The exchange traded fund industry has covered almost every corner of the markets. But the business is always on the prowl for new and exciting asset classes, sectors, global regions or investment styles that haven’t been explored.
For instance, I stumbled upon an intriguing mutual fund investment idea that could be easily translated into an ETF. Babson College Professor Joel Shulman heads a newly launched a mutual fund that tracks entrepreneurs. Since Babson is my alma mater, I reached out to Prof. Shulman and picked his brain on the idea of turning his mutual fund strategy into an ETF.
For five years, Prof. Shulman has headed a privately managed fund that has consistently outperformed peer benchmarks. Late last year, Prof. Shulman brought together his past research and created a stock Mutual Fund of Global Entrepreneurs called EntrepreneurShares, which is based on the entrepreneurial characteristics of managers in more than 400 of the best-managed, publicly-traded, entrepreneurial companies in the world.
“We have a very strong risk-adjusted alpha and high up capture ratio,” stated Shulman. “Over the past six years our extended performance ranks very high in our category.”
The fund is based on the Index of Global Entrepreneurs, which has generated annualized returns of over 12% for the past 5.5 years.
U.S. small-caps account for 60% of the EntrepreneurShares fund. It should be noted that small-cap stocks usually have limited liquidity and higher volatility. Small-cap companies often outperform in the early stages of bull markets.
“We have an up capture ratio of approximately 180%,” Shulman explained. “Consequently in positive equity markets our fund performs very well. In down markets we perform the same as the market (or slightly worse). Our fund provides no benefit in a negative market. Thus, if investors believe that market conditions are weak then they should not buy our fund. However, they probably should not buy most other equity funds either. We believe that the markets are well positioned for a strong rally in the second half of this year (personal opinion on the stock market—not a promise). Therefore, if the markets recover, entrepreneurial companies should perform very well.”
Prof. Shulman begins the selection process by pulling companies from a pool of 33,000 global publicly traded companies and selects entrepreneurial companies based on 15 attributes:
- Organic growth opportunities (not through acquisitions of other firms)
- Above average ownership stake among key stakeholders
- Low SG&A
- Above average return on invested capital
- Sustainable growth
- Manageable deb
- Active strategic alliances/partnerships/licensing
- Aligned executive compensation packages
- Low executive turnover
- Transparent governance
- Long duration of key managers
- Low or no dividends
- Family involvement
- High EBITDA Margin %
- Other significant stakeholder relationship
Through research at Babson College, it has been revealed that organizations with entrepreneurial culture, organic growth and aligned compensation tend to perform better. Companies with entrepreneurial characteristics tend to have leaders who “keep organizational costs lean, debt levels low, and expansion projects within reach,” according to a research paper Shulman wrote in 2009.
Shulman points out that non-entrepreneurial firms tend to create oversized organizational structures, payrolls and layers of red tape that would cut into efficiency. In comparison, entrepreneurial companies employ simplistic organizational designs that have less bureaucracy, allowing these firms to adapt to market conditions.
“Large companies tend to have higher turnover among senior managers and look for short-term solutions with growth,” said Shulman. “They are more likely to grow through acquisition. Moreover, compensation and equity holdings are significantly different.”
“We believe that entrepreneurs tend to grow organically and have a clear focus on their business units. Moreover, management of the companies that we invest in tends to hold a large economic stake in their companies,” Shulman added.
In comparison, entrepreneurial firms grow by looking into strategic partnerships and new business platforms. This “organic” expansion allows greater control over products or services. In addition, since organic growth requires minimal borrowing, companies are not as vulnerable to contractions in the credit market.
“Entrepreneurial companies grow in an organic manner and take better advantage of strategic relationships and alliances,” commented Shulman. “The managers focus on ROIC (return on invested capital) rather than revenue growth.”
The groundwork has been laid for a potentially new ETF product. The EntrepreneurShares Fund would translate fairly well into an ETF, said Shulman, and he does see himself managing an ETF of companies with the entrepreneurial spirit sometime in the future; however, Shulman will make the transition carefully since it is not their intention to cannibalize the growth in assets under management for their mutual fund.
The next big ETF might very well hold the next Apple.
Dr. Joel M. Shulman Ph.D., CFA, is the managing director & chief investment officer of EntrepreneurShares, LLC, which operates entrepreneurshares.com. EntrepreneurShares LLC is registered as an investment advisor with the Securities and Exchange Commission. EntrepreneurShares LLC serves as investment sub adviser to the Entrepreneur Series Trust, the EntrepreneurShares Indices, as well as for separate accounts.
Max Chen contributed to this article.