A lackluster US economic recovery doesn't bode well for smaller companies, many of which lack the financial strength and global reach of large-cap fare. Meanwhile, the financial crisis and market implosion of 2008 prompted many investors to exit mutual funds that use quantitative strategies. But don't write off this underdog just because it uses statistical models to pick ultra-small caps.
It's human nature to side with the underdog, but sentimentality is best left out of the investment process. John Montgomery, founder of quantitative investment firm Bridgeway Capital Management, often cites the dispassionate nature of statistical modeling as a distinct advantage.
While there's a kernel of truth to this philosophy--especially in an age of media sensationalism and a 24-hour news cycle--the painful losses many investors suffered in 2008 and early 2009 led many to pull their money from quantitative funds. These days, mutual fund investors want to know more about how their money is being put to work--at least for the time being.
But investors should get the facts before they dismiss Bridgeway Ultra-Small Company Market (BRSIX) out of turn. This is one underdog with a solid pedigree.
As with all of Bridgeway's offerings, Ultra-Small Company market relies on a mix of proprietary models that identify which stocks to buy, hold and sell based on company-level data from a variety of sources. These models are internally developed and recalibrated over time to evaluate risk and potential upside.
This unique fund seeks to approximate the sector and industry makeup of the CRSP Cap-Based Portfolio 10 Index, a benchmark of the smallest 10 percent of stocks that trade on US exchanges. In fact, the average market capitalization of its portfolio holdings is lower than 99 percent of all small-cap funds.
Besides its focus on tiny companies, the fund also features an undersized expense ratio of just 0.75 percent. Montgomery also makes a concentrated effort to limit trading costs and rebalances the portfolio less often than managers of other passive funds. This has kept the annual turnover rate to an impressive 43 percent, though this approach produces some tracking error.
A focus on quality traditionally has set the fund apart from the competition. Montgomery and his team have devised a "sidestepping model" that limits exposure to names that are at risk of bankruptcy or a precipitous decline in share price.
Although this focus on company-specific data doesn't protect against shifts in sentiment or broader, event-driven market moves, avoiding riskier names limited the fund's losses in 2008, a time when highly leveraged small caps bit the dust. A diverse portfolio that includes over 600 names likewise blunts the impact of any implosions.
A quick glance at the portfolio's top performers and losers in the second quarter underscores the advantages of having such a large portfolio. Whereas the fund's 10 biggest stragglers posted an average loss of 81.1 percent, its top gainers were up an average of 72.8 percent. And over the course of the fiscal year the top 10 winners were up an average of 307.8 percent.
The health care sector, which accounts for 17.2 percent of the fund's investable assets, produced six of its best performers and four of its biggest losers.
Financials, the fund's other overweight sector, included losers such as the failed Columbia Bankshares and Hampton Roads Bankshares ( HMPR ), a struggling community bank that required significant capital infusions from the federal government via the Troubled Asset Relief Program (TARP) and two private-equity firms.
This variation is a testament to the potential risks and rewards associated with micro-cap stocks.
The portfolio tends to lag when more speculative fare is in vogue. Although the fund returned 25.9 percent in 2009, it struggled to keep pace with aggressive peers that loaded up on penny stocks and highly leveraged names.
That being said, management has no plans to change its model to take on additional risk. Over the past 10 years, the fund's performance ranks it in the top 18 percent of Morningstar's Small Blend category.
This bodes well for prospective investors seeking to add micro-cap exposure to an already diversified portfolio, though we would caution against allocating too much money to the fund because of its volatility.
With a low expense ratio and a well-diversified portfolio, Bridgeway Ultra-Small Company Market should continue to generate solid returns over the long haul.