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The effect of Ethnic Diversity in the Board of Directors
on the Financial Performance of the Firm
Daphne Esmée Penning
11031662
Bachelor Economics & Business
Finance & Organisation
Supervisor: Ross Gardner
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Abstract
This thesis examines if ethnic diversity in the Board of Directors has a significant influence on the financial performance of the firm. The study is based on panel data of North American based S&P 500 companies in the services industry in the year 2015. Ethnic diversity in the board of directors is measured using the heterogeneity index of Blau. The performance of the firm is measured in two different ways. Tobin’s Q is used as forward looking market-based indicator of the financial performance of the firm, whereas return on assets (ROA) is used as the backward looking accounting-based measurement of financial performance. The results demonstrate that ethnic diversity within the board of directors has no significant effect on the financial performance of the firm.
Statement of Originality
This document is written by Student Daphne Esmée Penning who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document are original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
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Table of Contents
1. Introduction...4
2. Theoretical Framework...6
2.1 Firm Financial Performance...6
2.2 The Board of Directors...6
2.3 Board Diversity and Firm Performance...8
2.3.1 The knowledge based view theories...8
2.4 Ethnic Diversity in the Board of Directors...10
2.5 Hypothesis Development...11
3. Methodology...12
3.1 Data Gathering...12
3.2 Model and Measurements...12
3.3 Regression Specification...14
4. Results...15
4.1 Descriptive Statistics...15
4.2 Ordinary Least Squares Regression Results...16
5. Discussion...19
6. Conclusion...19
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1. Introduction
The increasing globalization of organizations and the expanding proportion of ethnic minorities within organizations in the United States have caused changes in the structure of the firm. This change raises the commitment to understanding how firm performance is connected with ethnic diversity (Wooten, 2008). For organizations aiming to grow into a more successful and universal company, it is necessary to diversify the executives of the company as well as the members of the board (van Veen et al., 2014). According to Carter et al. (2010) the competence of diverse boards to maintain legitimacy for the organization is of particular importance in the United States given the continuing ethnic minority growth.
Several researchers in the field of Behavioral Finance and Organizational Economics have investigated the relation between ethnic diversity in different layers of the organization and the financial performance of the firm. Considerable studies of Orlando (2000) and Cheong &Sinnakkannu (2014) suggest diversity within the board of directors has a positive effect on the value to the firm. Carter et al. (2003) found evidence of a positive significant relationship between the fraction of minorities on the board and the firm value, after controlling for board size and other corporate governance measures.
In this research the relationship between the level of ethnic diversity in the Board of Directors and the firm’s financial performance of United States based S&P 500 companies is examined. The fundamental reason for doing this research is to contribute a more thorough understanding of this relationship. Demographic diversity such as ethnic diversity in the board of directors, is a less studied topic compared to the relationship between gender diversity and the financial performance of the firm (Carter et al., 2010). Ethnic board diversity is characterized as the stretch out to which board members in a firm are from various racial and ethnic gatherings as opposed to being part of one division (Orlando et al., 2007).
This research aims to answer the research question by conducting a regression for the year 2015. The focus is on the services industry (SIC 7000-8999) since a majority of the firms in the United States is part of this industry. The companies in the services industry cover a wide scope of the economic movement in the United States (Berman et al., 1999). Seventy-five percent of minority-owned businesses are found in the service industry as well (Asiedu & Freeman, 2007), serving as a good benchmark for this thesis. A data sample of 145 services firms is collected form the database of Wharton. The regression performed is the Ordinary Least Squares regression to determine the relationship between ethnic diversity in the board of directors and the financial performance of the firm.
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After the introduction, the research topic will start with a theoretical framework in chapter 2. In this chapter, the different effects of heterogeneity on the firm performance will be investigated. The knowledge based-view is discussed on the basis of the resource dependence theory, the human capital theory, the agency theory and the social psychological theory. Then arguments and reasons are provided for the chosen variables. At the end of the chapter, the hypothesis will be formulated based on the conclusions drawn from the literature. In chapter 3 the model is specified and the measures of firm performance and ethnic diversity are discussed. In chapter 4, the regression is explained and the results from the regression will be discussed and analyzed. After that, concluding remarks will be made as well as limitations to the research and further research recommendations.
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2. Theoretical Framework
The second chapter consists of the theoretical background of this thesis. Relevant theories and former studies related to the relationship between a firm’s performance and its board of directors are discussed. Multiple frameworks are used to explain this relationship. The first section summarizes some of the major theoretical perspectives of board mechanisms which are considerable pertinent for this study: the resource dependence theory, the human capital theory, the agency theory and the social psychological theory. In the second section the main determinants of financial performance are discussed.
2.1 Firm Financial Performance
The overall performance of a firm has been defined in the literature in a wide range of variations (Mackey et al., 2007). Financial performance of a firm is the most frequently used indicator of firm performance. Firm financial performance considers the financial strength of an organization over a certain period of time and is commonly defined as the extent to which the firm acquirers revenue by using its assets (Atrill et al., 2009). To measure firm financial performance, both accounting-based and market-based estimations are used. By using those two different measures, the effects of ethnic diversity on the internal financial performance as well as the sentiments of market participants toward ethnic diverse firms will both be captured (Cheong & Sinnakkannu, 2014). The market-based indicator used to measure firm financial performance in this study is Tobin’s Q. Return on Assets (ROA) is used as an accounting-based indicator to measure the financial performance of the firm (Cheong & Sinnakkannu, 2014).
2.2 Board of Directors
The board of directors is an internal governance mechanism that is intended to ensure the interests of shareholders and managers are closely aligned (Kang et al., 2007). Different characteristics of the board of directors are expected to have a direct effect on the performance of the firm (Alesina & La Ferrara, 2005).
The size of the board is simply defined as the number of members within the board (Cheong & Sinnakkannu, 2014). The size of the board has both important direct and indirect effects on the performance of the firm (Nathan, 2013). Prior studies have shown various relationships between firm financial performance and the size of the board. A strong positive relationship between the size of the board and the financial performance of the firm was found by Jackling and Johl (2009). They state that better information is brought to the firm by more board members because of their greater total knowledge, which will improve the decision
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making process. In agreement with Jackling and Johl (2009), Van den Berghe and Levrau (2004) also argue that a board that consists of more directors will provide a greater extend of information which should contribute to a better performance of the firm. The relationship between the performance of the firm and the size of the board also relates to the theories which will be discussed in section 2.3. The resource dependence theory is used to explain the positive relationship. The resource dependence theory explains how firms are dependent of each other for resources because they are affected by external factors. Based on the resource dependence theory, larger boards can provide various advantages to the financial performance of the firm since a larger board can increase the firm’s ability to secure the critical resources needed (Dalton et al., 1999). The agency theory can be used to explain the advantages of a smaller board. A smaller board can be more productive and efficient in managing the decision making process (Jensen & Meckling, 1976). Yermack (1996) argues that there exists a negative relationship between the size of the board and the financial performance of the firm. An increasing number of board members can lead to the free-rider problem which will reduce the effectiveness of the board and thus the performance of the firm (Yermack, 1996). Eisenberg et al. (1998) also found a negative correlation between the size of the board and the profitability of the firm based on a study of firms in Finland. Relating to diversity in boards, Kang et al. (2007) state that firms with larger boards, can more easily afford to have a diverse board.
Next to the size of the board, the size of the firm is also considered to have a direct effect on the financial performance of the firm (Orlando et al., 2007; Lu et al., 2015) and is often used in an analysis of financial performance (Carter et al., 2010). The size of the firm is indicated as an important predictor of firm performance in past empirical evidence (Lu et al., 2015). Larger firms are more likely to have more resources available to the firm, which could be reflected in the firm performance (Miller, 1991). In accordance, the study of Lopez-Valeiras et al. (2016) aims to understand the connection between the size of the firm and its financial performance, suggesting that larger firm size is correlated with an absolute increase in the resources that are available to the firm. Consistent with the above findings, a positive relationship between firm size and firm performance is expected (Griffith et al., 2006). A study done by Eisenberg et al. (1998) conclude that the most favorable size of the board changes with the size of the firm. The effect of globalization on firm performance also depends on the size of the firm (Asiedu & Freeman, 2007). The percentage of ethnic minorities in the board of directors increases along with the size of the firm as well as the size of the board (Carter et al., 2003).
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The diversity of age in the board of directors is a less studied topic. It is a relevant variable to study since most of the board members are of the age of sixty and above (Rondøy et al., 2006; Kang et al., 2007). Firms with younger members on the board of directors will in contrast to firms with older board members experience a higher growth rate. Young board members are more likely to make more risky decisions (Hambrick and Mason, 1984). Barker and Mueller (2002) argue that older board members tend to be more risk averse. A younger board of directors could therefore increase the financial performance of the firm (Li et al., 2011). In contrast, researches have provided evidence that older board members have a positive effect on the financial performance of the firm. This can be explained by the assumption that older board members have obtained more experience during their careers (Kang et al., 2007). No effect of board age on the performance of the firm, measured as Tobin’s Q, was found by Rondøy et al. (2006) in Scandinavian countries. Kang et al. (2007) argue that the age range of directors is significantly affected by the size of the board.
2.3 Board Diversity and Firm Performance
Board diversity is defined as an assortment in the structure of the board of directors (Kang et al., 2007). Two categories of diversity can be distinguished. Observable diversity is described as promptly detectable attributes of board members. The second category is called less visible diversity (Milliken and Martins, 1996). Detectable attributes included in observable diversity are racial/ethnic background, nationality, gender and age. Less visible diversity consists of the educational background and former experience of the directors.Erhardt et al. (2003) identifies observable diversity as demographic diversity and less visible diversity as non-observable or cognitive diversity. The optimal composition of the board of directors relies on the nature of the firm and its context (Erhardt et al., 2003). For the purpose of this dissertation the main focus is on one observable diversity characteristic, namely ethnicity.
2.3.1 The knowledge based view theories
Ahead of a discussion of former studies about board diversity and firm performance, frequently used frameworks for explaining the complex relationship between board diversity and firm performance will be reviewed. The knowledge-based view thinks about knowledge as the most deliberately critical asset of the firm. The four main theories based on this view are the resource dependency theory, the human capital theory, the agency theory and the social psychological theory. The theories are explained to provide a more thorough understanding of the theory the hypothesis is based on (Carter et al., 2010).
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The resource dependence theory explains how the behavior of organizations is effected by external factors of the organization. The factors outside the control of the board will generate uncertainty and external dependencies (Hillman et al., 200). The theory describes that the board within a firm serves as an instrument to link those dependencies and to manage them (Pfeffer and Salancik, 1978), reducing the formed uncertainty (Hillman et al., 2000). According to Hillman et al. (2000) a more diversified board of directors will provide unique information and will contribute to more favorable resources. More valuable resources available to the firm should be translated in an excelling firm performance (Carter et al., 2010). Based on this, Carter et al. (2010) state that some persuasive theoretical arguments for diversity on the board are supported by the resource dependence theory.
The human capital theory contributes to some of the concepts obtained from the resource dependence theory as it explains how the firm performance is affected by board diversity (Carter et al., 2000). Human capital is referred to as the knowledge of the board members derived from education, skills and experiences which can be adopted to benefit the organization (Terjesen et al., 2009). Carter et al. (2010) state that unique human capital is brought to the firm by different members of the board, thereby diversifying the knowledge of the board. Therefore the human capital theory is an applicable theory when researching the relationship between diversity and the performance of the firm (Terjesen et al., 2009).
The resource dependence theory and the human capital theory are both based on the assumption that the performance of the firm is enhanced by a more diversified board. The latter two are both profoundly suggestive of a positive relationship (Carter et al., 2010). Consistent with the resource dependence theory and the human capital theory several studies suggested a positive effect. Homogeneity at the top level of a company is believed to result in a narrow perspective, while diverse top managers take a broader view (Carter et al. 2003, p36). Orlando et al. (2000) state that a sustained advantage can be derived from a diverse human capital because the resources are rare and hard to imitate.
The agency theory is a theoretical framework, which is often used to understand the relationship between board characteristics and firm performance (Carter et al., 2003). The agency theory aims attention to the affiliation between agents and principles. The actions taken by the directors and managers who will fulfill the role of the agent affect the returns of the shareholders who have the role of the principal. The agency problem appears when the agent abuses its position detrimental to the principal (Terjesen et al., 2009). Fama and Jensen (1983)
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propose that the board of directors serve as an important mechanism to control and supervise managers and to resolve agency problems. Agency theory in general does not support the benefits of board diversity to firm performance as do the resource dependence theory and the human capital theory, but the agency theory does not reject the likelihood that board diversity is valuable (Carter et al., 2010).
The social psychological theory deliberates the interaction within associations. The theory describes that having a majority status can be translated in an superfluous influence in the decision making process (Westphal & Milton, 2000). Because of the group dynamics within the board itself, the possibility exists that diverse directors will not have an impact on the performance of the board as a whole (Carter et al., 2010). Carter et al. (2010) tend to find how group dynamics influence the performance of the board and states that demographic diversity may either have a positive, negative or a neutral effect on the financial performance of the firm. The Social psychological theory indicates that a more diversified board of directors will have more diverse opinions and will obtain a higher level of critical thinking (Carter et al., 2010). A more diversified way of thinking can generate the company with more creativity and innovation, which may stimulate the decision making process (Westphal & Miltion, 2000). Therefore, some research conclude that firms with a more diversified board may benefit form an increase of the performance of the firm (Carter et al., 2010). On the other side, greater diversity can produce more critical thinking and different assessments that could lead to a more time-consuming and less effective decision-making process (Campbell & Minguez-Vera, 2008). The theory on group dynamics implies board diversity could both have a positive or a negative effect on the performance of the firm (Carter et al., 2010).
2.4 Ethnic Diversity in the Board of Directors
This section describes which variables have an important influence on the diversity in the board of directors and shows results from former studies.
Investigating the effect of ethnic diversity in the board of directors is of great value because the amount of people from different nationalities applying for board positions is expanding (Erhardt et al. 2003). The composition of the boards of directors in American firms is increasingly reflecting the changes in workforce diversity (Burke, 1995). Former studies have found positive effects of ethnic diversity on firm performance (Carter et al., 2003; Orlando 2000). Carter et al. (2003) concludes a positive effect of ethnic diversity in the United States and Orlando (2000) likewise states racial diversity has a positive effect. Erhardt et al., (2003) also found that ethnic minorities have a positive influence on firm performance in a
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study of American companies. Orlando et al. (2007) investigated the relationship between racial diversity and the productivity of the firm in different industries. When the research was done separately for the services industry, he found evidence of nonlinear effects. There is no evidence found of a negative effect of ethnic diversity on firm performance. Accoringly, there are some scholars who have concluded on no effect at all. Rondøy et al. (2006) researched the effect of ethnic diversity on firm performance in Scandinavian countries, but found no consistent relationship between them.
Demographic variables such as gender diversity are correlated with ethnic diversity (Pelled et al., 1999). To eliminate additional diversity effects, gender diversity in the Board of Directors is a relevant variable (Orlando et al., 2004). A control variable for the percentage of Caucasians in the Board of Directors is included, as ethnic diversity and the proportion of Caucasians in the board are not compatible (Orlando, 2000). Gender diversity and ethnic diversity will have a different effect on the functioning of the board as well as the performance of the firm, because of dissimilarities in human capital and extraneous relations with surroundings (Carter et al., 2010). As the nature of the sample used in this thesis is predominantly white, the results of the heterogeneity variable can be interpret with more confidence if a proportional control variable is included. The same heterogeneity index would derive from two different ethnicity compositions with the same proportions. To illustrate this, Orlando et al. (2004) show that two teams, one with ninety percent Caucasian and ten percent blacks and another with ninety Hispanics and ten percent blacks, will have the same heterogeneity score but are not the same in terms of ‘whiteness’.
2.5 Hypothesis Development
The theories discussed above resolving the knowledge-based view, explain that decision-making is an important feature for the members of the board. Therefore, it seems logical that diversified boards are expected to demonstrate higher levels of performance compared to less diversified boards (Erhardt et al., 2003), a positive relationships between ethnic diversity in the Board of Directors and the performance of the firm can be suggestive. Based on the conclusions from the literature the hypothesis is formulated as follows:
Increasing ethnic diversity in the board of directors has a positive effect on the financial performance of the firm.
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3. Methodology
In the third chapter the model is specified and the measures of firm performance and ethnic diversity are discussed. First, an explanation of the gathering of the data used is given. Then the model is defined by explaining the different measurements of financial firm performance and the control variables. This section clarifies how the measurements are determined. At the end, the regression specification is provided.
3.1 Data gathering
The Wharton Research Data Services contains various databases and is the primary source for the data used in this thesis. The data are all archival data collected from Compustat and Institutional Shareholder Services (ISS), which consists of S&P 1500 companies. Data regarding information about members of the board, such as the age, number of board members and their ethnicity can be found in ISS. Financial data to estimate Tobin’s Q, return on assets and the logarithm of the book value of total assets regarding the firms investigated can be found in the Compustat database.
The data is collected for the year 2015. This is the latest year that consists of the most updated information in Compustat. For this reason, this thesis investigates the research question for the year 2015. In first instance Compustat provided a sample of 587 firms in the services industry with SIC-codes 7000-8999. Since ISS does not have all information available that is needed about the board of directors, the sample is lowered to 145 firms with an exhaustive data set.
3.2 Model and Measurements
In this section the model that is examined is discussed. The variables used are described and the measurements are provided. First the model is specified, then measurements of financial firm performance are discussed. Following are the measurements of ethnic diversity in the board of directors and the control variables.
The elementary model being tested is
𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐹𝑖𝑟𝑚 𝑝𝑒𝑟𝑓𝑜𝑟𝑚𝑎𝑛𝑐𝑒
= 𝛽0+ 𝐸𝑡𝑛𝑖𝑐𝑖𝑡𝑦𝛽1+ 𝐵𝑜𝑎𝑟𝑑𝑆𝑖𝑧𝑒𝛽2+ 𝐹𝑖𝑟𝑚𝑆𝑖𝑧𝑒𝛽3+ 𝐵𝑜𝑎𝑟𝑑𝐴𝑔𝑒𝛽4+ 𝐺𝑒𝑛𝑑𝑒𝑟𝛽5 + %𝑜𝑓𝐶𝑎𝑢𝑐𝑎𝑠𝑖𝑎𝑛𝑠𝛽6+ 𝜀𝑖
where the financial firm performance is measured using either Tobin’s Q or the return on assets and Ethnicity is the determinant of the ethnic diversity within the board of directors. BoardSize
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and FirmSize are the size of the board and the size of the firm. BoardAge is the average age of the board members. Gender diversity within the board of directors is represented by Gender and %ofCaucasians is translated to the percentage of Caucasians in the board of directors.
The dependent variable in this analysis is the financial performance of the firm. Firm financial performance will be determined using two different measures. Two indicators are used to increase legitimacy (Cheong & Sinnakkannu, 2014). These two estimates are frequently applied in governance analysis as performance measurements. Both measure considerably various elements of firm performance, as they are not identical or interchangeable (Carter et al., 2010). The first measure is Tobin’s Q, which corresponds to the market value of the firm divided by the value of the total assets of the firm. Tobin’s Q is a forward looking market-based indicator of the performance of the firm. The second measure is the Return on Assets of the firm, which will analyze the backward looking accounting-based firm performance. Return on Assets will be measured using the net income divided by the book value of the firm’s total assets (Cheong & Sinnakkannu, 2014).
The main explanatory variable in the analysis is the diversity of ethnicity. The index of heterogeneity of Blau (1997) will be used to measure the ethnic diversity within the board. The heterogeneity index of Blau is frequently used as an examination method for categorical data (Orlando et al., 2007). This examination method appears to be consistent with other diversity measurements (Orlando, 2000; Carpenter et al., 2002). In order to be able to use the heterogeneity index, the board members have to be subdivided in divisions. The categories used are: Caucasian, African American, Hispanic/Latin American, Asian, and Middle Eastern.
The index is calculated as follows:
𝐻𝑒𝑡𝑒𝑟𝑜𝑔𝑒𝑛𝑒𝑖𝑡𝑦 𝑖𝑛𝑑𝑒𝑥 = (1 − ∑ 𝑝𝑖2)
where 𝑝𝑖 is the number of individuals in a division and i is the number of those divisions. The
values of the index can range from 0 to 0.80. For example, the index will have a value of 0.50 when there is maximum diversity between two divisions, this means fifty percent in each group (Orlando, 2000). As in this study, the value would have a value of 0.80 when there is maxim heterogeneity between five groups. The higher the resulting index, the greater the heterogeneity within the board of directors on a particular dimension (Carpenter, 2002) and an index value close to zero indicates only one category of board members (Orlando et al., 2011). In this sample, the index ranged from 0 to 0.518.
Control variables used in this study are board size, firm size and board age. Board size is computed as the number of board members within the board of directors. Firm size is
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measured as the logarithm of the book value of the firm’s total assets (Cheong & Sinnakkannu, 2014; Carter et al., 2010). Board age will be resolved from the average age of the board members. The age of the board directors are summed and divided by the number of directors in order to acquire the mean age of the directors. Other control variables used are gender diversity and the percentage of Caucasians in the board of directors. Gender diversity will be measured in the same way as ethnic diversity, using the heterogeneity index of Blau. As explained above, the index value can range between 0 and 0.50 when there are two divisions. In this sample, the index ranged from 0 to 0.48. Last of all, the percentage of Caucasian board members will be derived from the number of Caucasian board members divided by the total amount of board members.
3.3 Regression Specification
In this research, a regression model in which the diversity of ethnicity in the board of directors of S&P 500 services industry firms will be tested to have an effect on the financial performance of the firm. Since there may be unobserved factors other than ethnicity which can affect the firm performance, panel data methodology is used in this study, which is persuasive for controlling unobservable heterogeneity (Campbell & Minguez-Vera, 2008). A causality test is conducted to indicate whether ethnic diversity really affects firm performance or whether firms with a better firm performance are more likely to hire ethnic-minorities. In this thesis the Ordinary Least Squares (OLS) regression is performed to determine the relationship between ethnic diversity and the financial performance of the firm. The regression is performed using the SPSS program.
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4. Results and Analysis
This chapter is about the results of the research and gives an analysis about these findings. The hypotheses is discussed using the SPSS outcome of the OLS regression. First the descriptive statistics are shown and discussed. Then the results of the OLS regression are given and a clear analysis of these findings is provided. Finally, a short summary of the results is given.
4.1 Descriptive Statistics
Table 1 shows the descriptive statistics of the firms used in the data sample of this research. Included in the table are the mean, the standard deviation, the minimum and the maximum of the variables. The 145 companies used in the sample are all from the services industry, which has a SIC code of 7000-8999. The data measured are all from the year 2015.
Table 1 Descriptive Statistics
Mean Standard Deviation Minimum Maximum
Tobin’s Q 1.965727 1.778267 .0001531 14.24905 Return on Assets .0500084 .0869041 -.4361472 .3272166 Ethnic Diversity .1653642 .1529812 0 .5185185 Board Size 8.843654 1.918477 4 15 Firm Size 3.365469 .6412554 1.967492 5.246063 Board Age 65.13634 8.267086 46.38 87 Gender Diversity .2576725 .1315717 0 .48 Percentage of Caucasian .8809277 .1904565 0 1 Number of observations = 145
Tobin’s Q is a market-based financial firm performance measure. The mean value of Tobin’s Q is 1.965727, which is a value greater than one and proposes that the market value of the firm is greater than the book value of total assets (Carter et al., 2010). The values range from 0.0001531 to 14.24905. ROA is an accounting-based financial firm performance measure. On average, the value of ROA was 0.0500084 in 2015.The minimum and the maximum values are -0.4361472 and 0.3272166 respectively. The meaning of these results is that on average the
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financial performance of the firms reflected pertinent positive signs of development. Ethnic diversity in the board of directors is measured using the heterogeneity index of Blau. The mean value of the variable is 0.1653642. The minimum value is 0, which means that there are firms in which all the board members have the same ethnicity. The maximum value is 0.5185185. The mean value of 0.1653642 illustrates that the rate of diversity is relatively low. The average number of board members is 8.843, with a variation in size ranging from 4 to 15 directors on the board. Overall, 65 of the 145 American S&P 500 companies have a board size of 8 or 9 directors. The size of the firm is represented by the logarithm of the total assets. The minimum value of the logarithm of total assets in 2015 is 1.967492 and the maximum value is 5.246063. The mean value of the firm size is 3.365469. The average age of the directors on the board is the representation of the board age. The value of the variable on average is 65.13634, with a minimum value of 46.38 and a maximum value of 87. The average age is in consensus with the statement of Rondøy et al. (2006) and Kang et al. (2007) that most of the board members are of the age sixty and above. The heterogeineity index of Blau also represents the gender diversity in the board of directors. The value of the index on average is 0.2576725. The index ranges in value from 0 to 0.48. A minimum value of 0 reflects a board where all members are men. The mean value of 0.2576725 represents that women directors are underrepresented on the boards. The percentage of Caucasians on the board has a mean of .8809277. The minimum value of the variable is 0, representing no Caucasians on the board, and the maximum value is 1.
4.2 Ordinary Least Squares Regression Results
Table 2 shows the OLS regression results. In this table, the relationship between ethnic diversity in the board of directors and the financial performance of the firm is presented. The hypothesis is stated as follows: an increase of the ethnic diversity in the board of directors has a positive effect on the financial performance of the firm, and was tested using two variables for firm financial performance, Tobin’s Q and ROA. In the first column, Tobin’s Q is used as a measure of the financial performance of the firm. In the second column, the regression is carried out using the alternate performance measurement ROA. The regression is completed twice, this is done as a check to see whether the same results and relationships would show. Both times the regression was done, very similar results were displayed.
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Table 2 OLS Regression
Tobin’s Q Return On Assets
Constant 5.919249 (2.88)*** .2575555 (0.35) Ethnic Diversity -.0212977 (-0.02) .0403076 (0.63) Board Size -.0667798 (-1.68)* .0012629 (0.86) Firm Size -.5339386 (-1.83)* .0212456 (1.75)* Board Age -.0150605 (-0.74) -.0003934 (0.43) Gender Diversity -.9315155 (-0.71) -.0307036 (-0.52) Percentage of Caucasian -.7010496 (-0.44) -.0504873 (-0.79) R2 0.0618 0.0209 Adjusted-R2 0.0210 -0.0217 Notes:
* Indicates statistical significance at the 0.10 level (T-Value>|1.64|). ** Indicates statistical significance at the 0.05 level (T-value > |1.96|). *** Indicates statistical significance at the 0.01 level (T-value > |2.58|).
T-values are reported in parenthesis, behind the parameter estimates. Robust Standard Errors are used.
In the first column it can be seen that the coefficient of ethnic diversity on the board of directors is negative. Ethnic diversity in the board of directors is not found to have a significant effect on the financial performance of the firm, since the regression results have not indicated a statistical significance. In the second column, the coefficient of ethnic diversity on the board is positive, but not significant. Meaning that diversity of ethnicity within the board has no effect on the financial performance of the firm, measured by ROA. Both of the results are not in line with the hypothesis of this research. The findings are in consensus with the findings of Rondøy et al. (2006) who researched the effect of ethnic diversity on firm performance in Scandinavian countries, but found no consistent relationship between them. Carter et al. (2010) also found no significant effect of ethnic diversity in the board of directors on the financial performance of the firm in a study of US based organizations.
Concerning the control variables, it can be concluded that some of the variables are indicated to have a significant effect on the performance of the firm. Both the size of the board and the firm have a negative coefficient when measuring for Tobin’s Q and a positive coefficient when measuring for ROA. The coefficient of board size on financial firm performance, measured by Tobin’s Q, has shown to be significant. This negative relationship is in accordance with the study of Dalton et al., (1999), who state that the ability and functioning of the board may be decreased by the largeness of the board. Yermack (1996) also found a
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significant negative relationship in his study, reasoning that advantages related to board size might be overpowered by poor correspondence in the decision-making process. When measuring financial firm performance using ROA, the coefficient of board size has not shown to be significant. The size of the firm is significant for both independent performance measures. When measuring financial performance using Tobin’s Q a negative relation is shown. Campbell & Minguez-Vera (2008) show in their study that the size of the firm has a negative effect on the performance of the firm as measured by Tobin’s Q. But when measuring financial performance using ROA, a positive relation is shown. The positive relation between firm size and the financial performance of the firm is in accordance with the study Lopez-Valeiras et al. (2016). They show that the profitability of the firm increases with the size of the firm. The results according the relation between the size of the firm and the financial performance of the firm seem counterintuitive, since both performance measurements show inverse results. Additional research is necessary to analyze the legitimate effect of this coefficient on the financial performance of the firm. The coefficient of board age shows a negative effect in both regressions. The results illustrate that board age is not a significant indicator of Tobin’s Q and ROA. Gender diversity within the board and the percentage of Caucasians in the board show all negative coefficients regarding both performance measurements. Since the two variables are not found to have a significant coefficient, these variables will have no effect on the financial performance of the firm.
The overall results of the OLS regression indicate that ethnic diversity on the board of directors does not have any effect on the financial performance of the firm. These results are contrary to the literature discussed in section 2.4, where ethnic diversity in the board of directors was expected to have a positive effect on the financial performance of the firm (Carter et al., 2003; Orlando, 2000; Erhardt et al., 2003). The results are in accordance with the studies of Rondøy et al. (2006) and Carter et al. (2010), finding no significant relationship.
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5. Discussion
This study has a certain number of limitations, many of which that signify future research is needed. A key limitation for this study is the possibility of spurious correlation. This thesis attempts to understand if there is a direct causal relationship between ethnic diversity in the board of directors and the financial performance of the firm. Based on the literature it was suggested that a positive or negative effect could occur. The results of this research show a non-significant outcome, suggesting there is no causal relationship. This non existing relationship might be wrong due to the presence of a confounding factor, which wrongly influences the regression (Max Nathan, 2016). The different outcome regarding the relationship between ethnic diversity within the board of directors and the financial firm performance might be spurious.
It is also distinctive that other variables such as board size in regression 2 and board age in both regressions do not display significant effects on the financial performance of the firm. Prior research discussed in the theoretical framework suggested these variables to either have a significant positive (Li et al., 2011; Kang et al., 2007) or negative (Jackling and Johl 2009; Yermack, 1996) effect on the financial performance of the firm.
In this thesis the focus is only on American S&P 500 companies in the year 2015. Although the sample used consists of 145 companies, future research could investigate a wider scale of companies in a larger time period to more accurately investigate the effect of ethnic diversity in the board of directors on the long term.
6. Conclusion
The aim of this study is to investigate whether ethnic diversity in the board of directors affects the financial performance of American based S&P 500 companies. A sample of 145 firms is used to investigate the effect. The ethnicity within the board of directors is measured using the heterogeneity index of Blau, dividing the board members in five different divisions: Caucasian, African American, Hispanic/Latin American, Asian, and Middle Eastern. The effect of diversity of ethnicity in the board of directors on the financial performance of the firm is investigated using two measures of performance, Tobin’s Q and ROA. The results of the OLS regression have shown that there is no significant effect of ethnic diversity on the financial performance of the firm. Further research is necessary to be able to give a further evaluation on the relationship. After controlling for board and firm size, board age, gender diversity in the
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board and the percentage of Caucasians in the board, this thesis concludes there is no significant effect between ethnic diversity of board members and the financial performance of the firm.
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