Studies have shown time and again that diverse teams featuring women and people of different races outperform their ‘pale, male and stale’ rivals.
McKinsey, for instance, has found that companies with a good split of men and women and people of various races are more likely to have financial returns above their industry medians.
The positive impact of diversity doesn’t apply only to workplaces, though. A Duke University study showed students who interact with a diverse range of peers report higher confidence in creative problem solving and increased comprehension of science and technology.
Institutional investors in the US picked up on the value of diversity long ago, and have been investing with so-called ‘emerging managers’ – small asset managers that typically feature a greater proportion of women and ethnic minority groups – for at least a decade.
Some have been tapping this source of superior performance for even longer than that. ‘We have been investing with emerging managers in real estate, private equity and global equity areas for more than 20 years,’ Laurie Weir, investment director of targeted investment programs at the California Public Employees’ Retirement System (CalPERS), says.
Weir, who oversees emerging manager programmes at the €254 billion pension scheme, says the majority of large public pension funds in the US have robust emerging manager strategies in place, including the California State Teachers Retirement System, the New York City Retirement System, the Texas Teachers Retirement System and the Illinois State Retirement System.
However, Meredith Jones, a consultant at Aon Hewitt and a partner and head of emerging manager research, takes a different view, saying the use of emerging managers is still not that widespread. ‘There are actually only 26 states that have some kind of emerging managers programme in place,’ she says.
Nonetheless, in comparison with Europe and other global markets the US is clearly setting the pace, and the others need to catch up if they want to benefit from diversity.
One factor that makes the emerging manager concept difficult to explain is the fact that there are multiple definitions of the term. The most widespread meaning of the phrase refers to companies managing a ‘non-significant number’ of assets. The fact that these sort of investment companies are likely to include more women and ethnic minorities than bigger firms is not spelled out in the standard definition.
For the Employees Retirement System of Texas (ERS) the definition was decided by the state parliament and it is pretty straightforward: the state defines the term as a private professional investment manager with assets under management (AUM) of $2 billion or less.
However, for CalPERS, which has invested $9.4 billion (€8.2 billion) in emerging managers, the definition varies between each asset class, Weir says. ‘For instance, for global equity there is a $2 billion AUM ceiling, whereas in private equity an emerging manager oversees less than $1 billion and they are launching their first or second fund.’
Another important consideration is that some states, such as CalPERS’ home state of California, prohibit making investment decisions based on gender or race. In spite of that, Meredith Jones, who has written a book on this topic called Women of the Street: Why Female Money Managers Generate Higher Returns, says investing with smaller managers also does the trick, making it possible to capture the upside a minority manager brings to the portfolio.
‘The reason is that a lot of diverse funds, for instance those featuring a lot of women, tend to be small. So if you set a fund size as opposed to a gender or race requirement then you will still be able to invest and capture the upside and diversification benefits without making an investment decision based on race or gender.’
Emerging manager – case study
Name: Oak Street Real Estate Capital
AUM: $900 million
Institutional funds: Five raised to date
- Single tenant, investment grade net leased real estate assets
- Early stage, small cap and emerging manager real estate investments
Partners: Marc Zahr, Jim Hennessey, Larissa Herczeg
Headquarters: Chicago, Illinois
Institutions invested: ERS Texas, among others
Two types of alpha
Jones explains that there are two types sources of alpha that come from investing with emerging managers.
The first is a ‘structural alpha’ based on a fund’s size. ‘It says when a fund is smaller they’re able to do things that are more niche, be more nimble and their best ideas are more concentrated. Therefore they outperform.’
The second type Jones calls a ‘cognitive and behavioural alpha’, which is where the female and minority presence becomes important. ‘This is where these people think and behave differently. As a result they can produce differentiated returns that can be higher and can provide differentiated sources of return.’
Although not all asset owners agree that emerging managers necessarily produce higher returns, there is consensus that they can deliver profits uncorrelated to the rest of the market.
‘The CalPERS experience with emerging managers has been mixed. We have experienced great success and managers who delivered better returns, but we have also experienced managers who did not.
‘We remain committed to this space because we think we can deploy capital in highly disciplined ways that will identify managers who can meet our performance expectations,’ Weir says.
Although emerging managers sometimes require more thorough due-diligence, they can often be more flexible, making them easier to work with than legacy managers, Weir adds.
‘They are more aligned with us and more accommodating when it comes to setting up different fee structures. They are generally open to negotiations whereas some larger managers stand firm because they don’t have to negotiate,’ says Sharmila Kassam, Deputy CIO of ERS Texas, which has invested €1.1 billion to emerging managers – more than 10% of the pension scheme’s externally managed assets.
Despite enthusiasm among many US pension funds, investment in emerging managers still has huge room for growth in the country, not to mention in other markets, where the sector is virtually non-existent.
‘The trend is definitely accelerating in the US, but it is most definitely not mainstream at this point in time for a number of reasons,’ Jones says. One factor in this is that the number of women and minority-owned funds is quite small, so even if everyone decided they wanted to invest there wouldn’t be enough capacity.
Some emerging managers say the level of interest from institutions is still very limited, though they expect rapid progress in the years ahead.
‘There is more talk about it than there is more money directed to it,’ says Larissa Herczeg, who is managing partner and CIO responsible for seeding and strategic capital at Oak Street Real Estate Capital, a $900 million emerging manager.
She adds that a very small percentage of all pension funds have an emerging manager programme in real estate. ‘It’s much more popular with private equity and hedge funds. But hopefully the success of existing programmes will create some positive momentum in the future.’
Managers or owners?
In terms of the added value women and minority emerging managers provide, it’s not really important who owns a fund. What’s important is who runs it and manages the money, Meredith Jones says.
‘If you’re just looking to capture that cogitative alpha then who manages the money is more important than who owns the firm.
‘If you have a women or minority owned firm but the money is managed by caucasian men then you’re really not going to capture the same level of cognitive or behavioural alpha. But by the same token, if you have a firm that is owned by a man but you have a women or minority managing it then you can still pick up alpha.’
However, some US states require pension schemes to invest with a bias towards economic development impact, Jones says, and this means the ownership of assets becomes highly significant.
‘Those institutions want the firms to be run by women or minorities in order to get that extra bonus of empowering groups that have historically not had as much economic power. For those organisations the ownership status is very important.’