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E-MailYan Lu is an Associate Professor of Finance at the University of Central Florida, Narayan Naik is Professor of Finance at London Business School, and Melvyn Teo is Lee Kong Chian Professor of Finance at Singapore Management University. This post is based on their article forthcoming in the Review of Financial Studies. Related research from the Program on Corporate Governance includes Politics and Gender in the Executive Suite (discussed on the Forum here) by Alma Cohen, Moshe Hazan, and David Weiss; Will Nasdaq’s Diversity Rules Harm Investors? (discussed on the Forum here) by Jesse M. Fried; and Duty and Diversity (discussed on the Forum here) by Chris Brummer and Leo E. Strine Jr.
Investment funds are often managed by teams of portfolio managers. Anecdotal evidence suggests that driven by homophily, portfolio managers prefer working alongside other managers with similar backgrounds. it is not uncommon for investment firms to be staffed by portfolio managers who all attended the same university, chose the same major in college, worked at the same investment bank, identify with the same gender, or belong to the same race. For example, the majority of the partners at the now defunct Long-Term Capital Management worked at Salomon Brothers and studied at the Massachusetts Institute of Technology. To address the diversity issues confronting asset managers, industry associations have commissioned reports that seek to improve diversity and inclusion practices. Moreover, institutional investors such as the Yale University Endowment fund, the California Public Employees Retirement System, and the MacArthur Foundation now require that investment firms reveal the diversity of their leadership and workforce, to compel them to improve diversity. These developments beg the question: what are the implications of team diversity for investment performance? While a nascent literature has investigated diversity in asset management, strong and broad-based evidence of the investment benefits of diversity has proven elusive, and the mechanisms by which diversity affects value remain unclear.
In this study, we investigate the implications of team diversity for hedge funds. Hedge funds are uniquely positioned to harness the value of diversity given the complex and unconstrained strategies that they employ. Yet, they are often managed by teams with homogeneous educational backgrounds, academic specializations, work experiences, genders, and races. Indeed, anecdotal evidence suggests that the hedge fund industry suffers from a diversity and inclusion problem. Moreover, diverse hedge funds by exploiting a wider range of investment opportunities could be more resilient to the capacity constraints that limit the investment gains from allocating capital to skilled managers. Diversity could therefore have welfare implications for fund investors.
Theoretically, it is not clear whether diversity should create value in asset management. By harnessing the heterogeneous skill sets of their team members, diverse teams could exploit a wider array of investment opportunities, which should translate into superior investment returns. Moreover, by working alongside other managers from different backgrounds, fund managers in diverse teams could become more aware of their own biases and entrenched ways of thinking, and therefore avoid costly behavioral mistakes. Similarly, members of a heterogeneous team could more effectively serve as checks and balances for each other, which should engender more prudent risk management. Yet, based on the notion that similarity breeds connection, members of a heterogeneous team may find it harder to communicate with one another, convey tacit information, or make joint decisions in a timely fashion relative to members of a homogeneous team. Such operational challenges could lead to execution problems that adversely affect fund performance.
In this paper, we study diversity based on educational institution, academic specialization, work experience, gender, and race. A large body of work in sociology documents the prevalence of homophily along these dimensions. The advantage of focusing on educational institution, academic specialization, and work experience is that they more likely relate to managerial functional expertise. Moreover, these three dimensions are less confounded by the gender and racial discrimination-induced selection issues that complicate inferences about the value of diversity. For example, if women face greater barriers to entry in asset management, including a female in an all-male team should elevate performance as the female manager would likely be of higher quality than the men.
We establish three main results. First, we show that hedge funds managed by diverse teams outpace those managed by homogeneous teams by 1.96% to 5.59% per annum after adjusting for risk. The outperformance cannot be attributed to hedge fund database-induced biases, hedge fund characteristics, or omitted risk factors. Our findings are not a by-product of unobserved factors that simultaneously affect both team diversity and fund performance. Relative to comparable funds and to the previous 36-month period, funds that subsequently hire diversity-enhancing managers deliver greater fund alphas in the following 36-month period. After instrumenting for team diversity, using as the instrument the demographic diversity at the fund founder’s hometown, we find that diverse teams still outperform homogeneous teams. Moreover, after controlling for the performance of solo-managed hedge funds operated by members of the respective teams, diverse teams continue to outpace homogeneous teams.
Second, we provide insights into the mechanisms by which diversity leads to superior investment performance. Diverse teams outpace homogeneous teams by arbitraging a greater variety of prominent stock anomalies, by capitalizing on long-horizon investment opportunities, and by avoiding behavioral biases such as the disposition effect, overconfidence, and the preference for lotteries. Diversity is also associated with prudent risk management. Diverse funds eschew tail risk, exhibit lower operational risk, and report fewer suspicious returns.
Third, we find that diversity moderates the widely studied capacity constraints and performance persistence effects in hedge funds. Diverse teams, by harnessing a wider range of investment opportunities, circumvent fund-level capacity constraints. Consequently, the performance of diverse teams persists more than that of homogeneous teams.
These findings showcase the value of diversity. Not only do diverse teams outperform homogeneous teams, diverse teams are also more resilient to tail risks, and less susceptible to capacity constraints. Our results are especially important for fund management firms that are re-evaluating the diversity of their leadership and for investors who are keen to sidestep the capacity constraints that limit the returns from allocating capital to skilled fund managers.
The full paper can be downloaded here.
