Leadership Matters: Crafting a Smart Beta Portfolio with a Founder-CEO Twist
J OEL M. S HULMAN
I n recent years, considerable attention has f locked to smart beta strategies with investment managers applying reweighting schemes to peer bench- marks. 1 In essence, managers identify per- ceived f laws within an existing benchmark and craft a makeover solution offering a dif- ferent twist with hopes of capitalizing on embedded opportunities. Although billed as passive plays, these strategies comprise an active component cloaked in the inner workings of quant redesigns. 2 Savvy man- agers develop smart portfolios by selecting factors from a plethora of options, including market capitalization, volatility, and price- to-earnings ratios, (P/E) among others. Management attributes, however, despite being important criteria for active fund man- agers in selecting stocks, rarely appear as an exchange-traded fund (ETF) or smart beta option. 3 Although the absence or rarity of a management-based ETF does not, in itself, imply an investment dilemma demanding a solution, it does raise the broader, simpler question of why leadership does not matter when running a large, publicly traded com- pany. 4 In this article, we introduce a proxy factor for quality of management by cre- ating and rigorously testing a founder-CEO index relative to a comparative benchmark that includes many of the same holdings. 5 The spirit behind this selection stems from developing academic research, emerging
fund managers who specialize in this exper- tise, and the investment logic supporting the hypothesis that if leadership does indeed matter, it would most likely occur with a founder CEO, who has a greater likelihood of control, economic and personal incentives, ability to exert vision on governance issues (stewardship) and an extended (unimpeded) job tenure to see his or her vision through to completion. 6 Following the logic further, we note that if an index of founder CEOs provide superior risk–return benefits relative to a peer benchmark, a smart beta solution develops from the opportunity to overweight those companies within the benchmark. The overall result would then yield comparable risk characteristics (to those of the bench- mark) with superior risk-adjusted returns. 7 We conclude that although this approach does not work in all time periods or across all market conditions, it appears to be effective in economic environments favoring growth- oriented stocks and, in particular, specific investment sectors. 8
J OEL M. S HULMAN is a professor of
entrepreneurship at Babson College
and managing director at EntrepreneurShares, LLC in Boston, MA. shulman@babson.edu
MAKING A CASE FOR THE FOUNDER-CEO FACTOR
Smart beta approaches attempt to beat market capitalization-weighted bench- marks through the application of differing weighting methodologies that accentuate factors such as momentum, size, dividends,
W INTER 2017
T HE J OURNAL OF I NDEX I NVESTING
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