The Investment Case for Culture

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Our challenge and responsibility as investment professionals is to improve investor outcomes. Naturally, we’re curious what role the culture of the companies in which we invest plays. Does it contribute to the overall performance of our investments when it comes to portfolio returns?

In the first three parts of this series, I focused on culture’s role in the quest for better decision making that leads to better long-term firm performance. A culture that values respect, curiosity, and independent views raises collective intelligence (CI) levels and helps unlock the benefits of cognitive diversity.

My views are based on personal experience and evidence that indicates a positive relationship between the quality of an organization’s culture, good decision making, and firm value.

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How does selecting, avoiding, or reweighting stock positions based on culture metrics impact investment performance? For investment companies that create systematic investment strategies like Research Affiliates, this is a critical question.

The investment case for culture — and, more directly, culture’s relationship to investment performance — is less clear-cut than the business case. From the broader environmental, social, and governance (ESG) perspective, the general consensus is that good governance improves returns. Good management decisions — particularly when made in the interests of shareholders rather than management teams — are generally beneficial to investors. But the typical governance metrics are at best tangentially linked with culture.

Research on whether good social practice improves returns is harder to find. Why? Because quantitative metrics are harder to define. A number of studies apply external measures of employee or customer satisfaction as proxies for social practice. For example, Alex Edmans uses data from “100 Best Companies to Work For in America.” While his results are encouraging, the overall research findings are mixed.

Research that examines the more direct relationship between culture and investment performance generally shows that culture is associated with better business outcomes. For example, the authors of “Corporate Culture: Evidence from the Field” find that cultural values and norms are positively correlated with firm value. But these studies have shortcomings: They tend to be cross-sectional and capture point-in-time relationships based on proxies of culture.

Despite results consistent with a positive connection between culture and better business outcomes, the research does not provide enough empirical support to claim that an investment strategy based only on a firm’s culture should be expected to deliver excess returns over time.

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The biggest obstacle to more research is insufficient data. Culture has many definitions. Finding quantifiable measures that adequately capture its nuances — let alone its different definitions — is difficult.

And, even if we have acceptable metrics, most ESG data sources do not cover long enough time spans for the large numbers of companies needed to conduct a comprehensive study. Accordingly, we can’t determine with any certainty if culture is priced in or if the culture variable should lead to the persistence of unanticipated excess returns. 

In the future, improved reporting transparency and research methods — such as the application of machine learning to derive measures of corporate culture from new, likely unstructured, data sources — may remove the data hurdles. For now, we have to choose whether we want our ESG or our narrower culture preferences reflected in our investment portfolio without knowing if they have any implications for potential excess returns.

So if we’re going to make portfolio choices based on culture, we need to understand that these decisions may have more impact as values statements than on portfolio performance. We should also keep these three points in mind:

  1. The potential for data mining and exaggerating the robustness of research that supports culture as the basis for an investment strategy is real. Data mining is a significant problem in the smart beta space, according to Campbell R. Harvey. Because of their popularity and the dearth of related data, ESG products in general and culture-based products in particular are especially vulnerable.
  2. Culture is hard to define and even harder to measure. So focus on what about a firm’s culture is observable, such as evidence of good decision making in the areas of finance and governance, rather than relying on a direct culture metric.
  3. Be sure the investment strategy selected incorporates known sources of excess returns. While investor preferences are broader than the commonly accepted risk–return framework, the most important investment decision relates to the strategy itself.

So how can we meet the dual challenge of investor preferences and investment outcomes? As members of the investment community, we can work to build the desired culture within our firms and design investment strategies that reflect our own and our client’s values in pursuit of superior returns.

That is our challenge and our responsibility.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/ Syed Waseem


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Katrina Sherrerd, PhD, CFA

Katrina Sherrerd, PhD, CFA, is CEO of Research Affiliates. She is also a member of the Research Affiliates board of directors. Sherrerd manages the overall operations and resources of the firm, the communication between board and senior management, and the establishment of long-range strategy and policy, which allow the firm to deliver on its core mission of conducting cutting-edge research and advancing innovative product development for the benefit of investors.



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