Diversity Investing: Adding a “D” to ESG Investments

Most investors interested in environmental, social, and governance (ESG) investment factors generally look for vehicles that lean heavily toward improving the environment or promoting good corporate governance.

Social factors have generally been less of a focus for investors, but that seems to be changing. Protests over systemic racism are increasing investor interest in how companies interact with their communities, how they treat their employees, and the products and services they offer.

Some companies have changed the name of products, such as the Pepsi (PEP) Quaker Oats division, which has vowed to change the name of a popular pancake syrup that had racist origins. Other companies are putting money behind the social cause, like Target (TGT), which committed to spending $10 million to advance social justice through organizations such as the National Urban League and the African American Leadership Forum.

A big reason why ESG vehicles typically focus on the environment and governance is because of available data. There are quantifiable metrics around company actions related to energy efficiency or executive pay. There are far fewer metrics around social factors such as community relations and diversity investing.

Ethan Powell is founder of Impact Shares, which works with nonprofit partners to create exchange-traded funds (ETFs) that support those organizations. He pointed out that social factors are hard to quantify because they’re specific to companies and issues.

“Even if we agreed on metrics, it’s difficult to come up with a one-size-fits-all measurement,” Powell explained. “It’s really an art and a science. To me, it’s all about selecting the right artists.” In other words, finding companies that are the most effective in engaging with different constituents.

Just as investors traditionally review a company’s management, process, and philosophy when it comes to financial metrics, the same should apply to social and environmental outcomes. “Do we have the right people, process, and philosophy engaged to achieve what we are setting out to do?” Powell asked.

There’s continued and growing interest in ESG investing. Morningstar research for the first quarter of 2020 showed that flows from U.S. investors into open-end and exchange-traded sustainable funds reached $10.5 billion, above the last record set in 2019’s fourth quarter.

It’s More than Just Boardroom Diversity

According to Viraj Desai, senior portfolio manager at TD Ameritrade Investment Management, LLC, the governance factor has often looked to boardroom diversity as an example of good corporate governance. The racial diversity of a company’s board of directors is a place to start. “The way you get diverse ideas is by having diverse people,” he said.

To find companies that are making a difference, one can look beyond boardroom diversity. Many companies now allude to their corporate social responsibility in publicly available filings and documents listing their ESG accomplishments. A company’s financial statements, such as a 10-K filing, can also provide additional details on how the company is allocating its capital and whether investments are being directed in a socially responsible manner. These are paper trails that show how companies have evolved over time, including track records related to today’s issues of concern, such as diversity investing. Investors can also review public comments from top executives.

“If you’re researching Apple (AAPL), Tim Cook has a lot to say on a host of different issues,” Desai pointed out, referring to Apple’s CEO. “It gets a little more challenging when you get to the smaller companies.”

Doing the Social Research

Finding companies with racial diversity, a history of working with the communities they serve, and corporate policies that support Black, Indigenous, and People of Color (BIPOC) throughout their careers can be difficult because companies haven’t always been transparent with this information. For example, when hiring, companies can’t ask about a person’s racial background, although a person may self-identify as being BIPOC. 

Yet such things can change quickly. Gender diversity wasn’t measured as a social factor until recent years, but now more companies are transparent about how they invest in women. According to Powell, it’s possible that companies may start to release information about their efforts toward racial equality. Much of that news may not put companies in a favorable light initially.

“An obstacle to providing transparency is that people may not like the answers. But the problem is, you can’t start to work on it unless you understand the issue,” he said.

When it comes to individual companies, investors can look at a firm’s products and services, supply diversity programs, fair hiring and promotional practices, and other programs. For people who invest in mutual funds and ETFs, Morningstar and As You Sow are third-party organizations that rate funds on ESG factors, although racial diversity is not one of those factors—yet. Morningstar adds a low-carbon layer to its ESG research, while As You Sow has online tools to drill down on specific topics such as fossil fuels, gender diversity, and weapons.

Powell suggested that in the coming years technology may make it easier for everyday investors interested in specific topics in ESG to find data. He said there’s a lot of “cool stuff” being done with natural language processing and artificial intelligence to distill information from press releases, public filings, and even social media to bring needed transparency to these topics.

So for now, it may take a little more research by investors to find companies or investments that have a good track record when it comes to racial diversity. But looking for companies with strong policies of treating all stakeholders well, including employees, suppliers, and communities, can be a start.

“Ultimately,” Desai concluded, “investors need to remember why they’re investing. At the end of the day, it’s really about your wants and wishes.”