BlackBox With Heart

%
THE DOW JONES BUSINESS AND FINANCIAL WEEKLY
www.barrons.com
JULY 16, 2007
$4.00
Talking With
John Montgomery
Founder and Chief Executive
Bridgeway Funds
BlackBox
With Heart
by Jonathan R. Laing
Robert Seale for Barron’s
WHILE MANY ON WALL STREET SINGLEmindedly worship Mammon, the same
can’t be said for the 24-member mutualfund company Bridgeway Funds.
On a recent morning, its founder and
CEO, John Montgomery, spent much of a
weekly employee meeting talking about a
holocaust survivor he’d met on a recent
trip to Great Britain and her inspiring
tale of how she and her mother were rescued from near-certain death in an Austrian concentration camp by the providential
arrival of Allied forces.
Each year, Bridgeway gives half of its
net profits to charities, ranging from community groups and a Haitian medical clinic to genocide relief organizations around
the world. Last year, the total came to $8
million, with individual employees (called
“partners”) being able to designate
$20,000 gifts to charities they select.
Says Montgomery: “We tell job applicants that, if they want
to make millions right away, they should look elsewhere.”
Yet the Bridgeway funds usually trounce their benchmarks.
Montgomery’s philosophy of egalitarianism and antimaterialism extends to
other aspects of Bridgeway, which currently manages $5.6 billion in assets. He
limits his own annual compensation to
seven times the level of his lowest-paid
employee.
“Executive compensation is way out of
whack in this country, so we have our own
system to reduce any possible animosity
in the firm,” the lanky 52-year-old says
during an interview at the company’s
headquarters in a bank building in Houston, near the Rice University campus.
(over please)
THE PUBLISHER ’ S SALE OF THIS REPRINT DOES NOT CONSTITUTE OR IMPLY ANY ENDORSEMENT OR SPONSORSHIP OF ANY PRODUCT, SERVICE, COMPANY OR ORGANIZATION.
Custom Reprints (609)520-4331 P.O. Box 300 Princeton, N.J. 08543-0300. DO NOT EDIT OR ALTER REPRINTS ● REPRODUCTIONS NOT PERMITTED #32823
!
Standardized Performance as of 6/30/07
Average Annual Return
1 Qtr
1 Year
3 Year
5 Year
10 Year
BRAGX – before taxes
8.31%
10.79%
15.61%
15.91%
18.67%
Since Inception
(8/5/1994)
20.74%
- after taxes on distribution
9.17%
14.40%
15.18%
17.16%
19.33%
- after taxes on distribution and sale of fund shares
8.83%
13.27%
13.87%
16.09%
18.34%
Morningstar Ranking vs. Mid-Cap Growth Funds
727 of 983 150 of 814 58 of 662
BRUSX – before taxes
4.12%
- after taxes on distribution
- after taxes on distribution and sale of fund shares
9.12%
16.49%
24.08%
20.21%
22.26%
6.07%
13.40%
20.89%
17.35%
19.79%
19.26%
9.74%
13.70%
20.34%
16.86%
610 of 791
34 of 645
2 of 533
3 of 231
1 Qtr
1 Year
3 Year
5 Year
10 Year
11.14%
16.68%
17.90%
15.31%
--
Morningstar Ranking vs. Small-Cap Growth Funds
Average Annual Return
BRAIX – before taxes
2 of 269
Since Inception
(10/31/2001)
13.90%
- after taxes on distribution
16.32%
17.64%
15.16%
13.77%
- after taxes on distribution and sale of fund shares
11.23%
15.48%
13.45%
12.23%
542 of 983
54 of 814
93 of 662
Morningstar Ranking vs. Mid-Cap Growth Funds
Expense Ratios: BRAGX – 1.58%, BRAIX – 1.12%, BRUSX – 1.09%.
Performance data quoted represents past performance and is no guarantee of future results. Current performance may be lower or higher
than the performance data quoted. Investment return and principal value will fluctuate so that an investor's shares, when redeemed, may
be worth more or less than original cost. For the most recent month end performance, please visit our website at www.bridgeway.com or
call 800-661-3550. Periods of less than one year are not annualized. Morningstar ranks funds in various fund categories by making
comparative calculations using total returns.
“We tell job applicants that if they
want to make millions right away, they
should look elsewhere, but if they want to
make a real difference in life, this is the
place. Look, we make decent money
here—more than enough for our people to
have a spiritually satisfying life.” Likewise, investors appear to get a more than
a fair shake from Bridgeway’s mutual
funds, which impose no loads or 12b-1
fees.
And Bridgeway employees have a
strong reason for wanting the funds to
succeed. Each staff member is a shareholder and the firm prohibits investment
team members from investing in domestic
equities elsewhere.
Management fees and other fund expenses are below industry averages. And
the fees have a substantial performance
component, ensuring that Bridgeway is
rewarded for beating the market and
punished for trailing it.
A mistake in how the firm calculated
performance fees led to a 2004 regulatory
settlement with the Securities and Exchange Commission, under which the
company agreed to pay $4.4 million in
fees, plus interest, to investors in three of
its funds. Yet that hasn’t deterred fundrater Morningstar from consistently giving Bridgeway high marks on steward-
Bridgeway
Aggressive Investors 2
800-661-3550
Total Returns*
1-Yr
3-Yr
5-Yr
Aggr Investors 2
S&P 500
16.68%
20.58
17.90%
11.67
% Of
Top 10 Holdings Ticker Portf**
Big Lots
Guess?
BIG 5.0%
15.31%
10.71
Industry
Retail
Apparel
GES
3.5
McDermott Int’l MDR
3.0
Eng & Const
Crocs
3.0
Footwear
CROX
America Movil
AMX
2.9
Telecom
Avnet
AVT
2.8
Electronics
Varian Semi
VSEA
2.6
Semicond
Apple
AAPL
2.5
Computers
Bristol-Myers
BMY
2.2
Drugs
Tidewater
TDY
2.0
Drilling Serv
Total:
29.5
ship, both before and after the affair.
Bridgeway is quick to close funds to
new investors, forgoing additional profit
when cash flows threaten to make the
2
funds unwieldy. In addition, the company
strives to hold down trading costs and
keep its funds tax-efficient, even though
some have annual portfolio turnover rates
exceeding 100%.
Bridgeway is also one of the few fund
groups to rely solely on computer models,
rather than a phalanx of high-priced security analysts and managers, to pick
stocks. “Ours is a quantitative approach
that not only takes a lot of cost out of the
process, but also much of the emotionalism that so often trips up individual and
institutional investors alike,” Montgomery says.
Bridgeway’s black-box, or quantitative,
approach seems to have worked since the
company was launched in 1994. Since
then, all 11 of its funds have beaten the
indexes against which they’re measured—
some spectacularly so.
For example, the multi-cap Bridgeway
Aggressive Investors 1 Fund ($373 million in assets) has notched an average annual return of 20.74% since its inception
in September 1994 through this year’s
second quarter, compared with average
annual returns of 11.6% for the Standard
& Poor’s 500 index in the same span.
The Bridgeway Ultra-Small Company Fund ($140 million in assets) has
produced average annual returns of
Asks Montgomery: “Isn’t what goes on in the head of a fabled mutual-fund
manager, like Fidelity’s Peter Lynch, as much a black box as our models?”
22.26% during the same period, around
5.5 percentage points better than its
benchmark, Chicago’s Center for Research in Securities Prices Index, which
measures the performance of the smallest
10th of companies on the Big Board,
Amex and Nasdaq.
The 10-year record of Aggressive Investors 1 (ticker: BRAGX) puts it second
among 269 mid-cap growth funds tracked
by Morningstar. Ultra-Small Company
(BRUSX) finished third out of 231 smallcap growth funds in Morningstar’s database.
Montgomery’s path to a career in
money management was anything but direct. He started out as a transportation
engineer, after earning engineering degrees at Swarthmore College and graduate school at MIT. The vocation satisfied
his do-gooder impulses. “Some studies
have showed that grinding commutes and
poor public transportation have almost as
negative an impact on personal happiness
as the strain of children taking care of a
parent suffering from dementia,” he observes.
His engineering work also accustomed
him to applying statistics and advanced
mathematics to such esoterica as optimizing bus schedules and predicting traffic
flows. Montgomery insists that it wasn’t
that much of an intellectual leap to developing similar computer models to capture
the behavior of another complex system
—the stock market.
He began using models to invest for his
own account in 1982 after inheriting a
modest legacy upon the death of his father. That same year, he also enrolled in
Harvard’s MBA program to learn more
about business and investing.
There, he claims to have had an
epiphany in a finance class: In the main,
investors—especially bright Harvard
MBA students—don’t consistently beat
the market, because they’re both too
cocksure and too prone to emotional
swings. They lack the iron discipline of
rationality and careful diversification of
risk that black-box investing can provide.
Yet, after realizing this, he didn’t really consider quitting his day job at the
Houston Metropolitan Transport System—until the early 1990s, when his accountant, wowed by the trading profits
showing up on Montgomery’s stock returns, year after year, asked Montgomery to manage his own retirement account.
It took Montgomery until 1993 to incorporate, and another year to start his
first funds, which he operated out of a
tiny corner office in a strip mall across
the street from the current Bridgeway offices.
Bridgeway initially proved a hard slog,
attracting just $10 million in its first two
years. Then, Mutual Funds magazine
highlighted the lights-out performance of
Ultra-Small Company, which returned
39.84% in 1995 and 29.74% in 1996. The
article spurred some 10,000 requests for
fund prospectuses, and money began
pouring in.
To this day, to hold down expenses for
existing shareholders, Bridgeway does
little marketing. In line with its philosophy—You found us; we didn’t sell you—
Bridgeway gets new business mainly via
word-of-mouth, unsolicited news articles
like the one you are reading, and favorable mention in databases.
Institutions don’t give Bridgeway
much money. The exception: the socially
conscious Calvert Fund family, for which
the company subadvises on $1.6 billion of
small- and large-cap funds.
If Bridgeway’s quant philosophy isn’t
a complete conversation-stopper with
pension funds and the like, it certainly is
an inhibitor. As Montgomery observes
with bemusement: “It’s something of a
mystery to me, given our record, why our
technique is greeted with so much skepticism. Isn’t what goes on inside the head
of a fabled mutual-fund manager, like Fidelity’s Peter Lynch, as much a black box
as our models? At least if something were
to happen to me, our models would just
keep on cranking.”
Bridgeway follows 3,500 stocks, ranging
from behemoths like General Electric
down to micro and ultra-small names.
All are ranked according to their price
potential, employing a clutch of propri-
3
etary computer models looking at different characteristics. Portfolios are then
cobbled together from the top finishers in
different models to assure diversification
in the stocks’ attributes, sectors and risk
characteristics.
The composition of the 16 different
models that Bridgeway uses are, not surprisingly, closely guarded secrets. Montgomery doesn’t want to be front-run or
slip-streamed by nosy rivals. “All I can
say is that our models have multiple variables and different factor weightings,” he
comments.
Some idea of the company’s methodology can be gleaned, however, from factors that Bridgeway has tried unsuccessfully to model and back-test.
He avers, for example, that insider
trading data is overrated in delineating
the future direction of stocks. There’s a
perceptible “January effect” boosting
small-cap stocks, but transaction costs
limit the phenomenon’s profit potential.
And, he adds, noise in the data makes
shifts in economic growth or Fed policy
moves all but impossible to model.
Likewise, Bridgeway has never found
much value in using moving averages to
measure stock-price momentum. And
merely culling picks from stocks with low
price-to-earnings ratios doesn’t work unless growth potential factors are spooned
in.
Bridgeway’s multi-cap, “go-anywhere”
Aggressive Investors I Fund and its larger near-clone, the $651 million Bridgeway Aggressive Investors 2 (BRAIX),
are run with stocks selected from six different models.
One is purely technical, measuring
how stocks have acted in terms of price
and volume changes.
Three other models are biased toward
growth stocks trying to glean future
trends from past growth in earnings, cash
flow, book value and the like. Yet in one
of the growth models, value looms important. “We call this one our ‘growth at a
reasonable price’ model,” says Montgomery.
Finally, two pure-value-stock models
are employed.
He also talks excitedly about a new
“contrarian” model that the firm is rolling
out. It’s designed to uncover stocks that
have been unfairly beaten to a pulp.
Last year, Bridgeway’s models seemed
to short-circuit. Aggressive Investors 1
and 2 underperformed the S&P 500 by
8.68 and 10.35 percentage points, respectively. Montgomery minces few words
about the debacle, noting ruefully that
only one of the Aggressive Investors fund
models—a value measure—per-formed
well.
Yet, as he points out, Bridgeway has
recovered nicely from other down periods, such as the back-to-back years of
1997 and 1998, when Aggressive Investors 1 faltered.
Then there was a six-month period in
1998 in which Ultra-Small Company was
torched for a 50% loss.
In both cases, the funds roared back
to lay waste to their respective indexes.
And in both cases, some patience was
needed.
“I have a high tolerance to bad periods
and sleep quite well. We try to counsel
our fund investors to have a long-term
time horizon of at least three years, and
it just pains me that some of our clients
sold out late last year, rather than hanging around,” Montgomery muses.
Indeed that would’ve been good advice. This year, through July 9, Aggressive Investors 2 was up 21.38%, almost
triple the S&P’s 7.5% advance.
The argument could be made that
Bridgeway’s success arises in part from
the presence of small- and mid-cap stocks
even in larger-cap funds like Aggressive
Investors. In a market in which smaller
stocks have outperformed so dramatically
since 2000, that undoubtedly provided a
boost.
The median stock-market value of Aggressive Investors 2’s portfolio in 2002
was just half of its current level, $9.7 billion. Large-cap stocks then made up less
than 25% of the total portfolio; today,
they account for more than 46%. The
fund was able to capture the curl of the
small-stock surge. At the same time, its
performance also hints that, perhaps, bigcaps finally are back.
In addition, the models kept Aggressive Investors 1 from crashing and burning in the post-2000 collapse of the Bubble Market after the fund had returned
120.62% during the 1999 blow-off.
Over the following three years, it not
only avoided the Nasdaq’s 75% death
dive, but also annually outpaced the S&P.
“During 1999, the models made us pare
our tech positions from two-thirds to
about a third of the portfolio,” Montgomery recalls. “As a result, we were one
of only three members of the triple-digitreturn club of 1999 to beat the S&P each
of the following bear market years.”
The larger Aggressive Investors 2
fund’s latest top 10 holdings (as of March
31) reflect the models eclectic selections.
Montgomery isn’t one for personal
flash. He still lives in a modest four-bedroom home just three blocks from his office. What he likes to call his “yacht” is a
second-hand 15-foot boat that he keeps
stored near Galveston Island.
“In the end, it’s not the size of the
bank account that counts but the love and
relationships that one achieves in life,” he
observes.
A worthy sentiment, to be sure. And
one that many of Bridgeway’s investors
would endorse, even as their bank accounts expand. n
Before investing you should carefully consider the Funds’ investment objectives, risks, charges and expenses. This and other information
is in the prospectus, a copy of which may be obtained by calling 1-800-661-3550 or visiting the Fund’s website. Please read the
prospectus carefully before you invest.
©2007 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content
providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its
content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee
of future results.
Market volatility can significantly impact short-term performance. The Ultra-Small Company and Aggressive Investors Funds are subject
to above average market risk (volatility) and are not an appropriate investment for short-term investors. Investments in smaller
companies generally carry greater risk than is customarily associated with larger companies for various reasons such as narrower
markets, limited financial resources and less liquid stock. In addition, the Aggressive Investors Funds may exhibit added volatility due to
investment techniques such as use of futures, options and leverage. Total return figures include the reinvestment of dividends and capital
gains. Holdings are subject to change without notice.
The S&P 500 Index is a broad-based, unmanaged measurement of the stock market, based on the average performance, over any given
period, of 500 widely held common stocks. The CRSP Cap-Based Portfolio10 Index (CRSP 10 INDEX) is an unmanaged index of roughly
1,800 ultra-small companies compiled by the Center for Research in Security Prices. Both indexes assume that all dividends are
reinvested. It is not possible to invest directly in an index.
The Fund is distributed by Foreside Fund Services, LLC, which is not affiliated with Bridgeway Capital Management, Inc. or any other
affiliate.