Advancing Racial Equity Through Your Investments

Investors now have a variety of intentional investing approaches to pursue a more inclusive society, as well as their financial goals.
Mar 1, 2022 10:00 AM ET

Originally published on Morgan Stanley Insights

Building a truly inclusive society will require concerted action across governments, nonprofits, corporations and investors. We increasingly understand the benefits of advancing racial equity, but aren’t necessarily aware of the available tools for investors to pursue this goal. Whether considering restriction screening, promoting diverse ownership and representation, or delving into shareholder engagement and reporting, advancing racial equity through investment capital is a journey of discovery, understanding and action.

Opportunities to integrate racial-equity criteria across asset classes are growing, with research suggesting that such approaches can achieve market-rate investment returns—or better. Thoughtful guidance and partnership with your Financial Advisor in navigating these opportunities is essential

As outlined in our Racial-Equity Investing Guide, investors can consider four approaches:

  1. Supporting diverse-owned or -run asset managers
  2. Seeking investments in companies that are creating products and solutions directly addressing the needs of disadvantaged communities
  3. Looking at the diversity and inclusion records of publicly traded companies across industries
  4. Minimizing or avoiding exposure to companies with lagging racial-equity records

Shareholder engagement and impact reporting can strengthen each of these approaches.

By building your portfolio to support companies that take a stand for diversity and show accountability for their actions, as well as supporting diverse-owned firms and more, investors can play a critical role in helping to right historic imbalances. Here’s a closer look at these investment approaches.

Diverse Ownership: An Opportunity for Investors

While investors increasingly think about a range of social criteria, including the diversity of corporate boards, employees and senior leaders, fewer investors intentionally integrate diversity of ownership with how investment managers allocate their assets. Some institutions, such as endowments and foundations, have focused specifically on Women or Minority-Owned Business Enterprises (WMBE), a designation that asset managers use to identify businesses that are at least 51% owned, operated and controlled by one or more ethnic minority, gender or veteran classification.

At Morgan Stanley, we have highlighted investments with this status since 2015. Some investors have also sought out “emerging managers,” a term which can carry many different definitions but is meant to designate promising, often diverse-owned asset managers with fewer assets under management.

Recent research shows that diverse-owned asset managers are responsible for just 1.3% of assets under professional management in the U.S. Why are so few assets managed by racially and ethnically diverse firms? One possibility is that some investors—individuals, families and institutions, as well as the advisors that serve them—harbor implicit bias when selecting asset managers. This finding was the result of a study led by investment firm Illumen Capital and Stanford University’s SPARQ, a self-described “do tank” that helps policymakers, educators and nonprofit leaders apply social-psychology insights and methods to their work.1

Of note, the performance of diverse-owned asset management firms isn’t statistically different from the industry as a whole, according to a study conducted by Professor Josh Lerner of Harvard Business School and published by the Knight Foundation and Bella Research Group.2 This study also found that many strategies managed by diverse-owned firms performed in the top quartile of mutual funds, hedge funds and private equity funds.

Invest in Solutions to Help Disadvantaged Communities

When building a portfolio across asset classes, investors should also consider actively allocating capital to funds that invest in companies providing solutions to alleviate social disparities and help disadvantaged communities. This includes identifying products and services creating positive outcomes for communities of color in sectors such as health care, education, energy, affordable housing and more.

For example, investors can support affordable housing, schools and even provide access to lower-cost clean energy in diverse communities through tax-exempt bond funds. In addition, investors may be able to support companies creating products and services related to financial inclusion to close the wealth gap or improve health-care outcomes for communities of color as part of an equity fund.

Consider Diversity at Companies You Invest In

Investment funds that factor a holistic set of environmental, social and corporate governance (ESG) considerations into their investment selection process often include racial-equity criteria. For example, as part of social considerations (the “S” in ESG), companies may be evaluated on whether they have diverse representation across employees, as well as policies that support attracting and retaining diverse employees, which can boost talent retention and drive innovation.

As sustainability investors seek to reward companies with a more diverse workforce, research increasingly shows that this can lead to materially positive financial outcomes. For example, companies in the top quartile for ethnic and cultural diversity on executive teams were, according to a leading consulting firm,3 33% more likely to have industry-leading profitability. What’s more, the study found a persistent penalty for diversity laggards: Companies in the bottom quartile of diversity exhibited a 29% lower chance of above-average profitability.

Sustainable investors have long acknowledged that most companies, even those performing better than their peers, have work to do in achieving balanced representation across race and ethnicity at all levels of the organization. Sustainable and impact investment firms can also engage shareholders to foster more dialogue, activate proxy voting and file resolutions directly with the companies they own on the racial-equity issue. For investors, shareholder engagement can be an important tool to measure which managers in your portfolios actively engage with the companies they own to influence behavior over time. Our Morgan Stanley Impact Quotient® (Morgan Stanley IQ) tool can help provide this analysis, in addition to evaluating your portfolio, based on your social and environmental goals.

Consider Avoiding Racial-Equity Underperformers

For decades, some investors have been focused on avoiding companies that aren’t advancing racial equity. For example, in the 1980s and 1990s, socially responsible investors, including large religious institutions, used their capital to pressure companies to divest from operations in South Africa to protest apartheid.

Today, investors can seek to avoid companies engaged in sectors and industries that disproportionately impact communities of color—for example, the private prison industry or civilian weapons manufacturers. Many of the more than 160 investment strategies available on Morgan Stanley’s Investing with Impact platform intentionally avoid these sectors, as well as corporate laggards in diverse representation across board membership and employees. Investors can also develop custom, separately managed accounts, or apply overlay restriction screens on top of traditional investments, to avoid these industries.

A Path Forward for Investors

A Morgan Stanley Financial Advisor can help you select investment products incorporating some, or all, of the above approaches that align with your financial goals and impact objectives. Racial-equity investing can be activated across both equity and fixed-income allocations. By using Morgan Stanley IQ, Financial Advisors can help you track your investment portfolio and report on its alignment with environmental and social impact objectives—including diversity, equity and inclusion.

We believe that investors will increasingly be able to position their portfolios to take advantage of more emerging opportunities for racial-equity investing, along with a better understanding of the business case.

1Race influences professional investors’ financial judgments,” Proceedings of the National Academy of Sciences (PNAS), August 27, 2019.

2Diversifying Investments: A Study of Ownership Diversity and Performance in the Asset Management Industry,” January 28, 2019, Knight Foundation

3Diversity wins: How inclusion matters,” by Sundiatu Dixon-Fyle, Kevin Dolan, Vivian Hunt, and Sara Prince, McKinsey & Co., May 19, 2020

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Investment returns will fluctuate so that an investor’s shares when redeemed may be worth more or less than original cost. Investors should carefully consider the investment objectives and risks as well as charges and expenses.

The returns on a portfolio consisting primarily of Environmental, Social and Governance (“ESG”) aware investments may be lower or higher than a portfolio that is more diversified or where decisions are based solely on investment considerations. Because ESG criteria exclude some investments, investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria.

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This article is based on the Morgan Stanley Investing with Impact team’s Racial-Equity Investing Guide. Ask your Financial Advisor for a copy or find an advisor.