To understand why the Bridgeway Small-Cap Value Fund had a one-year return of nearly 111% through the end of October, just look at its nameplate. The words “small cap” and “value” tell you what it’s all about, and these have been good places to be as small-cap value strategies regained favor during the past year after several years of underperformance vis-à-vis the broader U.S. equity market.

Of course, if that’s all it took to shoot the lights out then every small-cap value fund would have 100%-like returns during the past year. They don’t, and they’re not even close (though the category on the whole has performed well). And there’s a reason why the Bridgeway fund has been in the top quartile among its peers in Morningstar’s small-value category during every measurable period from year to date through the past 15 years.

It remains to be seen whether the revival of the small-cap and value investment styles has staying power, but the managers of this fund believe they’ve been able to provide pretty consistent long-term results versus the small-cap value competition due to an approach that Bridgeway Capital Management describes as statistically driven and grounded in academic theory. Or, as the $5.3 billion Houston-based asset manager puts it, it follows a disciplined investment process that reflects its “passion for logic, data and evidence.”

“We look at company fundamentals such as income statements and balance sheets and cash flow statements and price data,” says Elena Khoziaeva, head of U.S. equity at Bridgeway Capital Management and co-portfolio manager of the Bridgeway Small-Cap Value Fund. “But we process everything systematically by creating factor models and having a very disciplined process at how we analyze that data.”

Factor-based investing seeks to boost returns or dampen risk by tilting toward one or more investment factors—the attributes of an asset that both explain and produce its excess returns. Structuring investment models based on factors has been around for a long time, but it came into vogue among the investing public during the past decade thanks to the widescale launch of so-called smart beta—or strategic beta—factor-based exchange-traded funds. Smart beta straddles the line between a purely active, full discretion strategy and a rules-based passive strategy. Smart beta is rules based, but the rules are derived from human input.

Khoziaeva likes that the smart beta craze brought attention to the company’s factor-based approach, but she doesn’t put Bridgeway into the smart beta camp. “It’s a great term, but I don’t think it applies to us,” she says. “We provide something else.”

What sets the company apart, she posits, is that its investment strategy is centered on deep-factor exposure and diversification.

The Bridgeway fund’s portfolio focuses on the value, quality (the company’s term for this is “financial health”) and price momentum factors. “We don’t blend these factors, nor do we expect each individual stock to have each of these characteristics,” Khoziaeva says. “It’s about deep exposure to a particular factor.”

Investment factors can do their own thing and go their own way depending on economic conditions and market cycles, resulting in variegated performance over time. Khoziaeva notes that Bridgeway’s research team evaluates long-term results in order to find an optimal allocation for their small-cap value strategy (and all of their investment strategies) to help drive long-term outperformance.

“Each of the factor models are there for a specific reason,” she says. “If you look at it over short time periods, some factors will work and others won’t, but over a longer time period is when it all comes together.”

Active Share
The fund’s investment universe is its benchmark, the Russell 2000 Value Index. Unlike the index, the fund isn’t market-cap weighted. “The weight of each stock [in the fund’s portfolio] is determined by the model, not by market cap. As long as there’s liquidity, we can bring a position into the portfolio,” Khoziaeva explains.

“We buy names throughout the index, so compared to the Russell 2000 we end up being smaller,” she adds. “That’s one of the risk factors. We are smaller, but we’re not in the micro-cap space. We just have more smaller-cap names than the benchmark, and our average market cap is about half of the benchmark—I think our average is about $1.5 billion versus $3 billion [for the benchmark].

“[Small is] in the name of the strategy,” she continues. “And our valuation ratios show that we’re deeper value versus the benchmark, so we’re also true to the value part of our name.”

According to Morningstar, the fund sports lower valuations based on price/earnings, price/book, price/sales and price/cash flow measures.

The fund’s differentiation from its benchmark is reflected in its active share score of nearly 90 (Morningstar says a score of 100 means that a fund’s equity portion and its benchmark don’t have common holdings). Its reported turnover rate was 102% as of the end of the third quarter, which Khoziaeva says is in line with the portfolio’s historical turnover.

“Because of the different categories of models in this portfolio, some of the models are rebalanced at a lower frequency than others,” she notes, adding that value is a steadier, longer-term category with less turnover than the quality category, which is in the middle of the three factors this fund employs. Momentum is the fastest turnover category.

Khoziaeva stresses that she and the fund’s other two co-managers, John Montgomery and Michael Whipple, think about the tax consequences related to portfolio turnover even though it’s not a tax-managed fund per se. (Montgomery, Bridgeway’s founder and chief investment officer, has been at the fund since its inception in 2003. Whipple, like Khoziaeva, joined the fund two years later.)

“To the degree that we can implement tax-management techniques, we’ll do it secondary to the primary objective of the strategy, which is to follow the factor model allocation,” Khoziaeva says. “We have a very experienced trading team that has worked together a long time, and we have multiple small-cap strategies where we’ve learned how to trade small-cap stocks. We monitor both tax efficiency and transaction costs.”

Pounding The Table
Khoziaeva recognizes that the Bridgeway Small-Cap Value Fund has benefited from strong tailwinds resulting from the rebound in U.S. small-cap value equities that began late last year. But she believes the fund’s recent surge is more than just being in the right place at the right time.

“It’s not magic or luck regarding what’s happening for us right now,” she says. “From a process standpoint, what’s behind our success are the people who created the models and designed the allocation, and our ability to maintain a consistent exposure. Rebalancing matters, and in this case rebalancing toward those categories that have exposure to the factors that have been out of favor for a long time period—which is value and size—has positioned us for this success.

“We’ve been pounding the table on value for a long time,” she adds. “When value turned around, that’s just a reality of the market cycles as factors go in and out of favor. And that’s where diversification comes into play with this fund. You want to have exposure to multiple factors.”

She points out that allocations to the quality and momentum factors help offset the value factor, improving the odds that the fund will have a more consistent long-term track record.

And that approach is informing the fund’s portfolio managers going forward. “We continue to invest the majority of our assets in value while diversifying into the other two categories of financial health and momentum,” Khoziaeva says. “When we studied the big gaps between value and growth and large and small during the past three years, there’s still a lot of catching up to do. There’s still room to grow both on value and size. I still believe in these two factors.”