Numerous studies have demonstrated the benefits of diverse management for companies. Teams comprised of people from different backgrounds are better at avoiding group-think and more likely to remain objective and challenge each other.
The financial world, however, is not known for its diversity. “[I]t is not uncommon for investment firms to be staffed by portfolio managers who attended the same university, worked at the same investment bank, or originate from the same country,” a recent academic paper found. And the authors said anecdotal evidence suggests portfolio managers prefer colleagues from similar backgrounds.
The authors also showed what the lack of diversity means for those firms’ clients. The study of hedge funds found that fund management teams with heterogeneous backgrounds outperformed homogeneous teams by 3.59% to 6.23% on an annual basis after adjusting for risk.
Diversity presents several benefits to investment management teams. (For the purposes of the study, diversity referred to managers’ educational background, work experience and nationality.) Diverse teams “harness a wider range of investment opportunities,” which contributes to more persistent performance. They’re also more prudent risk managers, delivering returns with smaller maximum monthly losses and shallower maximum drawdowns. And they report fewer suspicious returns that may be indicative of misreporting or fraud.
“These results are consistent with the view that the members of a diverse team, by serving as effective checks and balances for each other, help curb idiosyncratic and errant behavior,” the authors wrote.
Diverse teams are also better at avoiding behavioural biases that hurt investment performance. Working with colleagues from different backgrounds can make managers more aware of entrenched ways of thinking. The authors found diverse teams are less prone to excessive trading driven by overconfidence and less likely to favour lottery stocks. They’re also less prone to the disposition effect: the tendency to sell too early when assets have increased in value while holding onto declining assets.
Investment managers — take note.
“Diverse Hedge Funds” by Yan Lu (University of Central Florida), Narayan Naik (London Business School) and Melvyn Teo (Singapore Management University) was published in February on the SSRN network