The first path is very simple. The fund manager simply needs to purchase one or two indexes. If the fund manager only buys the founder-CEO index, the portfolio will experience greater volatility relative to a more comprehensive set of holdings such as the S&P 500 Index, VUG, or Russell 1000 Growth Index (owing to 30 stocks versus 500 or 1000) but will likely generate greater returns over a longer time period relative to the benchmarks. The second approach in developing a smart beta portfolio requires the fund manager to initiate the portfolio with the founder-CEO index, assess the rela- tive sector weightings, and then fill the sector shortfall with other securities to match the benchmark index. If the investor actually holds all of the securities in the S&P 500 or Russell 1000 Growth Index, the fund manager can overweight the 30 securities in the founder-CEO index and reduce all of the other secu- rities in the index on a pro rata basis. 62 Because the founder-CEO index is an equal-weighted index, the active share for each security in the final portfolio will likely be higher than the original benchmark, although it will vary depending on the market cap of each secu- rity. 63 Given the 30-stock equal-weighted composition of the founder-CEO index, the composition of the index relative to the VUG or other more popular U.S. large growth indexes, such as the S&P 500 Growth Index or Russell 1000 Growth Index, may vary. 64 Notably, the similarity in the sector composition of the founder-CEO index relative to the VUG, S&P 500 Growth Index, or Russell 1000 Growth Index should not appreciably alter the sector exposure. The sector weights of the founder- CEO index relative to the S&P 500 Index (not S&P 500 Growth) will create a larger deviation owing to dif- ferences in growth orientation. 65 The final weights of each security in the portfolio will hinge on the level of risk–return the fund manager desires. 66 In situations in which a fund manager has sig- nificant AUM, including U.S. large-cap growth expo- sure, it may be prudent to dedicate a portion of a U.S. large-cap growth equity allocation to a passively man- aged founder-CEO index. The risk characteristics are clearly identified and can be monitored in an ongoing manner with relatively straightforward parameters. As this article demonstrates, when market conditions favor growth or market appreciation, the founder-CEO index PORTFOLIO RECOMMENDATIONS
tends to outperform its U.S. large-cap growth bench- mark. Moreover, the founder-CEO index outperforms peer benchmarks and other U.S. equity funds by a wide margin over the nine-year analysis, encompassing both very strong and negative market conditions. In some years of the analysis, the founder-CEO index per- forms in spectacular fashion. However, to be clear, the founder-CEO index also performs very poorly in some years. Fortunately, the ratio of bad-to-good perfor- mance is not symmetrical: Strong performance occurs more frequently relative to weak performance. Most key analytics, including excess returns, risk-adjusted returns, risk-adjusted alpha, IR, SR, and up capture, suggest that the founder-CEO index has compelling data to support a decision to include it in a portfolio basket. 67 The case for the smart beta portfolio implementing a founder-CEO index appears extremely compelling. Founder-CEO companies, during our study period, produce stronger performance than companies without founder CEOs. Factor analysis of our data provides further support. Results suggest that a U.S. large-cap growth fund that shifts larger weights to companies led by founder CEOs can enhance risk-adjusted portfolio performance over an extended period of time. The overall portfolio will likely see an increase in standard deviation of returns along with an increase in down capture. However, the corresponding increase in excess returns, risk-adjusted alpha, IR, SR, and up capture should more than compensate for the incremental risk exposure. As our analysis shows, there are periods of time when market factors go against the founder-CEO strategy and result in portfolio underperformance. If such an event occurs, then alpha generation will be lost, although typically only for a brief duration. The founder-CEO index has recently become available in the marketplace, although this is the first study to document the actual index. 68 Managers can simply craft a founder CEO SMA strategy around the founder-CEO index and complement the holdings with a separate U.S. large-cap index in the corresponding benchmark (e.g., S&P 500, S&P 500 Growth, Vanguard Large Cap Growth, or Russell 1000 Growth). Alterna- tively, fund managers who chose to research and create their own index can glean SEC disclosure documents SUMMARY
L EADERSHIP M ATTERS : C RAFTING A S MART B ETA P ORTFOLIO WITH A F OUNDER -CEO T WIST
W INTER 2017
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