7 We recognize that the outperformance could be attributed to other factors or market conditions and, later in the article, examine performance attribution across varying sectors and time periods. Moreover, in selecting a market benchmark, we first regress the return stream against a few market benchmarks holding comparable security populations (e.g., growth, large cap) and then select the benchmark with the highest correlation for comparative purposes. Moreover, in determining any potential advantage to our security selec- tion, we adjust for a number of factors, including size, style, momentum, liquidity, yield, quality, volatility, and profit- ability. We note that other methodologies that disentangle stock returns, such as by Jacobs and Levy [1988], might yield different results. We show later in Exhibits 4 and 10 that the risk associated with the founder-CEO index does not vary appreciably from a comparable benchmark. 8 By definition, a risk variable will not consistently provide returns in each and every period. As we show in the results section, results favor traditionally entrepreneurial growth sectors, such as Information Technology, Health Care, and Consumer Discretionary. Most stock holdings in this article represent these sectors. By contrast, relatively few companies reside in the Utility, Telecommunication, and Materials sectors. 9 Jacobs and Levy [2014] differentiated between smart beta and smart alpha and discussed the potential for over- crowding among smart beta strategies due to their simplicity and transparency. 10 Clearly, not all of the evidence is positive, although the preponderance of academic literature provides encour- aging results. Early research on founder CEOs by Johnson et al. [1985] showed a positive stock price reaction following the abrupt death of a corporate founder. Morck, Shleifer, and Vishny [1988] found a negative effect associated with founders and market valuation (principally among older firms). Research by Fahlenbrach [2009]; Palia, Abraham, and Chia-Jane [2008]; Villalonga and Amit [2006]; Adams, Almeida, and Ferreira [2009]; and Shulman [2010] has showed a positive effect of founder CEOs and investment performance. Evidence from the more recent, comprehensive studies provides the motivation for our smart beta analysis. 11 As we will see later, the returns to shareholders decline sharply after the founder CEO departs the organization. The effect is especially distinct in the period 5–10 years before the founder CEO retires/departs. 12 Fahlenbrach [2009] conducted a study of 2,327 large U.S. publicly traded companies over the period 1992–2002 and found significant differences between founder-CEO companies and successor-run companies. In particular, he identified differences in R&D, M&A, capital expenditure debt/assets, age, ownership, and stock performance. As we show later in the descriptive statistics section, R&D as a
exclusions or omissions. Our motivation has been to identify as many unique, relevant factors as possible. Earlier academic reviews surmised that what we deemed to be an entrepre- neur factor was likely already encompassed in factors such as growth, momentum, earnings, or some other well-explored category. We find that one entrepreneur factor that we proxy as a founder-CEO factor dominates the explanatory anal- ysis by far over the period from December 2006 through December 2015. We recognize that there may be other entre- preneur factors that can help explain excess returns, although we leave it to future research scholars to consider additional related characteristics. Notably, the founder-CEO factor seems to provide unique value, although a reason does not yet appear obvious. We surmise that characteristics embedded in this factor may help clarify this conundrum. For example, founder CEOs may assemble a unique governance or incen- tive structure that generates returns that exceed expectations (Leland and Pyle [1977]). Board composition; hiring prac- tices; growth financing/trajectory; employee compensation/ ownership; share classes/voting rights; selling, general, and administrative expenses; management attributes; and so on may all share some systematic commonalities with founder CEOs. Theoretically, any implied benefits or pricing anomaly should be priced away over time. However, it is possible that a series of complex factors underlie or are encompassed within founder CEOs that generate unusual or difficult-to-predict surprises (e.g., earnings, growth, productivity) that have not yet been discovered. 6 Citations later in this article discuss the merits of founder-CEO research. The evidence will make clear that founder CEOs have almost double the average duration in their jobs (as CEO), higher ownership levels, higher research and development (R&D) investments, better results with mergers and acquisitions (M&A), and stronger revenue growth while in office. Moreover, as our study shows, periods before and after the tenure of founder CEOs demonstrate a signifi- cant difference in relative risk-adjusted stock returns. While governance differences appear to be central to this research, the exact reasons for continued outperformance in the stock market are not clear at this time (although likely stemming from the list just given). Theoretically, investors in the mar- ketplace would observe this anomaly and price it away imme- diately. However, the results of our study show that returns are not symmetrical among constituents in the founder-CEO basket. Like any other portfolio, results can be skewed by significant winners and/or losers. Performance distribution results (shown later) indicate significant difference between founder CEOs and the benchmark. We surmise that founder CEOs have inherent governance traits that allow the possibility for exceeding market expectations year after year. Anecdotal cases such as Apple, Netf lix, Amazon, Google, and Facebook (among others) appear representative of this conclusion.
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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