By Mitchell M. Merin May 2, 2023
There is a growing global movement toward greater consideration of environmental, social and governance factors in investing. As a result, mutual funds with responsible investment strategies, where investors actively seek out companies making positive contributions in these areas, have seen significant inflows over the past several years, with global ESG assets hitting $2.5 trillion at the end of 2022, according to Morningstar.
However, skeptics argue that ESG considerations are too subjective and difficult to define, leading to confusion and inconsistency in investment decisions. Moreover, they say, such considerations are secondary to the primary goal of generating financial returns for investors. This debate has morphed into a national political controversy dubbed the “ESG War.”
Recognizing the swirling tensions, The Harvard Law School Forum on Corporate Governance recently told boards to prepare for tough questions on ESG and recommended taking only those actions that promote and advance good governance.
Diversity is a primary social factor at the heart of good governance, enabling teams to collaborate, solve problems, make decisions, and deliver clients better investment results and solutions. In my opinion, the critical importance of promoting diversity should not be subject to debate.
It is time to develop a structured and data-driven review of advisor diversity efforts at both the fund and firm level and consider including this review as a component of the 15(c) process. Given that the board is required by the Supreme Court’s Gartenberg decision to review the nature, extent and quality of services the advisor provides, it makes good sense to recognize diversity as a critical element of 15(c).
Doing so would prepare for regulatory scrutiny. The Securities and Exchange Commission is focused on the importance of diversity and the lack of diversity in certain aspects of the industry, sending clear signals that fund boards should consider re-examining their approach to governance of this area.
In 2019, the SEC created the Asset Management Advisory Committee to provide varied perspectives on asset management and make policy recommendations. The committee, composed of a diverse group of well-regarded senior asset management industry executives, lawyers and academics, released a report summarizing its findings in 2021.
The committee was unambiguous in its conclusion that women and people of color “remain dramatically underrepresented (by all objective measures) at the board and senior management levels in asset management firms and fund complexes. This severe underrepresentation also extends to general employment in the industry.”
Additionally, the committee concluded that there was clear evidence that investment performance by diverse asset managers is equal to or better than that of firms that lack diversity in ownership and senior leadership despite differences in size and length of track records.
The committee stated that artificial barriers had been constructed that directly and indirectly excluded people of color and women of any color from the opportunity to compete and cited peer-reviewed academic research that indicated that diversity and life experience are additive to investment performance.
In its spring 2022 rulemaking agenda, the SEC moved to implement the committee’s recommendations for enhanced transparency and disclosure in filings by fund boards and investment advisors on issues of gender and racial diversity. In addition, in March of this year, SEC investment management division director William Birdthistle discussed the importance of improved reporting of diversity data by regulated entities in his remarks at the ICI Asset Management Conference.
Separately, the SEC’s Division of Investment Management has sent document requests to fund complexes seeking a vast amount of information regarding fund boards’ 15(c) process. As a result, several of the major ’40 Act law firms then published updates to their clients, suggesting that industry participants take a fresh look at their 15(c) process and make sure that, among other things, they thoroughly evaluate Gartenberg factors. Additionally, the SEC reiterated this area of focus in its 2023 investment management exam and enforcement agenda.
Past practice by the SEC would indicate that fund directors will be required to take on increased responsibility regarding diversity disclosures, reports and analyses and review of 15(c) processes as new rules are implemented.
Fortunately, there is a wealth of data for the metrics selected for quantitative analysis and to allow for the development of peer groups and comparisons. Morningstar, for example, has gathered and reported gender data on mutual fund portfolio management teams since 2015.
In addition, since 1966, the Equal Employment Opportunity Commission has been producing the EEO-1 report that asks companies with more than 100 employees to provide the number of employees by gender, racial and ethnicity identity (a total of 14 intersectional groups) by 10 standardized job categories.
The financial services industry has led the way in public disclosure of EEO reports. The development of EEO-1 report peer group data may require some new effort, but many public companies now disclose these reports. More granular analyses, such as the EEO-1 report for the investment department, would particularly interest boards for 15(c) purposes.
Some data providers that now publish fund performance, expense and other analytics for the asset management industry are currently gathering this EEO data. For example, Bloomberg, Broadridge and Morningstar have databases, and the ICI/IDC released the results of a comprehensive survey with similar data.
Fund boards have traditionally hired third parties to provide relevant expertise and to assist with the workload of analyzing vast amounts of 15(c) information. Retaining subject matter experts on diversity to help analyze and evaluate the advisor’s progress and provide specific expertise with meaningful recommendations will be key to balancing the workload for directors and developing best practice board governance of diversity.
“When you come to a fork in the road, take it” – famous Yogi Berra advice that may resonate with fund boards today, as efforts to develop ESG governance feel similarly like threading a needle.
For such a time as this, fund boards are positioned to improve governance and evaluate the nature, extent and quality of services the advisor provides by “taking the fork” with an enhanced, data-driven review of diversity.