Actively managed mutual funds invest with the goal of outperforming a benchmark index or achieving an investment objective. Many academic studies focus on whether mutual funds outperform benchmark returns and debate whether abnormal returns can be attributed to skill or luck. While that debate is still unsettled, little attention has been devoted to stock selection strategies adopted by the actively managed mutual funds to outperform their benchmarks.
Stock selection strategies are about identifying a “mispriced” asset that will eventually become correctly priced. Ultimately, it is a bet on the CEO running the firm (“the jockey”) or a bet on the business of the firm (“the horse”). Kaplan, Sensoy and Strömberg (2009) study the evolution of firms from early business plans to mature companies and conclude that “investors in start-ups should place more weight on the business (the horse) than on the management team (the jockey). In a new study, we undertake a similar analysis for the investments of 9,914 actively managed mutual funds in the United States from 2004 to 2020. Specifically, we examine whether active mutual funds bet on the jockey or the horse by looking at their trading activity around CEO turnover events.
Our idea can be illustrated by the story of Steve Jobs. Arguably the world’s most famous CEO, Steve Jobs stepped down as Apple’s chief on August 24, 2011. For each of the 743 funds that held Apple in the third quarter of 2011, we rank the absolute changes in stock holdings among all quarters that the fund held Apple in its portfolio. If the largest change took place in a given quarter, the quarter would receive a rank of 100. If the lowest change took place in a quarter, the quarter would receive a rank of 1. We then look at the distribution of the rank order in the quarter in which Steve Jobs stepped down (2011Q3): The median of this distribution across funds is 83, which is greater than 50 and close to 100. This means that there was an unusual amount of trading activity by mutual funds in the shares of Apple in the quarter when Steve Jobs left Apple. Many funds bet heavily on Jobs (we refer to them as “jockey funds”), but quite a few did not (we refer to them as “horse funds”).
The evidence from Jobs’ departure motivates a more careful analysis of mutual funds’ trading around CEO turnover events. Is that trading abnormal, and if so, which are the jockey funds and which are the horse funds? More important, is betting on the CEO a persistent strategy of some active mutual funds and do investors earn higher returns from that strategy?
We find strong evidence of abnormal trading by active mutual funds around CEO turnover events. For all funds holding the stock of the company that changed its CEO, the trading activity in that stock is the highest in the month of the CEO turnover compared with all other months, as well as highest in the CEO turnover stock compared with other stocks in the portfolio of the fund in the CEO turnover month in the 12-months around the CEO turnover event. We also find abnormal exit rates (but not entry rate) by active mutual funds in the CEO turnover month.
Our empirical tests address two potential endogeneity problems. First, CEO turnover could result from a more fundamental change of firm policies. If so, funds that trade in the CEO departure month are not just betting on the CEO, but also on the policy change. To mitigate this concern, we look at trading around CEO turnovers involving CEOs with high ability: serial CEOs and raided CEOs (CEOs who leave one firm to join another firm). We find large changes in holdings and exit rates for raided CEOs, suggesting that the bets are being placed on the CEO rather than on the firm policy. Second, CEO turnover is endogenous to market conditions. For example, there may be unusual CEO turnover in market downturns in which investors are also more likely to rebalance their portfolio. To address this concern, we employ a subsample of CEOs who depart for exogenous reasons – their sudden death. We use the sudden death of a CEO as a natural experiment to analyze mutual-fund trading activities solely attributed to the unexpected departure of the CEO. For this subsample, we also find evidence of higher turnover and exit rates, which bolster our interpretation that funds are betting on the CEO.
We perform further tests to confirm that the evidence is a result of an investment strategy. First, we test whether the strategy is persistent. If betting on the CEO is an investment strategy, then we should expect persistence in the tendency to bet on the jockey or the horse over time. We find evidence of very strong persistence. The conditional probability of remaining a jockey once classified as a jockey ranges from 78 percent to 84 percent; the conditional probability of remaining a horse once classified as a horse ranges from 84 percent to 89 percent. This implies that switches in strategies are relatively uncommon.
We also use a variety of measures to capture industry environments where human capital and managerial skills are more important. We follow literature that documents that managerial skills are more valuable in industries with a) high output growth, b) high volatility in output growth, and c) high import penetration. We find that jockey funds have higher portfolio weights than do horse funds in industries where human capital and managerial skills are more important. This is intuitive. Betting on the CEO can only be a smart strategy when the CEO can make a difference, which happens in industries where CEOs are perceived to be more valuable.
Finally, we test whether betting on the jockey or the horse pays off for investors. We notice that although jockey funds charge higher fees than horse funds, their net returns are similar. If we do benchmark-adjusted returns, for the main samples, jockey funds have lower risk-adjusted returns than horse funds, but they have higher style-adjusted returns. In short, we do not have conclusive answers as to who earns higher returns, suggesting that the jockey strategy and the horse strategy are different investment strategies, like the approaches of value funds and growth funds, that can coexist in an efficient market.
Our study provides evidence on the extent to which actively managed mutual funds bet on the CEO, and documents that such bets are more prevalent when CEO ability is perceived to be more valuable.
Kaplan, Sensoy, and Strömberg (2009). Should investors bet on the jockey or the horse? Evidence from the evolution of firms from early business plans to public companies. Journal of Finance 64 (1), 75-115.
Bhattacharya, Chau and Nielsen (2023). Betting on the CEO. Working paper.
This post comes to us from Professor Utpal Bhattacharya at the Hong Kong University of Science and Technology, doctoral student Yuet Ning Chau at the Hong Kong University of Science and Technology, and Professor Kasper Meisner Nielsen at Copenhagen Business School. It is based on their recent article, “Betting on the CEO” available here.