investing to enhance the returns at a prudent level of risk, in accordance with CalSTRS Investment Policies . . .”

Now I must rely on an anecdote from my own career to provide a data point in the conversation. I attended a Bank of America technology conference in 2001 to hear Michael Dell give a speech. In the hotel ballroom with me were 1,013 other investment professionals. Of the 1,014 attendees, 18 were nonwhite or females. Next time you go to a conference, do your own count. I am confident that you will find a shocking lack of diversity in your audience, either by gender (see above), or race. Or, if you prefer another measure to race, what about national origin?

No Educational Diversification

Investment management firms rarely (or never) confess their susceptibility to the subjectivity of groupthink. Yet, objectively measured investment returns tell a different story. Again, we see bland sameness in results. We see a clustering around investment category benchmarks. Could it be that this is because many in the investment management business went to a limited number of elite business schools, and were educated by a small number of the same professors, who by their limited numbers are also therefore teaching a limited number of ideas?

A report by eVestment tells the story of the lack of educational diversification in the asset management industry. An indicative quote: “The following report investigates the strength of school networks within the industry, where they are most concentrated, and how networks compare to each other.” Of course, the context of the eVestment report is entirely different: They believe such concentration suggests a great place for prospective asset management pros and asset management firms to converge. The top 15 schools (and likely sources of groupthink) are:

1. University of Pennsylvania
2. Harvard University
3. Columbia University
4. University of Chicago
5. New York University
6. Stanford University
7. Northwestern University
8. University of California – Los Angeles
9. University of California – Berkeley
10. Boston College
11. Cornell University
12. Massachusetts Institute of Technology
13. University of Michigan – Ann Arbor
14. University of Virginia
15. Yale University

Sample size was over 35,000 asset management employees educated at more than 900 universities. So the average number of alumni at each asset management firm should have been 39, or 0.1%, per school if there was even distribution (and I am not arguing for an even distribution). So the top five institutions described above are not responsible for 0.5% of employees in the asset management industry. Instead they are responsible for a whopping 13%. While the top 10 schools represent 19%, and the top 15 schools represent 24% of all asset management firm investment decision makers. I call this concentration, not diversification.

There are some good reasons for hiring candidates from a list of elite schools. Primarily a degree from an elite school is a form of underwriting or risk-mitigation on the part of the firm doing the hiring. Top schools presumably attract top talent that are intelligent and hard-working. Yet, there are two critical assumptions for this to be true: First, that these schools do, in fact, have outstanding recruitment policies in place on the front end, such that you need not engage in as much due diligence in your recruitment on the back end. Second, that your firm’s asset management recruitment tactics are enough. Remember the irritating detail of those underwhelming asset management returns data!

Again, from my own career, an anecdote: An older important person at the firm I used to rent my services to once told a younger important person at the firm, in an attempt at passing on words of wisdom, “Never hire anyone who went to school west of the Mississippi River.” I hold up my returns adjusted by risk over the course of my portfolio management career as evidence of the sheer folly of such a statement. However, it is indicative of a faith in the Ivy League and other elite institutions that seems unwarranted given our industry’s poor results.

Flipping the Argument on Its Head

So maybe you disagree that diversity all by itself is a panacea? No problem. Let’s flip the argument on its head then. Would you as a portfolio manager concentrate your portfolio in just one to 15 assets? Probably not, unless you knew you had a world-class analytical system in place to give you near certainty in your confidence level. Do you really trust your recruitment practices that much?

Remedies

I am engaged in this discussion because I hope to foster thoughtful reflection and conversation. Here are some suggested remedies to the problems caused by a lack of diversity in human resources portfolios:

• Invest time, energy, and mental capital in developing better recruitment practices designed to uncover quality investors — no matter their gender, race, or lack of an elite educational background.
• People living in glass houses should not throw rocks. So let me acknowledge that the CFA program is specifically designed to mint people with competency in the same set of knowledge. The solution to this problem, if you believe it is a problem, is not to abandon institutions and the knowledge that they pass on, but to design recruitment practices that uncover unique individuals with unique ways of seeing, interpreting, and understanding the world.
• Take a portfolio approach to your human resources portfolio. An investment in 10 utility stocks does not create diversity in a portfolio. Instead, savvy investors look to increase returns by minimizing autocorrelation, covariance, and so forth. Do the same with the people on your staff.
• If you can only imagine recruiting from the same elite schools, then encourage them to increase the diversity of their own recruitment practices on the front end.
• Recruit in a double-blind fashion. That is, have someone at your recruitment firm or in your human resources department redact names (gender), origin (race), and institutional names from the cover letters and resumes you review. Are you really assessing based on merits? Or are you relying on mental shortcuts to do your hiring?

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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