Legal challenges over diversity in investment portfolios and across the asset management industry created an impasse last month when an appeals court decision stopped a venture capital firm’s grant program for Black women entrepreneurs while Edward Blum’s American Alliance for Equal Rights’ case against Fearless Fund, which claims that the grant program for Black women entrepreneurs is discriminatory, proceeds.
At the same time that this and other legal challenges heighten the risk and cost of pursuing diversity and inclusion, organizations should not be too hasty to forgo the benefits of diversity and inclusion or abandon missions for which racial justice or diversity and inclusion are core.
It appears possible to continue to pursue diversity in institutional investment portfolios by broadening the range of types of diversity factored into sourcing and underwriting investments, being intentional, and adopting a genuinely open mind. Before detailing two approaches to do this, let’s first discuss the impact of the Fearless Fund ruling.
The Fearless Fund Ruling and Why it Matters
The Appeals Court for the Eleventh Circuit’s June 3rd decision marked a significant extension of the concepts established in Students for Fair Admissions v. Harvard and Students for Fair Admissions v. University of North Carolina, shifting legal skepticism of DEI and affirmative action programs beyond the college admissions process and onto the activity of private firms and private transactions. As Simpson Thacher explained in a recent memo, “While many similar lawsuits challenging corporate programs at companies like Amazon, Pfizer, Progressive Insurance and Starbucks have been dismissed, groups continue to file suit against corporate programs—and now may have greater leeway to do so given the anonymity under which one can file and maintain standing.”
The court decided that the grant at issue was a “contract” in part because the Fearless Fund described it as a contract in the initial version of the application. Word choice matters! With respect to charitable programs specifically, the ruling suggests that programs adhering more closely to “grants,” may be more likely to escape similar scrutiny.
The court held that the program does not meet the test for the exception for “remedial programs” that address racial imbalances because it creates an absolute bar to entry, in that only Black women may apply for grants under the program. It looks like absolute bars to entry are legally risky.
While First Amendment protections may cover certain speech that entails discriminatory statements, the act of discrimination is not so covered. The court saw the Fearless Fund as engaging in discrimination, not advocating for discrimination.
Approach One: Source and Consider Managers With a Wider Range of Dimensions of Diversity
Widening the range of facets of diversity in institutional investment portfolios should provide limited partners with more ways to win in ever-changing markets. It also reduces the likelihood that pursuing diversity can be construed as discriminatory.
With only 1.4% of assets in the $82 trillion US asset management industry entrusted to asset managers owned by women and/or people of color, despite diverse-owned firms’ investment performance matching those of their less-diverse peers, no one institution can address systemic bias on its own.
Accordingly, Institutional Allocators for Diversity Equity and Inclusion (IADEI), a consortium of over 800 institutional asset allocators that seeks to drive performance through broader representation within investment portfolios and teams across the investment management industry, started as do-it-yourself collaboration among endowments and foundations and quickly became the go-to place for limited partners (LPs) to access diverse managers. More specifically, the IADEI database is the largest open-source database of diverse-owned and diverse-led managers with over 1300 managers: it is free for LPs and diverse managers alike.
This week, IADEI is rolling out new diversity metrics in the IADEI Manager Database, driven by limited partner members’ calls for greater transparency and its interpretation of the implications of the Fearless Fund Decision. In particular, IADEI has revamped the database to allow firms to report additional diversity metrics and add custom metrics as well. Said differently, IADEI no longer defines all of the dimensions of diversity, and asset managers have the opportunity to widen the range of facets of diversity that LPs review and consider. This should allow institutional allocators to more precisely build diversity of thought into their investment portfolios.
Firms that provide data on race/ethnicity and gender, for both company-level economics and fund-level leadership, will earn a DEI badge. This badge signals a high level of transparency and commitment to diversity, enhancing the visibility and attractiveness of these firms to investors. It also makes the database more efficient to use for institutional allocators who are primarily focused on racial/ethnic and gender diversity
Approach Two: Underwrite Across a Wider Range of Dimensions of Diversity
By underwriting across more than twenty dimensions of diversity, the W.K. Kellogg Foundation has gained greater exposure to a wide range of underrepresented managers. This approach has resulted in more ways to win from an investment perspective, while also producing high racial/ethnic and gender diversity for its peer group.
The W.K. Kellogg Foundation uses an expansive definition of diversity that includes factors such as investment style, geography, sector, implementation method, and time horizon, in addition to collecting information about race/ethnicity and gender. The foundation’s broad definition of diversity is an intentional effort to capture the myriad ways that people can experience the world differently. For example, just as a woman and a man may experience a dimension of the same world differently due to differences in gender, a value investor may experience the same market environment differently from a momentum investor because of differences in investment style. One experience is not better than the other, but some factors tend to be underrepresented in institutional portfolios, and the W.K. Kellogg Foundation found that better balancing these factors improved investment returns.
The W.K. Kellogg Foundation’s investment staff also works to reduce their own unwarranted investment biases with each factor. This involves being open to embracing ways of thinking that are diametrically opposed to “how you were raised” as an investor. Reginald Sanders, Managing Director of Hedge Funds and Fixed Income at W.K. Kellogg Foundation, explains, “It took me years to get as comfortable with quant investing as I was with fundamental investing, because I was first taught to be a fundamental investor. However, overcoming this mental hurdle led us to make quant investments that has consistently paid off materially in market environments when fundamental investing has struggled. Doing this work on multiple factor dimensions has not only led to a more diverse portfolio, but a better performing portfolio.”
With respect to external work with others, it starts with the diversity of the Kellogg Foundation’s investment team. Given that every person has dimensions of diversity that cannot be changed (race/ethnicity, place or origin, college attended, undergraduate major, native language, inter alia), team members intentionally seek inputs that can reduce blind spots to unwarranted biases. Considering this broader range of factors can better achieve cognitive diversity with lower risk of being construed as engaging in discrimination.
By implementing this approach, the W.K. Kellogg Foundation has higher exposure to quantitative and momentum strategies than its peers, approximately 35% of its U.S. exposure being allocated to firms that are majority owned by women and people of color, and—most importantly—returns that reflect the benefits of this strategy.
Twin Approaches
For organizations where the benefits of diversity and inclusion are tangible or racial justice or DEI is fundamental to their missions, mitigating the risk of DEI-related litigation may come at the cost of violating fiduciary duty or duty to their missions. It should come as no surprise that the data shows that many organizations are making conscious moves to stay the course on their DEI initiatives, even doubling down, while navigating the headwinds of the current climate.
To better source diverse managers with a wider range of dimensions of diversity and underwrite equitably across a wider range of dimensions of diversity, institutional allocators may wish to access diverse managers and review a wider range of dimensions of diversity through the IADEI database, and learn more about the components of the W.K. Kellogg Foundation’s innovative approach to underwriting equitably. Navigating this fine balance remains a space to watch.
Note: None of this should be construed as legal advice. Bhakti Mirchandani is a co-founder, along with Rob Rahbari, Stephanie Westen, and Sophia Tsai of Institutional Allocators for Diversity, Equity, and Inclusion—a pro bono effort for which no one receives any compensation.
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