For Bridgeway Funds founder John Montgomery, investing is about more than money.
There aren't many mutual fund semiannual reports
that contain a discussion titled "Some Personal Thoughts on Genocide."
Then, again, there aren't many mutual fund families that operate like
Bridgeway Capital Management, or multibillion dollar investment
managers like John Montgomery.
The firm's 50-year-old founder views philanthropic work as part of his
firm's mission, and the letter to shareholders on the topic of genocide
in December 2005 describes his recent trip to the war-ravaged regions
of Uganda and Rwanda. His commitment extends beyond conveying his
thoughts to shareholders. Half of the firm's investment advisory fee
profits are donated to charities, with particular emphasis on small,
grass-roots organizations.
"We want to reach charities that larger foundations might not look at,"
he says. "We like helping the little guy because we know what it feels
like to start out small." Though he declines to disclose the exact
amount his firm donated last year, he expects this year's donations
will be "well into seven figures."
A lean cost structure also distinguishes the firm.
No Bridgeway partner can make more than seven times the total
compensation of the lowest paid employee, and no one's salary exceeds
six figures. Directors ascribe to the same "seven to one" fee cap, and
those who are also Bridgeway employees do not receive director's fees.
Word of mouth, media coverage and performance charts take the place of
an expensive marketing budget. The firm's passively managed funds have
lower-than-average expense ratios, while those that are actively
managed use performance-based fees.
To investors, the pledge to support worthy causes
and to keep costs low would ring hollow without good fund performance,
and Montgomery has generally delivered on that front. The 11 Bridgeway
Funds, some of them actively managed and some index funds, have all
beaten their benchmarks since inception. A combination of solid
performance and inflows have brought the firm some $4.5 billion in
assets under management, a tenfold increase over the last four years.
But growth has not come without some controversy. In
2004, Montgomery settled SEC charges that his firm overcharged
performance-based advisory fees for three of its actively managed
funds. The SEC rule required that the performance rate portion of the
management fee be applied to the average of net assets over the full
performance period rather than the current period, as the funds had
done. Bridgeway paid back $4.4 million plus interest to shareholders of
the three affected funds.
The firm has since beefed up its compliance-related
efforts, including hiring a full-time compliance officer with 20 years
of mutual fund industry experience and retaining outside accounting and
legal help to do compliance checks. "We messed up badly on a specific
rule of law, and we have tried to be forthright about what happened and
own up to our mistakes," says Montgomery. "I don't think the incident
has hurt our reputation over the long term."
As his firm moves from a small maverick shop to a
sizable quant boutique, Montgomery continues to cast a long shadow as
manager of ten out of the firm's 11 funds. Richard Cancelmo Jr.
oversees the lone non-Montgomery managed offering, Bridgeway Balanced.
The $73 million fund is designed to provide a high current return with
less than half the risk of the stock market. Up to 75% of its assets
may be devoted to option writing, such as selling covered calls or
secured put options, which provide downside protection in a bear market
but limit potential for appreciation in rising markets.
Montgomery relies on a quantitative investment approach that makes it
possible to oversee the rest of the firm's offerings without spreading
himself too thinly or paying for an army of expensive analysts, he
says. That approach, refined over nearly three decades, uses five
computer models that span different investment styles.
A former research engineer at MIT, Montgomery
decided to move into investment management after a stint as director of
operations for the Houston Metropolitan Transit Authority. He took that
job, he says, "to make a difference in urban transportation and improve
the quality of life in the city."
But for many years, his real passion had been investing. After the
death of his father in 1982, he used half of his inheritance to go to
business school at Harvard University, and the other half to invest on
his own. Pleased with the results of his hobby, he put his life savings
into an industry he had never worked in to establish Bridgeway Capital
Management in 1993.
Montgomery quickly distinguished his firm with a low
cost structure and a willingness to venture into less traveled corners
of the market in a more structured way than most of his competitors at
that time. One of the firm's first offerings, Ultra-Small, owns 73
stocks that have a median market capitalization of just $332 million.
The $136 million fund has been in the top 2% of its Morningstar
small-company growth category average over the last one-, three- and
five-year periods.
To keep Ultra-Small nimble, Montgomery closed it to
new investors in 2001. A "sister" fund established in 1997, Ultra-Small
Company Market, has a similar investment focus. With $1 billion in
assets and 643 holdings, it is much larger and remains open to new
investors. Despite a lower expense ratio made possible by its size, the
newer fund has not proven to be a mirror image of its older sibling.
Ultra-Small Market's annualized returns over the last one, three and
five years ending June 30 were 15.07%, 21.65% and 22.35%, respectively,
compared with 25.6%, 26.85% and 25.83% for Ultra-Small. Montgomery says
the difference reflects the funds' cash flows. "If cash flows were
identical, performance would be much more similar," he maintains.
Another early offering, Bridgeway Aggressive
Investors I, is a multicap actively managed fund that is also closed to
new investors. It has been in the top 1% of the mid-cap growth category
over the last five and ten years, and in the top 10% over the last one-
and three-year periods. Performance for five-year-old Aggressive
Investors 2 has been similar to that of its sibling.
But those funds and other Bridgeway offerings can be
volatile. "Investors should bear in mind that the longer its streak
lasts the more vulnerable the fund will be to suffering severe setbacks
if and when the long-running bull market for ultrasmall stocks finally
comes to an end," Morningstar analyst Kai Wiecking says of the
Ultra-Small Fund. Wiecking's analysis of the firm's Micro-Cap Limited
Fund notes that "volatility is a double-edged sword, and that sword it
quite sharp here."
No one has been more candid about the possibility of
a pullback in small-cap stocks than Montgomery himself. In
communications to shareholders, he emphasizes that the outsized gains
of recent years present an opportunity to lock in some profits, and
rebalance to make sure that an asset allocation hasn't gotten out of
whack. "We're big believers in encouraging people not to chase
returns," he says.
By contrast, he believes large-company growth stocks
are selling at very attractive valuations. "These stocks got badly
hammered in the worst bear market since World War II and people stayed
away from them for a very long time," he says. "But that can't last
forever. Eventually, you have to look at underlying values."
The situation reminds him of 1998, when the kinds of
small-company stocks that the Ultra-Small Fund then favored took a hit.
That year, its net asset value fell 50% from its April peak to October
trough, at a time when the S&P 500 rose nearly 30%. But over the
five years ending in early July, it posted average annualized returns
of nearly 27%.
"It's unwise to be underrepresented in areas of the
market that have been beaten up," he concludes. "Large caps will have
their day in the sun."
Reflecting that viewpoint, Aggressive Investors 2 has raised its
allocation to large-company growth stocks. With a more conservative
tenor, stocks in the portfolio sell at an average of 23 times earnings,
compared with 37 times earnings three years ago.
Montgomery refers to Aggressive Investors 2 as "a
big engine with no handcuffs," and its beta of 1.8 confirms that
description. Still, he believes its style-straddling investment
strategy creates diversification and dampens risk. He also tries to
limit sector exposure, as he did by pulling back on energy holdings
from 36% of assets late last year to 15.6% at the end of June.
As actively managed funds, both Aggressive Investors
1 and Aggressive Investors 2 have performance-based management fees
that rise when the manager outperforms a particular index. If he
underperforms its benchmark, the fee is proportionally lower. Although
superior performance has driven management fees above his peer averages
in some years, Montgomery says the policy is in line with the firm's
commitment to a low cost structure. "If our portfolios do extremely
well, the advisor should do extremely well, too," he says. "The
arrangement aligns our interests with those of shareholders."
