DOI: 10.1111/twec.

12511

SPECIAL ISSUE ARTICLE

Are top managers important for firm performance

and idiosyncratic risk? Evidence from sharia vs
non-sharia-compliant firms in the UK and Pakistan

Ali M. Kutan1 | Iram Naz2 | Syed Muhammad Aamir Shah3

1
Department of Economics and Finance, Southern Illinois University Edwardsville, Edwardsville, IL, USA
2
Capital University of Science and Technology, Islamabad, Pakistan
3
Allama Iqbal Open University, Islamabad, Pakistan

1 | INTRODUCTION AND BACKGROUND

One of the most important objectives of corporate enterprises is the maximisation of shareholder
wealth. In this regard, firm profitability is important. However, such profits are always accompa-
nied by risk driven by both internal and external factors. Uncertainty associated with firms’ inter-
nal factors and decisions is referred to as “idiosyncratic risk” (Heinle & Verrecchia, 2012).
Corporations generally do not have control over their external environment, but they may reduce
the idiosyncratic risk through diversification, financial decisions and operating leverage. Top man-
agers and their financial traits are thus important for firm profitability and specific risk. Regarding
the role of managers in managing idiosyncratic risk, the literature provides some indirect evidence.
For example, while dealing with borrowing and investment decisions, managers’ reputational con-
cerns may encourage them to pursue overly conservative business strategies (Diamond, 1989; Hir-
shleifer & Thakor, 1992). Managers who are overconfident are more likely to prefer more debt,
which leads to a higher level of idiosyncratic risk (Kraus & Litzenberger, 1973). Rotemberg and
Saloner (2000) and Van den Steen (2005) report that CEO vision is the most important ingredient
for the determination of a firm’s policy. Managers of levered firms tend to select investments that
increase the idiosyncratic risk (Galai & Masulis, 1976; Jensen & Meckling, 1976).
The importance of managerial financial styles in firm performance is also recognised in litera-
ture. For example, some studies argue that managerial styles are related to organisational outcomes
(Bamber, Jiang, & Wang, 2010; Bertrand & Schoar, 2003; Dejong & Ling, 2013; Dyreng, Hanlon,
& Maydew, 2010; Fee, Hadlock, & Pierce, 2013). Others report that managers can impact share
prices, a market measure of firm performance, by altering dividend policies, and firms with better
management tend to have more investment growth (Denis & Denis, 1994; Gunasekarage & Power,
2006; Jones & Brooks, 2005). Chemmanur, Kong, and Krishnan (2014) report that the relationship
between management quality and firm performance is strong. Bertrand and Schoar (2003) find that
management style is significantly related to managers’ fixed effect on firm performance and top
managers are important for financial and operating decisions and performance of firms.

World Econ. 2017;1–18. wileyonlinelibrary.com/journal/twec © 2017 John Wiley & Sons Ltd | 1
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Although the literature supports the view that top managers are important for organisational
policies and ultimately for the success of organisations, there are limited empirical studies on the
direct link between managers’ financial styles and firms’ risk-taking behaviour and performance.
There are three theoretical views on this issue. The neoclassical theory assumes that managers are
homogeneous and perfect substitutes for each other. In addition, all managers make similar rational
decisions in similar economic situations. According to the neoclassical view, top executives are a
key ingredient in firms’ strategic decisions, but such decisions are not influenced by managers’
individual financial styles (Weintraub, 2002). On the other hand, the upper echelons theory (Ham-
brick & Mason, 1984) argues that managers are different in their decision-making styles and
idiosyncratic differences exist due to different personal values and cognitive styles. Thus, accord-
ing to the echelons theory, decision-making preferences lead to different organisational outcomes.
The echelons theory is based on the characteristics of individuals and their judgement and deci-
sion-making.1 According to the theoretical view based on the judgement and decision-making liter-
ature, person, environment and task-related factors can affect the individual decision-making
(Bonner, 2008). For example, person-related factors refer to individual characteristics such as risk
behaviour, intrinsic motivation and confidence, which all influence the cognitive processes that
lead to decision-making. These personal characteristics are given different names in the literature,
such as financial styles (Prince, 2010; Shefrin & Nicols, 2014), managerial styles (Yang, 2012)
and managers’ fixed effects (Bamber et al., 2010; Bertrand & Schoar, 2003).
Overall, there is enough evidence to suggest that managerial financial styles can influence firm
performance and idiosyncratic risk. The literature, however, pays less attention to the direct role
played by managers in explaining cross-sectional variation in firm performance and idiosyncratic risk
in the context of sharia-compliant (SC) firms. There are only a few empirical studies. For example
Naz, Shah, and Kutan (2017) explore the impact of managers’ financial styles on financial decisions of
the sharia firms for Pakistan and the UK. For every firm, they construct a manager–firm matched panel
data to identify the top executives across the sharia-compliant firms and find that the managers play a
significant role in explaining the differences in financial decisions across the firms and the financial
styles of managers who move between a sharia and a non-sharia-compliant (NSC) firm are different.
Since performance and risk are the outcomes of financial decisions, in this paper we argue that the
managers may also play a role in explaining cross-sectional differences in firm performance and risk.
In another empirical study, Wooi and Ali (2015) show that there is no significant difference in
performance of SC and NSC firms, but the firms whose CEOs are Muslim show significantly lower
performance as compared to the firms of non-Muslim CEOs. They also find that Muslim-dominated
board could facilitate the lower performance of the firm with Muslim CEOs, and, more importantly,
the lower performance could be mitigated if the ultimate owner had a higher degree of control over
the firm. Another important finding in the Wooi and Ali (2015) study is that the Muslim CEOs can
contribute positively to the performance of the firm if the owners hold more controlling rights.
Our paper contributes to this line of research and attempts to fill the significant gap in the liter-
ature. In particular, we examine whether individual top managers are partially responsible for the
variation in firm performance and idiosyncratic risk after firm’s fixed effects and time-varying firm
characteristics are controlled for.2 We focus on the top executives’ effect on the idiosyncratic risk

1
According to the literature of psychology, three types of cognitive characteristics are important for affecting managerial
decisions: styles, abilities and strategies (Ho & Rodgers, 1993; Kozhevnikov, 2007).
2
Very few researchers examine the impact of managerial characteristics on performance and investment of the firm, and even
these do not control for the firms’ fixed effect, nor do they isolate the managers’ fixed effect from the firms’ fixed effect.
See, among others, Malmendier and Tate (2005).
KUTAN ET AL. | 3

and performance in the context of SC firms in both the UK and Pakistan. Our sample includes
only two countries due to data availability. However, our data set is interesting because it includes
firms operating under sharia or Islamic rule as well, allowing us to compare the findings between
a developed country, the UK, and a developing one, Pakistan.
In the context of SC firms, the literature on the importance of managers for firms’ risk-taking
behaviour and performance is very limited, but there are some related studies which address vari-
ous aspects of Islamic finance and business.3 However, these studies do not focus on the role of
manager in this context. In other related studies, Mansor and Bhatti (2011) study the perfor-
mance of mutual funds in Islamic and conventional portfolios and find no difference in between
returns of Islamic portfolios and those of conventional ones. They also report that the Islamic
portfolio is riskier than the conventional portfolios. They argue that the potential reason for this
unconventional finding is that the market penetration for Islamic portfolios is smaller but its
volatility is higher than that of conventional portfolios.4 We, however, argue that the managers’
financial styles may help in explaining such different risk characteristics of Islamic and conven-
tional portfolios.
The contribution of this study to the literature is threefold. First, it addresses the influence of
top managers’ financial styles on firms’ idiosyncratic risk and performance. Second, to explain
changes in firms’ idiosyncratic risk and performance, it examines the financial styles of managers
who switch from/to sharia and NSC firms. To study these issues, this paper uses the data on sharia
firms in the UK and Pakistan. SC firms are becoming increasingly popular after the global finan-
cial crisis of 2008–09. According to Robinson (2007), the market for the financial products of SC
firms has grown by 30% during the last few years. Third, this study extends a recent related study
by Naz et al. (2017) who explore the effect of managers’ financial styles on strategic financial
decisions, working capital and dividend policy of sharia and NSC firms and find that managers
play a significant role in explaining the variation in financial decisions. However, Naz et al.
(2017) focus only on financial decisions, while this paper considers issues related to idiosyncratic
risk and performance.
This paper adopts the research design of Bertrand and Schoar (2003) who construct a manager–
firm matched panel data set, and each of these managers in different firms was tracked for 3 years
at the firm where he/she worked.5 We find that top managers play a statistically and economically
important incremental role in explaining idiosyncratic risk and performance. Moreover, our results
indicate that, when managers move from a non-sharia to a SC firm, there is a statistically signifi-
cant difference between them in terms of their individual effects on firm performance and idiosyn-
cratic risk.

3
See, for example, leverage studies (Al-Deehani, Karim, & Murinde, 1999; Haron & Ibrahim, 2012; Singapurwoko & El-
Wahid, 2011), risk management and performance (Basov & Bhatti, 2014; Dejong & Ling, 2013; Hammoudeh, Kim, & Sar-
afrazi, 2016; Kamil, Alhabshi, Bacha, & Masih, 2014; Khan, Ahmad, & Gee, 2016; Saiti, Bacha, & Masih, 2015), stock
markets (Balcilar & Demirer, 2015; Bley & Saad, 2015; el Alaoui, Dewandaru, Rosly, & Masih, 2015; Kumar (2015);
Najeeb, Bacha, & Masih, 2015), efficiency and mutual funds investment (Al-Khazali, Leduc, & Alsayed, 2015; Merdad,
Hassan, and Khawaja (2016)) and Islamic modes of financing such as Islamic equity funds and sukuk (Islamic Bonds)
(Aloui, Hammoudeh, & ben Hamida, 2015; Kamil et al., 2014; Mohamed, Masih, & Bacha, 2015), differences between
Islamic bonds and conventional bonds (Alam, Hassan, & Haque, 2013). For example, according to Dharani and Natarajan
(2011), as compared to the non-sharia-compliant firms, sharia-compliant firms are less riskier.
4
On the other hand, Al-Khazali et al. (2015) find that conventional stock market indices are more efficient than their Islamic
counterparts. Abbes and Trichilli (2015) report that sharia-compliant shares could offer potential diversification benefits.
5
The three-year requirement will ensure that managers are given the chance to imprint their own “style” on a given com-
pany.
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| KUTAN ET AL.

The rest of the study is organised as follows. Section 2 presents a brief discussion of the empir-
ical methodology, while Section 3 describes the sample construction and defines major variables
of interest. Section 4 discusses the empirical results, while Section 5 presents the conclusions and
recommendations for policymakers.

2 | EMPIRICAL METHODOLOGY
To estimate the contribution of manager-specific effects to the variation in firm performance and
idiosyncratic risk, we follow Bertrand and Schoar (2003) and estimate the following equations:

yit ¼ at þ ci þ bXit þ 2it ; (1)

yit ¼ at þ ci þ bXit þ kCEO þ 2it ; (2)
yit ¼ at þ ci þ bXit þ kCEO þ kCFO þ 2it ; (3)
yit ¼ at þ ci þ bXit þ kCEO þ kCFO þ kothers þ 2it ; (4)
where yit stands for the firm performance and idiosyncratic risk in each year, at is year fixed
effects, ci is the firm’s fixed effects, Xit represents a vector of time-varying firm-level characteris-
tics, and 2it is a random error term. kCEO ; kCFO and kothers are variables of our interest that repre-
sent incremental fixed effects of individual managers on firm performance and idiosyncratic risk.
kCEO represents the fixed effects for the group of managers who are chief executive officers
(CEOs) in the last position we observe, kCFO shows fixed effects for the group of managers who
are chief financial officers (CFOs) in their last position, and kothers is the fixed effects for managers
who are neither CEOs nor CFOs but are in top positions such as chief operating officer (COO). In
our estimations, we account for serial correlation and allow clustering of the error terms at the firm
level.
Equation (1) is the benchmark model with the firms’ and year fixed effects along with time-vary-
ing firm-level control variables. In equations (2), (3) and (4), we add CEO, CFO and other managers’
fixed effects consecutively. These three later models allow us to test whether individual managers’
fixed effects play a significant role in explaining idiosyncratic risk and performance after controlling
for the firm’s fixed effects, year fixed effects and time-varying firm characteristics.
If managers have a significant role in idiosyncratic risk and the performance of the firm, we
expect significant values of the estimated coefficients on managers’ fixed effects. From equa-
tions (2), (3) and (4), it is evident that estimation of managers’ fixed effects is only possible when
a manager leaves a given firm during the sample period. If a firm has managers who never leave
the firm during the sample period, the firm’s fixed effects cannot be separated from the managers’
fixed effects because these two effects become perfectly collinear. To separate the managers’ fixed
effects from the firm’s fixed effects, the firm must have at least one manager who has switched
between firms.
To estimate the idiosyncratic risk, we follow the methodology used in Campbell, Lettau, Mal-
kiel, and Xu (2001). The Appendix reviews the estimation procedure in detail. To measure the
firms’ financial performance, researchers generally use accounting-based measures such as return
on assets (ROA), sales (ROS) and equity (ROE), or market-based measures such as Tobin’s Q and
market returns of stocks. In this study, we take two accounting-based measures, that is, ROA and
ROE, and a market-based measure, that is, stock market returns (Combs, Crook, & Shook, 2005;
Hoskisson, Hitt, Wan, & Yiu, 1999; Hult et al., 2008). In the literature, firm performance is linked
to certain variables including size (Love & Rachinsky, 2007), return on assets, dividend payout
KUTAN ET AL. | 5

ratio, liquidity (G€

urb€
uz, Aybars, & Kutlu, 2010) and sales (Forbes, 2002). We use these variables
as control variables in our estimations.

3 | SAMPLE AND CONSTRUCTION OF DATA

To examine the incremental role of top managers in explaining the cross-sectional variation in
idiosyncratic risk and performance of the sharia and NSC firms, we follow the longitudinal design
of Bertrand and Schoar (2003). Our sample consists of both SC and NSC firms from Pakistan and
the UK.6 We obtained the sample of SC firms in the UK and Pakistan from the Dow Jones Islamic
Index and the Karachi Meezan Index-30, respectively. The firm-level financial data and stock
prices for UK firms have been collected from the OSIRIS Database and DataStream over the per-
iod of 2001–14. Data for Pakistani firms have been obtained from the State Bank of Pakistan, and
stock price data have been extracted from DataStream over the period of 1999–2014. The sample
period choice has therefore been dictated by data availability.
The classification of Islamic firms is provided by Dow Jones, which categorises each firm as a
SC or NSC firm using a two-step approach. In the first step, all firms are classified based on
whether operations are in sectors that are prohibited in Islam. For instance, Islam prohibits firms
from generating income from pork-related business, alcohol, gambling and non-Islamic financial
services. In the second step, all firms that operate under the sharia law are examined for compli-
ance with certain financial ratios. According to the Dow Jones criteria, the ratios of leverage, cash
and liquidity have to be less than 33% for all sharia-compliant firms.7
Information on CEOs/CFOs has been extracted from the database “Who’s Who and Who
Was Who.” We restricted our attention to the subset of the sharia firms for which at least one
top manager can be observed in at least two firms (whether SC or NSC) for a minimum of
three years. The resulting sample contains about 42 companies from Pakistan (of which 25 are
SC and the rest are non-sharia-compliant firms) and 132 companies from the UK (of which 85
are SC and 47 are non-sharia-compliant firms). A total of 42 managers from Pakistan and 87
from the UK can be observed in the two different types of firms. The average length of stay in
a firm for a UK manager and a Pakistani manager is a little over 6 and 5 years, respectively.
We do not consider firms from the financial services and utilities industries, to preserve the
consistency of results.
The definition of variables is reported in the Appendix. The sample of Pakistani firms shows
that six CEOs moved from SC firm to other, while the same number of CEOs moved from non-
sharia to SC firms. In the case of CFOs, seven CFOs moved from an SC firm to another and 10
CFOs switched from NSC firms to SC ones. In the UK sample, 10 CEOs moved from an SC to
another and 22 CEOs moved from non-sharia to SC firms. Furthermore, 15 CFOs moved from
sharia to SC firms, while 25 CFOs switched from non-sharia-compliant firms to SC firms.

6
Untabulated results show idiosyncratic risk and performance are significantly different across UK and Pakistani firms. The
coefficients on dummy variables for all decisions are highly significant. The results are as follows: idiosyncratic risk
0.0113983 (p < .0001), stock prices 2.255 (p < .0001) ROA 0.09004 (p = .05) and ROE 0.087956 (p .0478).
7
The leverage ratio is measured as total debt divided by an average of 12 months’ market capitalisation; the cash ratio is
measured as the sum of the firm’s cash and interest-bearing securities divided by an average of 12 months’ market capitali-
sation, while the liquidity ratio is measured as accounts receivable divided by an average of 12 months’ market capitalisa-
tion. Available studies suggest that the idiosyncratic risk of Islamic firms is lower than the market risk (Al-Zoubi &
Maghyereh, 2007; Natarajan & Dharani, 2010; Shubbar, 2010).
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| KUTAN ET AL.

Table 1 presents the mean, median and standard deviation of data for firm characteristics and
financial decision variables. All variables are Winsorised at a 1% tail to mitigate the problem of
outliers. The first six columns report the descriptive statistics of the Pakistani and UK sharia-com-
pliant firms, and the next six columns report the descriptive statistics of non-sharia-compliant firms
for Pakistan and the UK. The average size of the UK firms is larger than that of the Pakistani
firms.

4 | INDIVIDUAL MANAGER’S FIXED EFFECTS ON FIRMS’

PERFORMANCE AND IDIOSYNCRATIC RISK

4.1 | Significance of incremental explanatory power of manager’s fixed

effects
Table 2 reports the results of the F test and adjusted R2 from estimating equation (1) for firm per-
formance and idiosyncratic risk for the Pakistani and UK firms. For every variable, we report in
the first row the fit of a benchmark specification that includes only time-varying firm controls,
firm’s fixed effects and year fixed effects. In the next three lines, we report the change in adjusted
R2 after adding the fixed effects of CEO and CFO as well as the fixed effects for all three groups
of executives. In the second and third rows, we also report the result of the F-statistics for the joint
significance of the different sets of managers’ fixed effects. In the last column, we report the F-sta-
tistics for SC firms.
The results in Table 2 suggest that fixed effects of top executives matter both economically and
statistically for the firm performance and idiosyncratic risk in both samples (Pakistan and the UK).
The inclusion of CEOs and CFOs as well as other managers’ fixed effects significantly increases
the adjusted R2 of the estimated model. Similarly, we find that the F tests are significant and allow
us to reject the null hypotheses that the managers’ fixed effect is jointly zero. We also see that
there are significant differences as to which firms’ performance and idiosyncratic risk are most
affected by the top executives. Moreover, we observe that different managers matter for different
types of decisions: for example, the CFO matters for capital structure decisions.

4.2 | Results for firms in Pakistan

Panel A in Table 2 reports the results of idiosyncratic risk and performance of the firms. We start
our discussion with the idiosyncratic risk. The benchmark specification includes firms’ fixed
effects, year fixed effects and control variables. The adjusted R2 for the benchmark specification,
which is 5.7%, increases by 8% when we include the CEO’s fixed effect. It further increases by
13.63% and 13.69% when we include the set of CFOs’ fixed effects and other managers’ fixed
effects, respectively. Interestingly, we can observe that fixed effects of CFOs and others, as com-
pared to that of CEOs, are highly significant and their inclusion has a large impact on the adjusted
R2. According to Chava and Purnanandam (2007), as compared to CEOs, CFOs are exposed to
more company risk. For ROA and ROE (accounting-based measures for performance), we observe
a 2.76% and 3% increase in adjusted R2, respectively, when we include the CEOs’ fixed effects.
On other hand, when we include the fixed effect of CFOs, the adjusted R2 increases by 11.97%
and 5.31% for ROA and ROE measures, respectively. These findings show that the CFOs and
other managers matter more for company performance as compared to CEOs. For stock prices, we
notice an 8.45% increase in adjusted R2 after inclusion of CEOs’ fixed effects, while the adjusted
R2 increases by 15.87% with the inclusion of fixed effects of CFOs and other managers. According
 KUTAN
ET AL.

T A B L E 1 Summary statistics of sharia and non-sharia-compliant firm characteristics

Manager–firm matched sample
Pakistan sharia firm UK sharia firm Pakistan non-sharia firm UK non-sharia firm
Mean Median SD Mean Median SD Mean Median SD Mean Median SD
Size 4.545804 4.41027 1.510187108 13.5218 13.76695 1.951143 3.694032 3.84818 1.662856 13.5948 13.6757 2.448363
Current Ratio 1.672232 1.243 1.133196717 1.810612 1.49 1.045235 1.578206 1.19 1.10699 1.48638 1.16 1.076763
Dividend 0.417223 0.369004 0.416755499 0.3377922 0.2982 0.3717469 0.405119 0.325154 0.405808 0.3098221 0.10005 0.4057247
payout
Leverage 0.524252 0.55686 0.225486121 0.147178 0.149605 0.117914 0.550997 0.587623 0.23252 0.170372 0.158536 0.133029
Price 4.0749 4.193285 1.144595 5.983874 5.974319 0.8827734 4.305563 4.161536 1.345667 5.147182 5.320788 1.230773
ROA 11.09718 9.45 10.2526 10.55519 9.39 6.998982 11.70959 9.2 10.50515 3.638247 4.67 6.76314
ROE 10.89635 8.7953 8.47523 8.78965 7.4526 4.7853 9.8754 7.4856 8.47896 1.7895 2.7859 4.8479
Sales 9.392667 9.272188 1.404875 13.60669 13.76831 1.491423 8.445015 8.55258 1.570911 13.72016 13.67573 2.203506
Idiosyncratic 0.022436 0.0111823 0.0245522 0.000758 0.0001517 0.0011964 0.006383 0.0015907 0.0100181 0.0006814 0.000035 0.0012473
risk
Sample size 375 1,112 252 616
Notes: Manager–firm matched sample includes the following: (i) firm-year observation for the sharia-compliant firms that have at least one manager observed in multiple sharia-compliant firms/non-
sharia-compliant firms with at least a three-year stay at each firm and (ii) observations for these firms in the years in which they have other managers that we do not observe in multiple firms.
We choose the sample of sharia-compliant firms where the manager may come from a sharia-compliant firm or a non-sharia-compliant firm.
All variables are winsorised at 1% tail.
|
7
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| KUTAN ET AL.

T A B L E 2 Managers’ fixed effects on firms’ performance and idiosyncratic risk

F test on fixed effects for
CEO CFO Others N Adjusted R2
Panel A: Pakistan
Idiosyncratic risk 627 .0570
4.61 (<0.0001) 627 .1370
3.62 (0.0001) 627 .1933
3.66 (<0.0001) 3.32 (<0.0001) 2.13 (<0.0001) 627 .1939
ROA 627 .2801
2.45 (<0.0001) 627 .3077
3.93 (<0.0001) 627 .3998
5.26 (<0.0001) 6.10 (<0.0001) 7.79 (<0.0001) 627 .4391
ROE 627 .2947
3.78 (<0.0001) 627 .3247
6.18 (<0.0001) 627 .3478
5.89 (<0.0001) 4.85 (<0.0001) 8.75 (<0.0001) 627 .3886
Stock price 627 .3637
6.59 (<0.0001) 627 .4482
6.15 (<0.0001) 627 .5224
8.01 (<0.0001) 6.22 (<0.0001) 10.58 (<0.0001) 627 .5224
Panel B: UK
Idiosyncratic risk 1,728 .1383
3.20 (<0.0001) 1,728 .1721
3.57 (<0.0001) 1,728 .2294
3.18 (<0.0001) 3.73 (<0.0001) 2.06 (<0.0001) 1,728 .2469
ROA 1,728 .0135
3.29 (<0.0001) 1,728 .0535
3.94 (<0.0001) 1,728 .1212
3.89 (<0.0001) 3.38 (<0.0001) 3.77 (<0.0001) 1,728 .1715
ROE 1,728 .1278
2.54 (<0.0001) 1,728 .1582
2.69 (<0.0001) 1,728 .1936
3.15 (0.0001) 4.52 (<0.0001) 2.81 (<0.0001) 1,728 .1989
Stock price 1,728 .0432
2.95 (<0.0001) 1,728 .0768
5.02 (<0.0001) 1,728 .1760
4.82 (<0.0001) 5.42 (<0.0001) 4.63 (<0.0001) 1,728 .2367
Notes: Sample is the manager–firm matched panel data.
Results that are reported in the table are the fixed effect panel regression, where standard errors are clustered at firm level. For each depen-
dent variable (as reported in column (1)), the fixed effects included are row (1): firm’s fixed effects, year fixed effects; row (2): firm’s, year
and CEO’s fixed effects; row (3): firm’s, year, CEO’s and CFO’s fixed effect; and row (4): firm’s, year and all managers’ fixed effects.
Reported in Panel A and B are the F test joint significance of CEO’s fixed effects (column (2)), CFO’s fixed effects (column (3)) and
all managers’ fixed effects (column (4)) of Pakistan and UK firms. For each F test, we report the value of F-statistics and p-values.
KUTAN ET AL. | 9

to Mian (2001), CFOs retain the crucial responsibility for the design and implementation of the
policy decisions that are directly linked with performance of the firm. In summary, our findings
show that CEOs/CFOs all matter for the firms in Pakistan.

4.3 | Results for the UK firms

Panel B in Table 2 reports the results for managers’ fixed effects on idiosyncratic risk and perfor-
mance of UK firms. The first variable is the idiosyncratic risk, and the benchmark specification
includes firms’ fixed effects and year fixed effects. When we include the CEOs’ fixed effects, the
adjusted R2 increases by 3.38%, and when CFOs’ and other managers’ fixed effects are included,
the adjusted R2 increases by 9.11% and 10.86%, respectively. In the case of ROA and ROE, we
observe that adjusted R2 increases by 4% and 3.04%, respectively, when we include the CEOs’
fixed effects, and by 10.77% and 6.58% for ROA and ROE, respectively, when we include the
CFOs’ fixed effects. For stock prices, we observe a 3.36% increase in the adjusted R2 when CEOs’
fixed effects are included, and the adjusted R2 increases by 13.28% and 19.35% when CFOs and
other managers’ fixed effects are added.
We have estimated additional regressions, not reported here for space considerations, by break-
ing down the categories into more specific job titles such as CFO, COO and CIO. The results
show that CFOs explain most of the increase in the adjusted R2 as compared to the others. Accord-
ing to Frank and Goyal (2007), CEOs do not run a firm by themselves; there are many others who
are also involved. For example, CFOs are naturally responsible for firm performance and idiosyn-
cratic risk. Although all top executives are expected to be an important ingredient for the firm, our
empirical findings show that CFOs matter more than CEOs for firm performance and idiosyncratic
risk in the UK, during our sample period.
Overall, we find for both countries that top managers are important for firm performance and
idiosyncratic risk but CFOs matter more than CEOs.

4.4 | Movement of Executives across Firms

An important question is how a board identifies an individual manager’s financial style when
selecting an executive. Bertrand and Schoar (2003) suggest that managers’ styles can be identified
by examining a manager’s choices of policy at their previous firm. If the style shows fixed or
innate characteristics, then the manager should display a similar style across different firms.8 To
study this issue in our sample, we identify all CEOs and CFOs who were previously employed as
CEOs/CFOs at other sample firms during the sample period. We eliminate the cases in which an
old employer was acquired by the new employer. Following Bertrand and Schoar (2003), we
employ the same imprinting condition; that is, a manager serves in a top executive position at each
firm for at least 3 years.
Following Bertrand and Schoar (2003), we estimate the regressions for each of the three depen-
dent variables. Regressions include firm–year’s fixed effect and firm-specific control variables.
Based on the regressions, we obtain the average regression residuals of the new and old employer
and estimate the correlation between the two. However, in contrast to Bertrand and Schoar’s

8
A famous example is that of Al Dunlap, a CEO, who displayed a style of massive cost cutting across different firms. The
question that arises is whether the style’s portability reflects a more general phenomenon (Perel, 2003). According to Cron-
qvist, Makhija, and Yonker (2012), the portability of managers’ styles depends on personal and corporate borrowing
choices.
10
| KUTAN ET AL.

(2003) findings of strong correlation, our untabulated results show smaller correlation between the
first and the second firms.9 Our results are more consistent with those of Fee et al. (2013), who
use a comprehensive sample of Compustat US firms from 1990 to 2007 and report that there are
causal managerial style effects that are idiosyncratic but not fully anticipated by the board.

4.5 | Magnitude of manager’s mixed effects

Previous results show that manager’s fixed effects explain a significant fraction of the variation in firms’
idiosyncratic risk and performance. Next, we gain more insight into the economic magnitude of the man-
ager’s effects on idiosyncratic risk and performance of the firm and the difference between the managers.
We report the size distribution of Pakistani and UK’s managers’ fixed effects in Panel C and Panel D of
Table 3, respectively. We show the mean, standard deviation, 25th percentile, 50th and 75th percentile.
The overall results in Panel C and Panel D in Table 3 show that the variation in the size of man-
ager’s fixed effects is economically large. For the distribution of manager’s fixed effects on idiosyn-
cratic risk, when it is compared to a mean level of 0.0154 for Pakistani firms and 0.00074 for UK
ones, the difference between a manager at 25th percentile and 75th percentile is 0.0026 for Pakistan
and 0.0007 for the UK. In Pakistan, the managers who are in the bottom quartile increase their firm’s
performance by 3% and the managers who are in the upper quartile increase their firm’s performance
by 18.3%. The UK managers who are in the lower quartile increase the performance by 2.88%, while
the managers who are in upper quartile increase the performance by 13.42%.

4.6 | Movement of CEOs and CFOs from SC and NSC Firms

In all the cases above, we used at least two companies to which each CEO and CFO moved. We
also selected the CEOs/CFOs of SC firms who may have moved in from either a SC firm or a

T A B L E 3 Size distribution of managers’ fixed effects

Mean SD P25 P50 P75
Panel C: Pakistan
Idiosyncratic risk 0.0153887 0.0190452 0.0013132 0.0.0058717 0.0239605
ROA 11.30947 10.29499 3 9.45 18.2
ROE 10.87542 8.7852 2.4789 8.4756 16.78
Stock price 4.125461 1.165264 3.258481 4.178379 15.153292
Panel D: UK
Idiosyncratic risk 0.0007358 0.0012281 0.00000172 0.0001105 0.0007376
ROA 8.015477 6.925186 2.88 7.39 13.42
ROE 6.78524 4.78524 1.869 6.479 11.785
Stock price 5.714833 1.018014 4.95603 5.754222 6.525689
Notes: The fixed effects used in this table are retrieved from the regression in Table 2 row (4).
Column (1) reports the mean fixed effect for each dependent variable; column (1) reports the standard deviation of the fixed effect;
columns 3, 4 and 5 report the fixed effect at 25th percentile, 50th percentile and 75th percentile of the distribution, respectively.

9
The correlation is .070 (p = .452) for idiosyncratic risk, .152 (p = .098) for ROA, .039 (p = .676) for ROE and .785
(p = .4785) for the stock price of Pakistan firms. For the UK firms, the correlation is .074 (p = .468) for idiosyncratic
risk, .089 (p = .380) for ROA, .0785 (p = .425) for ROE and .163 (p = .106) for the stock price.
KUTAN ET AL. | 11

NSC firm. In untabulated results, the joint F test of significance shows that the coefficient of
sharia dummies is jointly significant, showing that the idiosyncratic risk and performance of the
SC firms are different from the NSC ones.10 For the SC firms, there are certain Islamic rules and
guidelines which they must follow. According to the sharia law, SC firms are not allowed to
become involved in the production of any prohibited products and debt is discouraged. When
CEOs/CFOs move from a NSC firm to a SC one, they need to follow the rules of that firm.
Fee et al. (2013) raise the question as to whether managers imprint their own preferences on
the corporation or are selected to implement the preferences of the board. Hence, it is important to
identify whether the managers who come from a sharia-compliant firm have distinctive financial
styles as compared to those who move from a non-sharia-compliant firm. To test this in our sam-
ple, we regress the dependent variables against firm’s fixed effects, year fixed effects, control vari-
ables, CFOs’ fixed effects and others’ fixed effects in equation (1) to capture the fixed effects of
the CEO. We then calculate the residuals for the sharia and non-sharia-compliant firms. Note that
these residuals represent the fixed effect of CEOs. We repeat the same process for CFOs and
obtain residuals representing CFOs’ fixed effects. To test the difference in sharia styles of manager
who moved from sharia or non-sharia-compliant firms, we apply a t test on both groups (move-
ment of CEOs/CFOs from non-sharia to sharia-compliant firms or from sharia to sharia-compliant
firm). These results are reported in Table 4.
Panels E-H in Table 4 compare the fixed effects of CEOs and CFOs who move from non-
sharia to sharia-compliant firms and from sharia to sharia-compliant firms of the UK and Pakistan.
When we compare the movement from non-sharia to sharia-compliant firms, all t-statistics are sig-
nificant, suggesting that, in terms of their individual effects on firm performance and idiosyncratic
risk, there is a significant difference between CEOs and CFOs who worked in a non-sharia-compli-
ant firm and then joined a SC firm. On the other hand, when we compare CEOs and CFOs who
move from one SC firm to another, all t-statistics are insignificant, which indicates that there is no
significant difference between CEOs and CFOs who move from one sharia-compliant firm to
another.

4.7 | Robustness checks: Movement of CEOs and CFOs across firms

In Table 5, we report the regression results for CEOs and CFOs of Pakistani and UK firms who
moved either from non-sharia or sharia-compliant firms. In the previous section, we discussed the
results based on a t test for the movement of CEOs and CFOs. To check the robustness of our
results, we now regress the residuals of new firms (SC firms) of CEOs and CFOs on residuals of
old firms (which may be sharia or NSC firm) for all decision variables. The results show that the
decisions of CEOs/CFOs who moved from one SC firm to another are same in both firms. This is
due to the nature of the firms (i.e., the SC firms should obey the Islamic rules).
The results for CEOs/CFOs who move from non-sharia to SC firms are statistically insignifi-
cant. This is because the decisions in SC firms and non-sharia-compliant firms are totally different.
According to Hakim and Rashidian (2002), the risk and return characteristics of SC firms are sta-
tistically different from those of conventional firms. Islamic indexes also outperform their non-Isla-
mic counterparts (Ahmad & Ibrahim, 2002; Hussein & Omran, 2005; Mallin, Saadouni, & Briston,
1995).

10
For the UK, the results are as follows: idiosyncratic risk 9.43 (p = .0022), ROA 174.47 (p = .000), ROE 10.96
(p = .0013) and share price 163.47 (p = .000), whereas for Pakistan, they are idiosyncratic risk 6.96 (p = .0086), ROA 3.86
(p = .036), ROE 9.83 (p = .000) and share price 4.92 (p = .001).
 12
|
T A B L E 4 Movement of CEOs and CFOs from sharia- to sharia-compliant firm or non-sharia- to sharia-compliant firm
Non-sharia Sharia Differential mean t-Stat p-Value Sharia Sharia Mean t-Stat p-Value
Panel E: UK: CFO Movement
Idiosyncratic Risk 0.000749 0.001024 0.000275 6.9018 .0002 0.000571 0.000799 0.000228 1.40776 .080449
ROA 12.09349 9.717765 2.375725 2.8347 .01967 6.962162 7.314595 0.352433 0.50839 .305895
ROE 10.78543 7.23658 3.54884 2.8689 .02785 5.7896 6.7895 0.999 0.7896 .45879
Share Price 7.132179 8.007478 0.875299 1.84172 .033568 5.561461 5.764808 0.203347 1.52974 .064168
Panel F: UK: CEO Movement
Idiosyncratic Risk 0.000978 0.000601 0.000377 2.69841 .04603 0.000356 0.001039 0.000683 1.5083 .067442
ROA 4.712309 9.123653 4.41134 5.92153 2.66E08 12.74721 10.59427 2.15294 1.230527 .111031
ROE 3.17895 6.12589 2.94694 3.8967 .00245 10.8965 8.6987 2.1978 1.4879 .14587
Share Price 5.511193 5.642198 0.131005 2.758 .01478 7.23606 8.235163 0.999103 1.32111 .095005
Panel G: Pakistan: CFO Movement
Idiosyncratic Risk 0.006431 0.016195 0.009764 2.50987 .007 0.02439 0.016737 0.007653 0.17309 .2369
ROA 12.34062 8.190492 4.15013 2.739444 .00412 15.08263 16.54184 1.45921 0.69396 .245149
ROE 10.89678 8.12569 2.77109 2.6897 .00785 13.47896 12.78542 0.690418 0.8759 .15698
Share Price 4.837812 9.763886 4.92607 3.903811 .0001 4.241904 4.503378 0.26147 0.49081 .12586
Panel H: Pakistan: CEO Movement
Idiosyncratic Risk 0.012585 0.005297 0.120553 3.999364 .0001 0.028144 0.015882 0.012262 1.258692 .11097
ROA 9.796059 13.36006 3.564001 2.206167 0.0169 20.11264 13.73165 6.38099 1.10264 .14378
ROE 7.4263 12.4786 5.0523 2.7896 .02547 24.7896 16.4895 8.3001 0.8967 .2698
Share Price 4.405706 4.312487 0.093219 2.3585 .0114 4.824364 4.350242 0.474121 0.275847 .39262
Notes: Panels E and F summarise the CFOs and CEOs of UK firms who move from non-sharia-compliant to sharia-compliant firms and from sharia to sharia-compliant firms. Panels G and H
reports the results of CEOs and CFOs of Pakistani firms who move from non-sharia to sharia-compliant firms and from sharia to sharia-compliant firms.
Reported in panels E to H is the comparison of fixed effects of managers who moved from non-sharia- to sharia-compliant firms and from sharia to sharia-compliant firms for Pakistan and UK.
KUTAN

t-statistic significant at the 5% level.

ET AL.
KUTAN ET AL. | 13

T A B L E 5 Robustness checks: CFO and CEO movement

Coefficient p-value
Pakistani CFO Movement from
Idiosyncratic Risk Sharia to Sharia 0.560622 .034
Non-sharia to Sharia 0.163132 .257
ROA Sharia to Sharia 0.546206 .008
Non-sharia to Sharia 0.479044 .293
ROE Sharia to Sharia 0.45762 .012
Non-sharia to Sharia 0.5897 .354
Share price Sharia to Sharia 0.305969 .0114
Non-sharia to Sharia 0.04374 .828
Pakistani CEO Movement from
Idiosyncratic risk Sharia to Sharia 0.191 .019
Non-sharia to Sharia 0.5009 .401
ROA Sharia to Sharia 0.6052 .015
Non-sharia to Sharia 1.629 .20
ROE Sharia to Sharia 0.7589 .024
Non-sharia to Sharia 1.875 .426
Share price Sharia to Sharia 0.391 .0186
Non-sharia to Sharia 0.699 .380
UK CFO Movement from
Idiosyncratic risk Sharia to Sharia 0.8202 .008
Non-sharia to Sharia 0.224 .074
ROA Sharia to Sharia 0.2484 .05
Non-sharia to Sharia 0.1152 .3959
ROE Sharia to Sharia 0.879 .047
Non-sharia to Sharia 0.7854 .4796
Share price Sharia to Sharia 0.299 .0077
Non-sharia to Sharia 0.134 .2418
UK CEO Movement from
Idiosyncratic risk Sharia to Sharia 0.2038 .0094
Non-sharia to Sharia 0.222 .06
ROA Sharia to Sharia 0.4873 1.46E-06
Non-sharia to Sharia 0.0712 .51384
ROE Sharia to Sharia 0.256 .0048
Non-sharia to Sharia 0.1256 .3454
Share Price Sharia to Sharia 1.008 2.4E-25
Non-sharia to Sharia 0.09664 .3769
Notes: Columns (1) and (2) report the coefficient and p-value of CEOs and CFOs who moved from sharia to sharia-compliant firms
and non-sharia to sharia-compliant firms.
The p-value significant at the 5% level.
14
| KUTAN ET AL.

5 | CONCLUSIONS AND POLICY IMPLICATIONS

Despite indirect evidence linking managerial styles to firm performance and idiosyncratic risk,
research examining the direct role of managers in explaining cross-sectional variations in firm per-
formance and idiosyncratic risk in the context of sharia-compliant firms is limited. In this paper,
we bridge this gap in the literature by analysing the importance of managerial dimensions to
explain variations in idiosyncratic risk and performance for a sample of SC firms operating in Pak-
istan and the UK. We quantify how much of the observed variation in a firm’s idiosyncratic risk
and performance could be attributed to the managers’ fixed effects after controlling observable and
unobservable differences across firms. Our results show that top managers play a significant role
in explaining firms’ idiosyncratic risk and performance. We also find a statistically significant dif-
ference between managers who move from a non-sharia to a SC firm, but not for managers who
move from one SC firm to another.
Our results have important policy implications for shareholders who elect the directors, institu-
tional investors who invest massive amounts in the shares of listed companies and creditors who
advance significant loans to large companies. The findings suggest that it is important to discern
the differences between the managerial financial styles of top officials in SC and NSC companies.
Investors can accordingly develop their tick-list of managerial financial styles for the companies in
which they plan to invest. Similarly, shareholders are well advised to select those managers whose
financial style best represents their interests.

ACKNOWLEDGEMENTS
Naz and Shah are grateful to the Gulf One Lancaster Centre for Economic Research (GOLCER)
and Higher Education Commission of Pakistan for financial and academic support. We would like
to thank two anonymous referees and the guest editors, Prof. Dr. Mansor H. Ibrahim and Dr. Nafis
Alam, for their excellent comments and guidance. The usual disclaimer applies.

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How to cite this article: Kutan AM, Naz I, Shah SMA. Are top managers important for
firm performance and idiosyncratic risk? Evidence from sharia vs non-sharia-compliant firms
in the UK and Pakistan. World Econ. 2017;00:1–18. https://doi.org/10.1111/twec.12511

APPENDIX

DATA
The data related to stock prices and market capitalisation that are used in this paper are extracted
from DataStream, whereas the data for control variables for the UK used in this paper are extracted
from a major data source, OSIRIS, and data for CEOs/CFOs are extracted from the database of
Who’s Who & Who was Who.
OSIRIS is a database that reports financial variables for more than 80,000 individual worldwide
listed companies.
DataStream comprises key data sets from both developed and emerging markets—equities, mar-
ket indices, company accounts, macroeconomics, bonds, foreign exchange, interest rates, commodi-
ties and derivatives.
For the CEO/CFO information, we used the database Who’s Who, which includes up-to-date
information about over 33,000 influential people from all walk of life, worldwide.
For Pakistan, we used Balance Sheet Analysis (published by the State Bank of Pakistan) for the
collection of decision variables data, while for CEO/CFO information, we used companies’ web-
sites and LinkedIn.
The specific variables used in this analysis are defined as follows:
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| KUTAN ET AL.

• Firm’s size is log of total assets.

• Return on assets is net income divided by total assets.
• Return on equity is net income divided by shareholders’ equity.
• Current ratio is current assets divided by current liabilities.
• Dividend payout is defined as dividend per share divided by earnings per share.
• Leverage is defined as total financial debt divided by total assets.
• Details of idiosyncratic risk are as follows.

DERIVATION AND CALCULATION OF IDIOSYNCRATIC RISK

In this appendix section, we reproduce the methodology used by Campbell et al. (2001) to esti-
mate the measure of volatility without estimating covariance or betas. We present selected parts of
the derivations. The starting point is the CAPM model with the restriction of a zero intercept:

Rjit ¼ bji bim Rmt þ bji~eit þ g

~ jit ; (A1)

where Rjit represents the returns for a firm j in industry i at time t and Rmt is the market return. bji
is the beta for the firm j with respect to the industry returns, and bim is the beta for industry i with
respect to the market returns. Due to the condition of orthogonality, bjm = bji bim, and ~eit is the
residual of industry, and g~ jit is the residual of the firm. The decomposition of variance following
the equation (A1) is as follows:

VarðRjit Þ ¼ b2jm VarðRmt Þ þ b2ji Varð~eit Þ þ Varð~

gjit Þ: (A2)

Using this scheme of decomposition, we have to estimate the industries and firms’ betas which
might be not constant over time. Instead the “market-adjusted return model” is used. See, for
example (Campbell, Lo, & MacKinlay, 1997), for firms’ returns:

Rjit ¼ Rit þ gjit : (A3)

This model is only suitable when all firms on the market are included, and the beta can be sup-
posed to be one. Moreover, the beta-free variance decomposition to the model of market-adjusted
returns with the weighted averages across industries can be written as follows:
X X
wit wjit VarðRjit Þ ¼ r2mt þ r2et þ r2gt ; (A4)
i jei

where wit and wjit are the weights of industry and firm, respectively. We utilise equation A4 to
estimate the firm’s specific volatility or its idiosyncratic risk.
To estimate the firm’s specific volatilities, we begin by summing up the squares of the residuals
of equation A3:
X
r^ 2gjit ¼ g2jis ; (A5)
set

where s represents months and t represents years. To obtain the firm’s idiosyncratic risk, we then
multiply the weighted average within every industry with its respective residuals:
X
r^ 2git ¼ ^ 2gjit :
wjit r (A6)
jei