Dick Cancelmo Head of Trading and Portfolio Manager at Bridgeway bio image

Richard P. Cancelmo, Jr.

Cindy Griffin, CIPM

We strongly believe in the potential for ultra-small stocks, and while we do not condone market timing, we believe we may be poised for a unique opportunity to capture a return to the long-term mean for ultra-small stocks.

In March of 2021, we wrote about an opportunity in the small-cap space that we call “ultra-small” stocks.[i]  This exemplified one of Bridgeway’s relational investing[ii] principles of stating where we stand. We wanted to briefly update that piece and re-state where we stand, but also be intentional (another relational investing principle) about disclosing what challenges investors may face by investing in ultra-small stocks.

The Ultra-Small Stocks Opportunity

Ultra-small stocks are smaller than micro-cap stocks and are represented by the smallest decile of stocks defined by the Center for Research in Security Prices (“CRSP”). For purposes of this post, we will use both “ultra-small stocks” and “CRSP 10 stocks” interchangeably. To briefly recap our thoughts from March 2021:

  • Since July 1926, the smallest decile of stocks (“CRSP 10”) has outperformed the largest decile of stocks (“CRSP 1”) and all other deciles of stocks on an annualized basis
  • In the last decade, CRSP 10 stocks have lagged CRSP 1 stocks on an annualized basis
  • The current trend of CRSP 1 outperforming CRSP 10 in the last decade represents an opportunity for ultra-small stocks. Historically, these stocks have experienced a reversion to long-term levels after dramatic periods of underperformance (such as the previous decade)

A year has gone by, and while ultra-small stocks have made up some ground, there is still a long way to go, as evidenced by the following chart:

Source: CRSP

We remain steadfast that ultra-small stocks represent a unique opportunity in today’s market, particularly given historical returns of the asset class. But challenges do exist for any investor who is willing to explore the exciting world of ultra-small stocks. We briefly touched on one in the last paper – liquidity – while two other primary challenges exist: higher potential for bankruptcy and cost erosion in trading. The first – higher potential for bankruptcy – can be addressed by a disciplined, systematic process that assesses a company’s potential for bankruptcy and other issues related to quality that could cause near-term underperformance. The second – cost erosion in trading – will be our focus below.

A Practitioner’s View on Trading Ultra-Small Stocks

By definition, to be a practitioner, one must be “actively engaged in an art, discipline, or profession”[iii]  which in some cases would be better known as an “artisan.”  We have long admired the work of artisans who make high-quality and distinctive products. Their work inspires with great attention to detail and beauty. Their vision and passion for conceiving and executing a project that results in an object – be it a leather handbag, a child’s wooden toy, or something else –  is a singular pleasure to see, to use, perhaps to hold, and sometimes even to give. None of this is possible without talent, time, and significant training.

As investment practitioners, we are artisans of a different sort. We each share the essential qualities of an artisan – vision, attention to detail, training, passion – and have the privilege of working with equally passionate and dedicated colleagues. Together we have created and manage unique investment strategies with an artisan mindset.

One of these strategies is our Ultra-Small Company Market strategy, which focuses on buying those ultra-small stocks in the CRSP 10 universe. The strategy’s overall goal is to achieve the CRSP 10 return net of fees over long time periods by roughly matching the sector and industry makeup and financial characteristics of the CRSP 10 Index.

Our approach to managing the Ultra-Small Company Market strategy is sometimes referred to as “passive, asset class investing” because it refers to the fact that the strategy intends to provide risk and return characteristics similar to investing in a basket of stocks in a specific asset class. From an implementation and trading perspective, we believe that this approach can offer investors a great advantage, particularly in this asset class. As practitioners, we know from more than 25 years of experience and data that trading costs are generally less in a passive or asset-class based approach. This experience holds especially true in the CRSP 10 universe, where active trading can be quite costly and diminish returns. Given that there are known challenges in trading ultra-small stocks, as practitioners, what have we done to mitigate outsized trading costs and improve trading efficiency in our Ultra-Small Company Market strategy?

First, our statistical, evidence-based investment approach combined with our passive trading approach means we have flexibility in which stocks we want to own within the universe of ultra-small stocks. The list of eligible stocks contains stocks that are statistically indifferent from each other and can provide similar contributions to risk and return. In other words, we do not have to own ABC stock. We could just as easily own XYZ. The urgency to trade a specific stock can destroy value through increased costs and higher purchase prices. Our patient approach to trading is a great advantage in the ultra-small stock universe.

Second, we can be opportunistic traders. Our many years of trading in ultra-small stocks have developed numerous beneficial, long-term relationships with brokers who know this space well. We have established processes that allow us to communicate and quickly reply to these brokers, especially when stockholders are urgent to sell an ultra-small stock. In many cases, a seller’s urgency is our opportunity and can result in a better (i.e., lower) purchase price. This is an example of how we have invested in the outcome – one of the principles of relational investing. The relationships that we’ve fostered over time with these brokers have ultimately improved the outcomes for our investors.

Finally, securities lending can be another integral aspect to the process. For portfolios that have an approved securities lending program, securities lent out may generate additional revenue/return. Securities lending is especially lucrative in the ultra-small stocks space as the supply of these stocks is more limited than larger-cap stocks, and demand is high. However, the practice is not without risk – a borrower of the lent security could become insolvent, or the collateral’s value could decline below the cost of replacing the securities. Bridgeway has robust processes, procedures, and controls around borrowers and collateral and works closely with custodian banks in implementing a securities lending program.

Our approach to trading in the ultra-small stock universe has helped Bridgeway provide better outcomes for our investors over the long term. Trading cost analysis and the additional return from securities lending in the Ultra-Small Company Market strategy provide strong evidence for that. For the calendar year 2021, transaction cost analysis[iv] showed our trading costs for the Ultra-Small Company Market strategy were -30 basis points versus the expected estimate of -84 basis points. In addition, the one-year return from securities lending on the strategy was 49 basis points. As noted above, a securities lending program needs to be approved and implemented for each account and must be carefully monitored to mitigate potential downside risks, and as each account is unique, there is no guarantee that this additional return from securities lending will be achieved in any account.

Summary

One of the most striking principles of relational investing is “discover the power in the paradox.”  The ultra-small company space is one of those places where an investor can find the paradox – attractive returns are paired with substantial challenges in implementation and practice. We strongly believe in the potential for ultra-small stocks, and while we do not condone market timing, we believe we may be poised for a unique opportunity to capture a return to the long-term mean for ultra-small stocks. For investors, trading can be a challenge in this universe, so knowing the challenges and how to mitigate them (or how their professional investment manager would mitigate them) can capture the power of the ultra-small stocks paradox.


[i] https://bridgeway.com/perspectives/crisis-and-opportunity-the-overlooked-role-of-ultra-small-stocks/

[ii] Relational investing unites investment results and returns for humanity by taking an innovative approach to asset management. It is a statistical, evidence-based investment approach motivated by a passion for servant leadership and global impact which we accomplish by donating 50% of our firm profits to organizations making a positive impact for humanity.  Relational investing focuses on generating enduring results that meet client investment objectives while fostering transformative change in the world. For more detail, please see https://bridgeway.com/perspectives/an-open-letter-on-relational-investing/ and https://bridgeway.com/perspectives/relational-investing-in-action/

[iii] Oxford Languages

[iv] Transaction Cost Analysis (“TCA”) measures the implicit and explicit costs of trading.  Bridgeway’s third party TCA vendor focuses on implementation shortfall, which measures the difference between the dollar return of a paper portfolio for which all shares are assumed to transact at the prevailing market price at the time of the investment decision, and the actual dollar return they realize in their portfolio. In general, a smaller shortfall is perceived to be better for the investor.

DISCLOSURE

The opinions expressed here are exclusively those of Bridgeway Capital Management (“Bridgeway”). Information provided herein is educational in nature and for informational purposes only and should not be considered investment, legal, or tax advice.

Past performance is not indicative of future results.

Investing involves risk, including possible loss of principal. In addition, market turbulence and reduced liquidity in the markets may negatively affect many issuers, which could adversely affect client accounts.

Diversification neither assures a profit nor guarantees against loss in a declining market.

The Center for Research in Security Prices (“CRSP”) US Stock Databases contain daily and monthly market and corporate action data for over 32,000 active and inactive securities with primary listings on the NYSE, NYSE American, NASDAQ, NYSE Arca, and Bats exchanges and include CRSP broad market indexes. CRSP databases are characterized by their comprehensive corporate action information and highly accurate total return calculations. The CRSP Cap-Based 1 Index (“CRSP 1”) is an unmanaged index of roughly 200 ultra-large companies compiled by the Center for Research in Securities Prices, with dividends reinvested. The CRSP Cap-Based 10 Index (“CRSP 10”) is an unmanaged index of roughly 500 ultra-small companies compiled by the Center for Research in Securities Prices, with dividends reinvested.

One cannot invest directly in an index. Index returns and references to specific company earnings and other financial metrics do not reflect fees, expenses, or trading costs associated with an actively managed portfolio.

Tammira Philippe President, CEO, and Head of Strategic relationships at Bridgeway bio image

Tammira Philippe, CFA

Tamla Wilson Director of Institutional Relations at Bridgeway bio image

Tamla Wilson, DMin

Conscious Capitalism title graphic

Business Through a New Lens: Balancing Profit and Purpose
The following virtual gathering was held on February 17, 2022. The video is posted here by permission of Conscious Capitalism.

Click here to watch the video.

Businesses should exist for reasons beyond just making a profit. Conscious businesses bridge the gap between profit and purpose in order to elevate the communities they serve. Bridgeway, a national investment management firm, does so through their focus on relational investing, an approach to investing that unites results for investors and returns for humanity, as well as their commitment to supporting global transformative change by investing in humanitarian organizations.

During this Virtual Gathering, Tammira Philippe, President and CEO of Bridgeway, delves into how she has led her company and how others can ensure profit for their business while honing in on their Higher Purpose, including her take on the importance of servant leadership, fostering a culture of stewardship, and maintaining unwavering company core values. Tammira was joined by Tamla Wilson, DMin, Director of Institutional Relations, who shared her unique story and calling.

To learn more about Conscious Capitalism, visit their website https://www.consciouscapitalism.org/

Conscious Capitalism logo

The opinions expressed here are exclusively those of Bridgeway Capital Management (“Bridgeway”). Information provided herein is educational in nature and for informational purposes only and should not be considered investment, legal, or tax advice.

Tammira Philippe President, CEO, and Head of Strategic relationships at Bridgeway bio image

Tammira Philippe, CFA

This article was originally published June 7, 2021 on LinkedIn by Tammira Philippe, CFA

White male founder. Quantitative asset management firm. Female CEO. 67% of all professionals, 60% of portfolio managers, and 60% of senior leadership identify as a woman or person of color, or both. 100% of staff believe the firm provides sufficient resources to foster the success of a diverse team.

Are these statistics probable? No. Possible? Absolutely! I know this kind of diversity is achievable because this is real data from Bridgeway Capital Management, the asset management firm that I lead as CEO. Of course, even a quant like me will say with certainty that there’s a whole lot more that numbers can’t tell you about diversity, equity, and inclusion (DEI) at Bridgeway or any organization.

As more companies recognize the benefits and tackle the challenges of making progress on DEI, we get asked a lot of questions on this topic. Our favorites by far are: How did you do it? How can I do it? How can others do it? Our answer is: Be Intentional[1]. We accept the challenge of this simple and complex solution because it’s part of discovering the power in the paradox, a principle in our approach to relational investing.

So, what do we mean when we say “Be Intentional”? Our outcomes did not happen overnight; they are the result of continuous work and learning over more than two decades. Since 1993, Bridgeway has been intentional on our journey towards DEI, starting with clear commitments in our mission and vision statement and carrying through to our actions every day. As one example, both the Head of US Equity and I are women who started in the industry at Bridgeway and were mentored and developed internally over more than a decade to become leaders of the firm.

Bridgeway is still a work in progress on DEI, and we will never stop learning. By sharing some of our story, I hope to spark more action on this vital topic that is crucial to prosperity[2] in the decades ahead for every individual and organization. It’s time to reclaim prosperity for all.

As the leader of an investment manager who invests in public equity around the globe, I want to see progress on DEI at Bridgeway and all the public companies globally that we hold in our portfolios. I firmly believe, based on the evidence, that diverse and inclusive teams and organizations make better decisions and achieve better outcomes. I want to see companies strive, as we do at Bridgeway, for both cognitive and identity diversity[3]. Cognitive diversity is about bringing together different ways of thinking, while identity diversity is about bringing together different demographics of people, and they are, of course, often related. Cognitive diversity without identity diversity falls short of achieving true diversity, equity, and inclusion. Cognitive and identity diversity must also permeate an organization at all levels – from interns through the C-suite to the board room, and especially on the research and portfolio management team in investment management.

Being intentional on DEI starts at the top: “Want progress on diversity? Link it to your CEO’s pay,” said Phil Wahba in an April 2021 Fortune article. According to the same Fortune article, only 97 of the companies in the Russell 3000 have at least one diversity goal for at least one top executive; that leaves gigantic room for improvement. The Fortune article also cites the 320 to 1 CEO-to-worker pay ratio as a cause for scrutiny and concern. In contrast, Bridgeway has a stewardship commitment that sets a cap on the highest compensation after considering pay ratios and other financial outcomes. This helps us focus on stewardship which we define as having the passion and discipline to care for an asset for the benefit of others. I wholeheartedly support moves to address the CEO pay gap that has grown dramatically over the last three decades. It is hard to have equity and inclusion with a 300x pay gap – a diverse workforce notices that and cares.

My experience and the research I’ve seen also tells me that links to pay will be only part of the equation to make the massive progress needed on DEI. While explicit diversity metrics tied to pay may be necessary to accelerate DEI efforts in many businesses today, we must also realize that pay is already tied to business goals that depend on DEI for success. This is the mindset that we have successfully fostered at Bridgeway and how we have recruited and retained a diverse team with a strong culture and sense of belonging over decades. I hope to see a future when more people cultivate DEI in more places and capture the innovation, profitability, and other benefits that a diverse, motivated, and collaborative workforce can bring.

Going way beyond pay, in the Lean In/McKinsey 2020 Women in the Workplace Study, 25% of women are contemplating downshifting their careers or leaving the workforce due to the challenges of the last year which have disproportionately impacted women, the Black community, and other under-represented groups in our organizations. This could unwind years of progress toward gender and other dimensions of diversity. Not one of the considerations for leaving is related to pay (or the CEO’s pay, for that matter). Flexibility is a key aspect of establishing equity in a DEI program in our experience at Bridgeway, and both men and women benefit from it. Solutions that we have implemented successfully include flexible schedules, part-time roles, and a results-focused work environment.

You have to get pay right, but it is not enough. A clear sense of purpose is essential for companies and individuals to create a vibrant culture and workplace with diversity, equity, and inclusion.

This is highlighted in the work of Daniel Pink in DRiVE where his research and experience show that mastery, autonomy, and purpose are what really motivate us. In addition, a 2020 McKinsey survey revealed that only 18% of respondents get as much purpose from work as they want, and this is even more prevalent among women and people of color based on my experience.

At Bridgeway, our vision is “A world without genocide. Partnering to create an extraordinary future for our clients, community, and world.” Our purpose comes from the nobility of being entrusted to steward assets for the future well-being of our clients and from donating 50% of our earnings to generate returns for humanity. We ask every person who joins Bridgeway to commit to servant leadership, to put our clients’ interests ahead of our own, and to help make a positive impact in the world with our united commitment to Bridgeway Foundation and by supporting community organizations in other personal areas of interest.

When 67% of your firm identifies as a woman or person of color, you get asked a lot about how you did it. Be Intentional is our simple and complex answer. What keeps me up at night is how we are going to keep doing it and where we are falling short. We are still learning and growing on our own journey for DEI and will never stop. Staying curious and striving for continuous improvement is in the fabric of our firm. Being intentional about pay and purpose is at the heart of what we have been able to accomplish so far, and we expect that to continue. Join us on Mission Possible for diversity, equity, and inclusion and see the success that awaits.

[1] Be Intentional is one of five principles that we practice at Bridgeway as leaders in relational investing, an approach that unites results for investors and returns for humanity. We believe everyone can implement all five principles. For more, see Relational Investing in Action.

[2] Prosperity is more than financial success. Prosperity is the success we achieve when we follow principles and strive for our highest aspirations for ourselves and others. See An Open Letter on Relational Investing for more. https://bridgeway.com/perspectives/an-open-letter-on-relational-investing/

[3] The Diversity Bonus and other work by Scott Page is a great resource on cognitive and identity diversity.

The opinions expressed here are exclusively those of Bridgeway Capital Management (“Bridgeway”). Information provided herein is educational in nature and for informational purposes only and should not be considered investment, legal, or tax advice.

The following podcast originally appeared on September 10, 2021, on the Take the Long View podcast. The podcast is posted here by permission of the Take the Long View podcast.

Click here or on the following image to listen to the podcast.

I don't think life is all about a pure financial equation, it's really about becoming the best human being that you can be and being able to give the world the best of yourself.

From Take the Long View:

Tammira Philippe is the embodiment of the American dream. The first in her family to go to college and now the CEO of Bridgeway Capital Management, Tammira has paved a purposeful path for herself and her organization. Enjoy this episode as Matt talks with Tammira about her journey from Channelview, Texas, to the boardroom. Hear how Matt insulted Tammira a decade ago, how Tammira believes balance is boring, and her take on the essential qualities of a leader.

More about Tammira

Tammira began her career at Bridgeway in 2005. She is President and Chief Executive Officer of Bridgeway Capital Management and is a member of the firm’s Board of Directors and Portfolio Innovation and Risk Committee. As President, Tammira’s responsibilities include developing and executing the firm’s strategy, overseeing all operations, and contributing to the marketing and client service efforts. Before becoming President, Tammira led strategy and operations projects at Bridgeway from 2005 to 2010 and was Head of Client Service and Marketing from 2010 to 2016.

Tammira earned an MBA from Stanford’s Graduate School of Business and graduated summa cum laude with a BS in Computer Science from Texas A&M University. Her experience before Bridgeway includes strategy consulting with McKinsey & Company and business development and marketing for a global satellite communications startup. She is passionate about promoting education and social justice and volunteers with organizations focused on those missions. Tammira serves on the Texas A&M University Computer Science and Engineering Advisory Council. She previously served as a board member for the Education Foundation of Harris County and as a member of the Advisory Board of the Terry Foundation. This scholarship provider supported Tammira’s education.

Key Topics

Intro (00:13)

  • Growing up and early dreams of leadership (3:22)
  • Working for McKinsey (6:08)
  • ROI of an MBA (9:10)
  • Finding Bridgeway (11:10)
  • Partnership at Bridgeway (19:25)
  • Married to a Frenchman (21:57)
  • Teaching kids about money (24:32)
  • Where to learn more about Tammira (39:00)

Disclosures

The opinions expressed here are exclusively those of Bridgeway Capital Management (“Bridgeway”). Information provided herein is educational in nature and for informational purposes only and should not be considered investment, legal, or tax advice.

Investing involves risk, including possible loss of principal. In addition, market turbulence and reduced liquidity in the markets may negatively affect many issuers, which could adversely affect investor accounts.

Diversification neither assures a profit nor guarantees against loss in a declining market.

Jacob Pozharny Head of International Equity at Bridgeway bio image

Jacob Pozharny, PhD

Cindy Griffin, CIPM

As we continue to monitor economic and market trends in emerging markets (EM), we find that the Price-to-Book – Return on Equity (PB-ROE)[1] analysis we described in our last update offers a flexible methodology for applying different lenses to the EM investment landscape.

Our last analysis used the PB-ROE analysis to examine how cheap or expensive different EM countries were relative to their level of profitability. In this update, we’re comparing valuations and profitability among major industries in the EM small-cap universe. To provide additional context that’s important to many investors, we’ve also applied a layer of Environmental, Social, and Governance (ESG) analysis to examine the potential relationships between valuation, profitability, and ESG considerations.

The chart below highlights conditions in the EM small-cap landscape as of June 30, 2021.

  • The y-axis plots each industry’s median book yield, placing cheaper industries higher on the chart.
  • The x-axis plots each industry’s median return on equity, placing more profitable industries farther to the right.
  • Industries are color-coded according to their median ESG scores based on MSCI ESG ratings. Industries in orange have the lowest median ESG scores, while industries in blue have the highest.
Chart highlights conditions in the EM small-cap landscape as of June 30, 2021

Source: FactSet, MSCI, and Bridgeway

More profitable industries typically command a higher valuation. We expect that the cross-section of industry Book Yield and ROE medians to be negatively correlated as more profitable industries are more expensive while less profitable industries are less expensive. This chart uncovers investment opportunities in the outliers – industries that don’t conform to these expectations.  So what does this PB-ROE scatter chart tell us about EM small-cap industries?

Lower profitability or valuation

  • Consumer Services and Transportation currently have the lowest profitability—and also look quite expensive given those low levels of profits. We see the impact of COVID-19 on those two industries, which were hit particularly hard by lockdowns.
  • Banks and Real Estate companies in the EM small-cap universe are viewed as risky by investors and are valued cheaply considering their ROEs. They certainly don’t conform to our PB-ROE expectations because of the economic pressures that COVID-19 has placed on these industries. For example, investors may see bank loans and real estate rents as at-risk as segments of the economy as borrowers may not be able to pay mortgage and interest payments. Further, global COVID-19 policies have placed significant pressures on commercial real estate properties. Our PB-ROE model see these industries as interesting opportunities as market expectations stabilize. We will be monitoring their profitability levels and earnings forecasts closely to determine if the current valuations and investor reactions are overdone.

Higher profitability or valuation

  • At the far right of the chart above, we see industries that benefited from the pandemic: Household and Personal Products, Commercial and Professional Services, Software, and Semiconductors enjoyed higher demand and higher profits as consumers stocked up on household goods and electronic devices during lockdowns. At the same time, valuations have risen, making these industries relatively expensive.

ESG Considerations

Given the rising interest in sustainability and ESG strategies, understanding how different industries perform on ESG metrics can be another important consideration for EM investors. In the bar chart to the left of the PB-ROE analysis above, we’ve ranked industries by median ESG score based on MSCI ESG ratings. MSCI’s methodology is one of the leading industry frameworks for determining a company’s resilience to long-term financially relevant ESG risks.  More specifically, MSCI ESG scores measure exposure to ESG risks and opportunities at the industry level. Each industry is evaluated on the three pillars – Environmental, Social, and Governance – which comprise 10 separate themes.  Each theme has multiple Key Issues that may or may not be relevant to a company’s specific industry.  Company specific MSCI ESG ratings are a weighted average of the scores on the Key Issues and are normalized relative to the compay’s industry peers.  In the bar chart, the lowest-scoring industries are at the top, while the highest-scoring industries are at the bottom:

  • Telecommunication Services and Utilities currently have the highest overall median ESG ratings in the emerging markets small-cap universe.
  • Household and Personal Products and Semiconductors/Semiconductor equipment have the lowest overall ESG ratings. Household and Personal Products historically (and currently) have a particularly low median score on the Environment pillar of the MSCI ESG scoring methodology, while the semiconductor industry has a particularly low median Governance score.

As with other metrics, this is a snapshot in time: industry median ESG scores and their rankings change over time. But for EM small-cap investors interested in incorporating ESG into their portfolios, this data provides additional context about conditions in the EM small-cap universe. Bridgeway investment professionals have extensive experience building ESG-aware, non-US equity portfolios that seek a strong risk-adjusted return profile while simultaneously seek to improve the ESG profile across industries and countries using our proprietary Active Share Proportionality portfolio construction techniques.


[1] PB-ROE are financial measures referring to the price-to-book (PB) ratio and return on equity (ROE) of a company.

DISCLOSURE

The opinions expressed here are exclusively those of Bridgeway Capital Management (“Bridgeway”). Information provided herein is educational in nature and for informational purposes only and should not be considered investment, legal, or tax advice.

Past performance is not indicative of future results.

Investing involves risk, including possible loss of principal. In addition, market turbulence and reduced liquidity in the markets may negatively affect many issuers, which could adversely affect client accounts. Value stocks as a group may be out of favor at times and underperform the overall equity market for long periods while the market concentrates on other types of stocks, such as “growth” stocks.  Emerging markets are those countries that are classified by MSCI as emerging markets and generally consist of those countries with securities markets that are less sophisticated than more developed markets in terms of participation, analyst coverage, liquidity, and regulation. These are markets that have yet to reach a level of maturity associated with developed foreign stock markets, especially in terms of participation by investors. These risks are in addition to the usual risks inherent in U.S. investments. There is the possibility of expropriation, nationalization, or confiscatory taxation, taxation of income earned in foreign nations or other taxes imposed with respect to investments in foreign nations, foreign exchange control (which may include suspension of the ability to transfer currency from a given country), default in foreign government securities, political or social instability, or diplomatic developments which could affect investments in securities of issuers in those nations.  The government and economies of emerging markets feature greater instability than those of more developed countries. Such investments tend to fluctuate in price more widely and to be less liquid than other foreign investments. Investments in small companies generally carry greater risk than is customarily associated with larger companies.  This additional risk is attributable to a number of reasons, including the relatively limited financial resources that are typically available to small companies, and the fact that small companies often have comparatively limited product lines.  In addition, the stock of small companies tends to be more volatile and less liquid than the stock of large companies, particularly in the short term and particularly in the early stages of an economic or market downturn.

 Diversification neither assures a profit nor guarantees against loss in a declining market.

 The MSCI Emerging Markets Small Cap Index includes small cap representation across 27 Emerging Markets countries. With 1,692 constituents, the index covers approximately 14% of the free float-adjusted market capitalization in each country. The small cap segment tends to capture more local economic and sector characteristics relative to larger Emerging Markets capitalization segments.

One cannot invest directly in an index. Index returns do not reflect fees, expenses, or trading costs associated with an actively managed portfolio.

The following podcast originally appeared on June 23, 2021, on the Meb Faber Show. The episode was recorded on June 9, 2021. The podcast is posted here by permission of the Meb Faber Show.

In episode 323, Meb Faber welcomes guest, John Montgomery, founder and Chief Investment Officer of Bridgeway Capital Management, a $5 billion quantitative manager that donates 50% of its profits to charity.

Viewers will hear what made John leave a job in the Transit sector to start a quantitative investment firm. We walk through what drew him to a rules-based approach and then touch on different factors, including size, value, and low volatility. We even touch on Bridgeway’s ultra-small cap strategy and how it captures the small-cap premium.

As we wind down, we hear about the firm’s unique structure, which includes donating half its profits to charity with the goal of ending genocide.

Please enjoy this episode with Bridgeway Capital Management’s John Montgomery.

  • 1:18 – Intro
  • 2:12 – Welcome to our guest, John Montgomery
  • 4:09 – Early career inspiration; Silent Spring (Carson)
  • 5:23 – John’s first investing classes
  • 6:47 – Insights into the benefits of quantitative methods
  • 9:06 – Transitioning from hobby to career
  • 11:41 – Foundations of Bridgeway Capital Management
  • 12:44 – John’s ultra-small company strategy
  • 18:38 – Bridgeway’s evolving research approach
  • 20:44 – John’s fascination with low-volatility investing
  • 22:10 – Blending different factor exposures
  • 25:04 – Bridgeway’s rules on leverage
  • 28:22 – The Great Depression: A Diary (Roth)
  • 29:22 – Preparing yourself for lean times
  • 31:05 – The importance of risk management
  • 32:03 – John’s asset allocation strategy
  • 38:53 – Bridgeway as an enduring firm
  • 43:19 – Bridgeway’s giving culture
  • 45:09 – Bridgeway Foundation
  • 46:18 – To Stop a Warlord: My Story of Justice, Grace, and the Fight for Peace (Davis)
  • 47:47 – Helping child soldiers come home
  • 54:15 – John’s most memorable investments
  • 56:34 – Planning your exit
  • 58:02 – Learn more at Bridgeway.com

Disclosures

The opinions expressed here are exclusively those of Bridgeway Capital Management (“Bridgeway”). Information provided herein is educational in nature and for informational purposes only and should not be considered investment, legal, or tax advice.

Investing involves risk, including possible loss of principal. In addition, market turbulence and reduced liquidity in the markets may negatively affect many issuers, which could adversely affect investor accounts. Value stocks as a group may be out of favor at times and underperform the overall equity market for long periods while the market concentrates on other types of stocks, such as “growth” stocks. International stocks present additional unique risks including unstable, volatile governments, currency risk and interest rate risks.

Diversification neither assures a profit nor guarantees against loss in a declining market.

Diversity, Equity, and Inclusion (DEI)
A real conversation about what’s possible, what it means, and why it matters.

Get Smarter With Bridgeway Webinar Series #3

Moderator:
Tamla Wilson, DMin, Director of Institutional Relations

Panelists:
Tammira Philippe, CFA, President and CEO
Ryan Bailey, CFA, FRM, CAIA, CMT, Partner and CIO, Carbonado Partners, BCM Board Member

Jacob Pozharny Head of International Equity at Bridgeway bio image

Jacob Pozharny, PhD

Cindy Griffin, CIPM

The emerging markets category comprises dozens of countries with unique financial, political, and geographic conditions that can affect local stock performance. Because of these variations, investors need a reliable way to monitor overall conditions in the emerging markets landscape as a starting point for a deeper, multi-faceted analysis.

P/B-ROE analysis is  a classic methodology to provide this overview. First described more than 30 years ago by Jarrod Wilcox, the Price-to-Book/Return on Equity (P/B-ROE) model is typically used to measure how cheap or expensive a company’s assets are relative to its level of profitability. Bridgeway has adapted this model to provide an aggregate view across MSCI Emerging Markets Small Cap Index country constituents. By measuring the median book yield (the inverse of price-to-book), ROE, and year-over-year returns for each country’s small-cap stocks, we can begin to understand country-level tradeoffs between valuation and profitability that investors might face in the emerging markets small-cap universe.

This chart highlights conditions in the emerging markets small-cap landscape as of April 30, 2021.

  • The y-axis plots each country’s book yield, placing cheaper countries higher on the chart
  • The x-axis plots return on equity, placing more profitable countries farther to the right
  • Country names are color-coded according to the median year-over-year returns for EM small-cap stocks. Countries in red have the lowest median returns, while countries in blue the highest.
Chart highlights conditions in the emerging markets small-cap landscape as of April 30, 2021

Source: FactSet

Based on the P/B-ROE model, we expect a generally linear relationship between profitability and valuation: Investors typically are willing to pay higher prices for higher profitability while driving prices down for countries with lower profitability. We see that relationship in April among the countries grouped near the center of the chart.

What’s particularly useful for investors, though, is to note the outliers—countries whose placement isn’t in line with the model’s expectations for valuation and profitability. This analysis highlights conditions in those countries that represent potential risks and opportunities.

Lower profitability or valuation

  • Greece is among the least expensive and least profitable countries. Greece historically has had below-average ROE (as shown above in the Median Return on Equity chart on the bottom left), while Kuwait – the least profitable country on the chart – has only been in the index a short time. It remains to be seen whether Kuwait will continue to be among the least profitable with a valuation that is in the middle of its country peers.
  • Chile and Argentina stand out as two major outliers, given that their valuations appear much cheaper than we’d expect given their ROE. One potential reason is that both countries are experiencing recent surges in COVID-19 infections, creating uncertainty about the future (Argentina’s health system, for example, was recently reported to be on the brink of collapse). Investors’ concerns appear to be reflected in those countries’ valuations.

Higher profitability or valuation

  • Turkey and India are both highly profitable and expensive—a trend we see stretching back several years. India has been able to maintain high profitability over the last year due to the government’s unwillingness to impose an economic lockdown because of the pandemic.
  • But each country faces potential risks in the future. Turkey’s political climate is creating volatility in its currency prices and inflation. Likewise, India’s historically high profitability and high valuations may be under pressure due to that country’s recent COVID surge. If India goes into lockdown to help contain the virus, investors should expect to see an impact on both prices and profitability—with India potentially following the trajectory we saw in Argentina and Chile.

Investor Sentiment

Median year-over-year returns – represented by the bar chart above on the top left – can be a useful proxy for investor sentiment for each country, offering investors further context in addition to the PB/ROE analysis.

  • South Africa has the highest median year-over-year return despite having among the lowest profitability and a middle-of-the-pack valuation among MSCI Emerging Markets Small Cap member countries.  This could potentially be explained by South Africa’s concentration in commodity production, which has been bid up by global fears of inflation due to expansion in global money supply to overcome the effects of economic lockdowns during the pandemic.
  • Chile and Argentina have the lowest median year-over-year returns. Like each respective country’s valuation, returns have been affected by COVID-19 impacting economic prospects.  Also among the lowest median year-over-year returns despite middling valuation and profitability, China has experienced political instability in Hong Kong and has suffered from the trade war with the US.

We don’t recommend making investment decisions solely on the inputs of valuation, profitability, or sentiment. Bridgeway’s own Emerging Markets Small-Cap Equity Strategy uses a much more detailed, multi-layered investment process to help determine exposures and holdings. However, we believe this analysis gives investors valuable context for how local conditions and events can alter the emerging markets small-cap investment landscape over time. This is just one example of how we stay curious at Bridgeway, one of our five principles of relational investing.

DISCLOSURE

The opinions expressed here are exclusively those of Bridgeway Capital Management (“Bridgeway”). Information provided herein is educational in nature and for informational purposes only and should not be considered investment, legal, or tax advice.

Past performance is not indicative of future results.

Investing involves risk, including possible loss of principal. In addition, market turbulence and reduced liquidity in the markets may negatively affect many issuers, which could adversely affect client accounts. Value stocks as a group may be out of favor at times and underperform the overall equity market for long periods while the market concentrates on other types of stocks, such as “growth” stocks.  Emerging markets are those countries that are classified by MSCI as emerging markets and generally consist of those countries with securities markets that are less sophisticated than more developed markets in terms of participation, analyst coverage, liquidity, and regulation. These are markets that have yet to reach a level of maturity associated with developed foreign stock markets, especially in terms of participation by investors. These risks are in addition to the usual risks inherent in U.S. investments. There is the possibility of expropriation, nationalization, or confiscatory taxation, taxation of income earned in foreign nations or other taxes imposed with respect to investments in foreign nations, foreign exchange control (which may include suspension of the ability to transfer currency from a given country), default in foreign government securities, political or social instability, or diplomatic developments which could affect investments in securities of issuers in those nations.  The government and economies of emerging markets feature greater instability than those of more developed countries. Such investments tend to fluctuate in price more widely and to be less liquid than other foreign investments. Investments in small companies generally carry greater risk than is customarily associated with larger companies.  This additional risk is attributable to a number of reasons, including the relatively limited financial resources that are typically available to small companies, and the fact that small companies often have comparatively limited product lines.  In addition, the stock of small companies tends to be more volatile and less liquid than the stock of large companies, particularly in the short term and particularly in the early stages of an economic or market downturn.

Diversification neither assures a profit nor guarantees against loss in a declining market.

P/B-ROE are financial measures referring to the price-to-book (P/B) ratio and return on equity (ROE) of a company.

The MSCI Emerging Markets Small Cap Index includes small-cap representation across 27 Emerging Markets countries. With 1,692 constituents, the index covers approximately 14% of the free float-adjusted market capitalization in each country. The small-cap segment tends to capture more local economic and sector characteristics relative to larger Emerging Markets capitalization segments.

One cannot invest directly in an index. Index returns do not reflect fees, expenses, or trading costs associated with an actively managed portfolio.

John Montgomery Founder and CIO of Bridgeway bio image

John Montgomery

Christine Wang Portfolio Manager at Bridgeway bio image

Christine Wang, CFA, CPA

Summary

As a firm that practices relational investing, we stay curious about what we see in the market, how that translates to our investment strategies and are committed to stating where we stand.  The first quarter landscape for US small-cap value stocks presents a wonderful case study to share.

After a dramatic four-plus years of underperformance, small-cap value stocks came roaring back over the last year through March 31, 2021. Is this “run” of small-value stocks over, or is there more to go? Bridgeway’s analysis indicates that the size factor (less so the value factor) has indeed made up tremendous ground over the last year. However, based on our analysis of relative book-to-market valuations through the end of March, prices of small-value stocks would have to rise another 43% relative to the broader US market to get back to median historical levels.[1] At Bridgeway, we don’t believe in timing the market, but we do believe in establishing and holding appropriate factor exposures as a long-term investing best practice. After the tremendous run of large and growth stocks over the last decade, we believe small-value stocks still have room to run, and investors whose portfolios have become underweight to this segment of the market should add to their allocation.

What a Difference a Year Makes

Anyone investing in small-value stocks over the last handful of years has felt the full brunt of two factors dramatically out of favor at the same time. The Russell 2000 Value Index lagged the S&P 500 Index of large US companies by roughly double digits four years in a row from 2017 through 2020. In 2020 alone, large-cap stocks trounced small-cap value stocks by more than 33%.[2] FANMAG stocks were all the rage[3]. In this environment, not surprisingly, we have seen articles calling out the death of value and examining the question of whether size ever really was a factor.[4] Our favorite title was “Waiting for Godot.”[5]

But what a difference a year makes. First, let’s look at size. Table One below shows the performance of stocks as measured by deciles of size in the Center for Research in Securities Prices (CRSP) database as of March 31, 2020. The smallest companies (“CRSP 10”) lagged the largest companies (“CRSP 1”) in every category except the twenty-year and since-1926 periods.

Shows the performance of stocks as measured by deciles of size in the Center for Research in Securities Prices (CRSP) database as of March 31, 2020

Source: CRSP

Table Two shows the same chart, but a year later. Including a very strong first quarter to start 2021, the small size factor has come roaring back. During this period, many of the top-performing funds and ETFs (Exchange Traded Funds) had “small-cap” in the name. No wonder why: looking at the full spectrum of companies by size in the Center for Research in Securities Prices database, we find the smallest companies (“CRSP 10”) made up tremendous ground. For example, at the end of Q1 2020, the smallest decile of stocks lagged the largest by over –15% annually for the past three years. Yet just one year later, those smallest stocks have now outperformed their larger peers by over 3% annually for the trailing three years. With this dramatic recovery of size, it’s fair to ask, “Is there any room to run?”

Shows the performance of stocks as measured by deciles of size in the Center for Research in Securities Prices (CRSP) database as of March 31, 2021

Source: CRSP

Despite the strong recent returns, note that the long-term, 10- and 15-year results are still negative as of the end of Q1 2021. The decade of underperformance suffered by small stocks has not yet fully recovered. Furthermore, one criterion that we use to judge a factor like size is that it be persistent, working across long periods of time.[6] This doesn’t mean that it should always work, as all factors go through periods where they lag. But after such weak periods, we should expect stronger performance so that returns provide the long-term expected premium. Having lagged by almost 1.3% over the last 10 years, small stocks would need to notably outperform large to get back to the historic premium seen since the inception of CRSP.  There is indeed room to run.  We’ll now turn to valuations to get an idea of how much.

Using the standard academic definition of valuation, “book-to-market,” we can examine both just how far out of favor small-value stocks became before March 2020 and how much they have come back.

The chart below shows the ratio of median book-to-market (BtM) for the Russell 2000 Value Index to median BtM for the S&P 500. The solid green line shows the median ratio for the entire history of the Russell 2000 Value, from 1978- Mar 2021. Ratios above this line signal that small-cap value stocks are cheaper than their historical average.

Shows the ratio of median book-to-market (BtM) for the Russell 2000 Value Index to median BtM for the S&P 500

Source: Compustat, Bridgeway calculations

Indeed, the peak of small-value underperformance (low valuation) was at its worst (highest in the graph) in March 2020. While the graph shows a tremendous turnaround over the following 12 months, the recent relative valuation level on March 31, 2021, was still near the level of previous peaks since 1978. It’s also of note how quickly the turnaround occurred, concentrated primarily in the last six months.

So, where do we go from here? Holding book value constant and varying only the relative prices of small-value stocks, prices would have to rise 43% from their March 31, 2021 levels to return to the historical median ratio. In other words, we’ve still got quite a bit of open field in front of us, or “room to run ” relative to the S&P 500.

Does that mean we know the timing or can guarantee 2021 will continue to be a small-value-dominated year? No, we don’t, and we can’t (see below). We do believe that factors tend over time to revert to long-term historical levels. If this happened all in one year, it would mean a 43% tailwind in performance for small-cap value as measured by the Russell 2000 Value Index relative to the S&P 500 Index. If it happened over a five-year period, that would mean a 7.4% per year (compounded) tailwind. Over a ten-year period, a 3.6% per year tailwind. We believe these are very big numbers.

Is This a Timing Factor?

No. We don’t believe in timing the market at Bridgeway, though we do believe in managing risk. Note that the recent peak of relative valuation exceeded the prior peaks, and it can happen again. As John’s Harvard Business School professor used to say, “The problem is, a very cheap investment can always get cheaper.” But it’s also true that the pullback to historical factor norms is very strong. In this case, economic and market environment factors that might cause a further comeback of small and value factors include:

  • A realization by investors of just how out of favor these factors became and still are
  • A market correction, which sometimes has investors flock to cheaper market niches, as happened with small-value stocks in the bear market of 2000-2002
  • A growth economy, which paradoxically helps value stocks, resulting from the pandemic recovery underway, the economic stimulus approved by Congress in March, and/or a $2 trillion infrastructure investment package introduced by President Biden in his April 28 “100 days” speech
  • An increase in interest rates from current very low levels, which favors value stocks over growth stocks

Nevertheless, Bridgeway doesn’t believe in timing the market. Rather, we believe in establishing a long-term plan with specific factor exposures, sticking with the plan through thick and thin, and especially when it feels least comfortable to do so. We believe small-value stocks have an appropriate role in portfolios with a long-term investment horizon and that many investors, especially those who have not rebalanced back to appropriate target levels or who have followed the “investor herd” into attractive but overpriced large-growth stocks, are underexposed to small-value stocks today.

For a PDF download of this thought piece, please use the following link:

“Room to Run” with US Small-Cap Value Stocks?


[1] Small-value stocks and broader US market as represented by the Russell 2000 Value Index and S&P 500 Index, respectively

[2] In 2020, the Russell 1000 Growth index returned +38.49%, compared to the Russell 2000 Value Index returned +4.63%

[3] FANMAG stocks are Facebook, Apple, Netflix, Microsoft, Amazon, and Google

[4] See, for example, Fact, Fiction, and the Size Effect by Ron Alquist, Ronen Israel, and Tobias Moskowitz, Journal of Portfolio Management, Fall 2018; There Is No Size Effect: Daily Edition, Cliff Asness, AQR, September 18, 2020; and Settling the Size Matter, by David Blitz and Mattias Hanauer, Journal of Portfolio Management Quantitative Special Issue 2021

[5] Link: https://blogs.cfainstitute.org/investor/2018/08/09/growth-vs-value-waiting-for-godot/

[6]See Your Complete Guide to Factor-Based Investing” by Andrew L. Berkin and Larry E. Swedroe


DISCLOSURE

The opinions expressed here are exclusively those of Bridgeway Capital Management (“Bridgeway”). Information provided herein is educational in nature and for informational purposes only and should not be considered investment, legal, or tax advice.

Past performance is not indicative of future results.

Investing involves risk, including possible loss of principal. In addition, market turbulence and reduced liquidity in the markets may negatively affect many issuers, which could adversely affect client accounts. Value stocks as a group may be out of favor at times and underperform the overall equity market for long periods while the market concentrates on other types of stocks, such as “growth” stocks.

Diversification neither assures a profit nor guarantees against loss in a declining market.

The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on the average of 500 widely held common stocks.

The Russell 2000 Index is an unmanaged, market value-weighted index, which measures the performance of the 2,000 companies that are between the 1,000th and 3,000th largest in the market.  The Russell 2000 Value Index measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values with dividends reinvested.

The Center for Research in Security Prices (“CRSP”) US Stock Databases contain daily and monthly market and corporate action data for over 32,000 active and inactive securities with primary listings on the NYSE, NYSE American, NASDAQ, NYSE Arca, and Bats exchanges and include CRSP broad market indexes. CRSP databases are characterized by their comprehensive corporate action information and highly accurate total return calculations.

One cannot invest directly in an index.  Index returns do not reflect fees, expenses, or trading costs associated with an actively managed portfolio.

Jacob Pozharny Head of International Equity at Bridgeway bio image

Jacob Pozharny, PhD

Cindy Griffin, CIPM

Executive Summary

Bridgeway’s goal to be an enduring firm and to serve our clients, colleagues, and community for the long-term has led us to consider offering a number of different strategies over the years.  Through the lens of relational investing, we have stayed curious and completed countless hours of research, continuously looking for the intersection of where our investment expertise lies and what strategies to offer that could best serve our clients.  Through this journey, we concluded that emerging markets small-cap equity is an attractive asset class and that Bridgeway is uniquely positioned to maximize the opportunities in this asset class for the following reasons:

  • Emerging markets small-cap equity has historically offered lower correlation not only to non-equity asset classes but also to other equity asset classes
  • Active management has the potential to outperform in emerging markets small-cap equity
  • A systematic, quantitative process is able to assess opportunities in emerging markets small-cap equity efficiently
  • Relative to other equity markets, emerging markets small-cap equity currently has a more attractive value-to-quality profile
  • Bridgeway’s history of closing strategies at responsible asset levels allows us to explore capacity constrained areas such as emerging markets small-cap equity without compromising the investment philosophy or process
  • Bridgeway’s global research into intangibles offers a novel approach to investing in non-US markets

Comparing Emerging Markets Small-Cap Correlation

Much has been written about how the emerging markets equity asset class can be a good diversifier to non-equity asset classes.  Viewing correlations for the MSCI Emerging Markets Small Cap Index versus various representative non-equity indexes shows that correlations are also low for this asset class relative to non-equity asset classes.  And while some correlations have nominally crept up in recent years, the long-term correlations of the MSCI Emerging Markets Small Cap Index have remained low for longer time periods.

Correlation Relative to MSCI Emerging Markets Small Cap Index as of 3/31/2021

Asset ClassIndex Representative3 Year5 Year10 Year
US Broad Fixed IncomeBloomberg Barclays US Aggregate0.120.160.10
US High Yield Fixed IncomeBloomberg Barclays US High Yield – Corporate0.820.780.79
US Real EstateMSCI US REIT INDEX – Gross Return0.760.600.61
CommoditiesS&P GSCI Total Return0.630.560.56
Source: FactSet

While the correlations of emerging markets small-cap equity relative to non-asset classes are relatively low, how do correlations for this asset class compare to other equity asset classes? We looked at rolling 36-month correlations for various MSCI indexes relative to the MSCI AC World IMI.  Since the common inception in 2001 of the indexes shown, the MSCI Emerging Markets Small Cap Index has shown a persistently lower correlation relative to the MSCI AC World IMI.

Chart of 3 year correlation relative to the MSCI AC World IMI January 01, 2001 to March 31, 2021
Source: FactSet

Lower correlations may be attributed to larger differences in cyclical versus defensive sectors, which can – and have – driven differences in returns even within emerging markets.  Comparing the sector weights of the MSCI Emerging Markets Index versus the MSCI Emerging Markets Small Cap Index shows these stark differences.  In the table below, cyclical sectors (Communication Services, Consumer Discretionary, Financials, Industrials, Information Technology, and Materials) had an average weight difference of 6.49%, while defensive sectors (Consumer Staples, Energy, Health Care, Real Estate, and Utilities) had an average weight difference of 2.87%.  As these differences persist, correlations may remain lower particularly during different economic regimes, which provides good diversification opportunities for emerging markets small-cap.

Sector Weights (%)
As of 3/31/2021
MSCI Emerging
Markets Index
MSCI Emerging Markets
Small Cap Index
Absolute
Difference
Communication Services11.743.678.07
Consumer Discretionary17.6512.585.07
Consumer Staples5.635.670.04
Energy4.832.102.73
Financials18.2410.737.51
Health Care4.468.994.53
Industrials4.3014.9510.65
Information Technology20.9217.653.27
Materials8.0812.464.38
Real Estate2.156.884.73
Utilities2.004.322.32
Source: FactSet

Another potential contributor to lower correlations within emerging markets and drivers to return is the difference in country allocations. An examination of country weights of the MSCI Emerging Markets Index versus the MSCI Emerging Markets Small Cap Index shows some stark differences.

Country Weights (%) as of 3/31/2021

CountryMSCI Emerging Markets IndexMSCI Emerging Markets Small Cap Index
Argentina0.110.55
Brazil4.466.05
Chile0.570.95
China37.9110.80
Colombia0.160.24
Czech Republic0.100.03
Egypt0.080.26
Greece0.111.40
Hungary0.210.08
India9.6516.98
Indonesia1.221.80
Korea13.3318.00
Kuwait0.500.73
Malaysia1.373.06
Mexico1.741.83
Pakistan0.020.45
Peru0.210.11
Philippines0.640.73
Poland0.631.17
Qatar0.680.88
Russia3.110.83
Saudi Arabia2.772.42
South Africa3.813.58
Taiwan13.8421.49
Thailand1.883.66
Turkey0.291.37
United Arab Emirates0.580.52
Source: FactSet

The most significant difference between the two is the weighting to China.  The MSCI Emerging Markets Index is dominated by its weight in China at 37.9% while the MSCI Emerging Markets Small Cap Index weight is more modest at 10.8%.  Further differences are evident when looking at the composition of the largest and smallest country weights.  The top three country weights in the MSCI Emerging Markets Index – China, Taiwan, and Korea – make up 65.1% of the total weight of the Index while the top three country weights for the MSCI Emerging Markets Small Cap Index – Taiwan, Korea, and India – make up 56.5% of the Index.  On the smaller side, countries with individual weights of less than 1% in the MSCI Emerging Markets Index make up more than half of the country constituents, but less than 5% of the total weight of the Index in aggregate.  In contrast, the MSCI Emerging Markets Small Cap Index has fewer than half its constituents with individual weights of less than 1%, but the aggregate weight of these constituents is larger at 6.4%.  Like the differences in sectors, as these differences in country weights persist correlations may remain lower and broader diversification opportunities across countries may continue to exist for emerging markets small-cap.

Active Management in Emerging Markets Small-Cap

The argument on whether to pursue an active versus passive approach in equity strategies has been long debated with strong proponents on each side.  Each side has put forth compelling considerations.  However, we believe that in the case of the emerging markets small-cap, active management has an edge over passive management.   Historical evidence has shown that active management in emerging markets small-cap equity tends to well outperform a common benchmark, which is not always the case for other asset classes.

The excess gross return over the long-term (10 years) of the median institutional manager in four equity universes from the eVestment database: US Large Cap Core Equity, US Small Cap Core Equity, Global Emerging Markets Equity, and Global Emerging Markets Small Cap Equity against a common benchmark for each universe.
Source: eVestment; the eVestment universe median calculation is using the default reporting method and default vehicle for all universe constituents to determine the median for each universe.

In the chart above, we show the excess gross return over the long-term (10 years) of the median institutional manager in four equity universes from the eVestment database: US Large Cap Core Equity, US Small Cap Core Equity, Global Emerging Markets Equity, and Global Emerging Markets Small Cap Equity against a common benchmark for each universe and the results are striking.  Over this long-term period, the median Global Emerging Markets Small Cap Equity manager outperforms the MSCI Emerging Markets Small Cap Index by more than three percent.  And while the median Global Emerging Markets Equity performance against the MSCI Emerging Markets Index and the median US Small Cap Core Equity manager performance against the Russell 2000 Index are both positive, they are only modestly so and such modest performance could likely be eroded by management fees.  Finally, during this same period, the median US Large Cap Core Equity manager underperforms the Russell 1000 Index.     We believe this is strong evidence that persistent excess return in emerging market small-cap equity can be achieved with an active approach to management.

Quantitative Management in Emerging Markets Small-Cap

Historically, asset managers who wanted to invest in emerging markets small-cap faced some difficulty as data from these markets were viewed as not as reliable as developed markets; this was a particular challenge for those managers – traditional fundamental or quantitative – that relied on evaluation of company fundamentals as a key part of the investment process.  In recent years, as emerging markets economies have opened up, better governance and more reliable data allow managers to evaluate company fundamentals more consistently.  However, this does not put traditional fundamental managers and quantitative managers on the same footing when investing in emerging markets small-cap.  Quantitative management in emerging markets small-cap equity has potential advantages over traditional fundamental management.  Most importantly, the large number of constituents tends to favor a quantitative approach to investing.  With nearly 1,700 names in the MSCI Emerging Markets Small Cap Index, even the largest traditional fundamental manager would need several analysts to cover the entire Index.  Similarly, the MSCI Emerging Markets Small Cap Index covers 27 diverse countries from Argentina to the United Arab Emirates. Because a quantitative approach relies on data and can use modern programming and statistical analysis to evaluate companies, quantitative investment managers can cover these same 1,700 names in 27 countries more quickly and efficiently and with more accuracy than a traditional fundamental manager.  And because a quantitative approach allows an investment manager to cover all the names in the universe, there may be more potential opportunities for a quantitative investment manager than a traditional fundamental manager may ever discover.

A quantitative investment approach can also have an advantage over a traditional fundamental approach because of the systematic nature of the typical quantitative investment process.  A quantitative investment manager builds a rules-based system for managing the entire investment process from what variables to use to evaluate companies to when and what size positions to establish to when to sell.  In more volatile markets like emerging markets, this can be particularly beneficial as it takes out the doubt or emotion that may set in during uncertain market environments.   And systematic, quantitative managers can still uncover new research and incorporate new data into the process to ensure that the process continues to capture the returns being sought.

Is Emerging Markets Small-Cap an Attractive Asset Class Now?

The question of whether to invest in any asset class at a particular time very often hints at market timing, something we do not suggest attempting.  Even the most sophisticated  investors would need to get the timing right multiple times for each asset class if a market-timing approach was implemented.  That said, we believe emerging markets small-cap is an excellent diversifier and can be part of an allocation designed for long-term goals.

Nevertheless, asking the question of whether emerging markets small-cap is an attractive asset class now can be informative and assist with understanding how the asset class fits into an overall asset allocation.  To do this, we reviewed the year-over-year return of indexes that make up the MSCI ACWI IMI Index and plotted each return value (book yield) versus quality (return on equity) profile.

MSCI ACWI IMI Index Perspective chart
Source: FactSet

As of April 1, 2021, the MSCI Emerging Markets Small Cap Index has one of the most attractive value versus quality profiles on the chart: the book yield is the second highest among all the indexes plotted while the return on equity is the third highest.  And while the Index has an attractive profile that appears relatively cheap and higher quality, the year-over-year return has not yet reflected that attractiveness with only a very slight modest positive return, indicating a possibility for further growth in the asset class.

Responsibly Managing Capacity in Emerging Markets Small-Cap

At Bridgeway, we believe in doing what is best for the long-term interests of existing investors.  This means that in asset classes that are capacity constrained, we will close at responsible levels in order to maintain the integrity of the investment process for our existing investors.  Bridgeway has a history of closing strategies early to protect the process and existing investors, even when it means turning down large amounts of assets.  In fact, in one of our most capacity-constrained strategies, we have been closed to new investors for more than a decade. 

In any capacity constrained asset class, investors should be concerned about how an investment manager manages that capacity.  In emerging markets small-cap equity, investors should be even more concerned about capacity constraints as opportunities to stray from the investment process abound and liquidity can be a potential issue.  Bridgeway’s experience in managing assets in capacity-constrained asset classes can help successfully guide our experience in emerging markets small-cap.  Additionally, Bridgeway’s international equity team, led by our Head of International Equity, Jacob Pozharny, PhD, has more than 25 years managing non-US equity strategies, including in capacity constrained asset classes.  Along with the support and expertise of the entire investment management team at Bridgeway, this creates an experience in which our investors can be confident that we have their long-term interests in mind and that our investment philosophy and approach maintain integrity.

Bridgeway in Emerging Markets Small-Cap

Expanding our investment strategies into non-US equity is a natural evolution from our US equity strategies.  As a quantitative investment firm, the factors we utilize are tested not only in the US, but worldwide.   And our multiple decades of experience qualifying and validating fundamental data in lowly trafficked areas of the equity markets serves to enhance our capabilities in emerging markets small-cap equity.

Most notable, though, is our innovative approach to investing in emerging markets small-cap.  As with our approach to the US market, we believe that equity price changes are driven primarily by financial fundamentals over the long run.  However, as companies increasingly rely on intangible assets to drive business, we have seen these intangible assets displace traditional tangible, physical assets affecting financial statements.  Based on our research, we believe that categorizing companies based on their Intangible Capital Intensity (ICI) has the potential to improve stock selection by using the most relevant metrics, particularly in non-US markets.

Our framework for ICI is determined at the industry level, with high ICI industries having higher levels of intangible investment (e.g., pharmaceuticals, software, telecom services, media, etc.) while low ICI industries have lower levels of intangible investment (e.g., utilities, materials, capital goods, real estate, etc.). In applying factors to these ICI categories, we use three distinct groups: Value, Quality, and Sentiment.  Our research has found:

  • Value has higher factor application efficacy in low ICI companies
  • Quality’s efficacy remains relatively steady for high and low ICI companies
  • Sentiment has higher factor application efficacy in high ICI companies

Contextually applying factors based on ICI has the potential to shape stock selection in a way that no other previous research on intangibles has.  For more on this innovative approach, read Measuring Intangible Capital Intensity: A Global Analysis by Head of International Equity, Jacob Pozharny, PhD, Head of Research, Andrew Berkin, PhD, and Research Analyst, Amitabh Dugar, PhD.

Conclusion

As Bridgeway enters this period of expansion into non-US equity strategies, our emerging markets small-cap strategy is one way to further our approach to relational investing – where we unite results for investors and returns for humanity.

With the maiden launch of our emerging markets small-cap strategy, we bring together an attractive asset class with established experience and expertise and a reputation for maintaining integrity by managing capacity responsibly.  Beginning our foray into non-US equities in emerging markets small-cap equity lies squarely at the intersection of our investment expertise and how we can best serve our clients. We are confident we can offer a unique strategy in emerging markets small-cap equity with high conviction in our investment philosophy and process.

DISCLAIMERS AND DISCLOSURES

The opinions expressed here are exclusively those of Bridgeway Capital Management (“Bridgeway”). Information provided herein is educational in nature and for informational purposes only and should not be considered investment, legal, or tax advice.

Past performance is not indicative of future results.

Investing involves risk, including possible loss of principal. In addition, market turbulence and reduced liquidity in the markets may negatively affect many issuers, which could adversely affect the strategy. Value stocks as a group may be out of favor at times and underperform the overall equity market for long periods while the market concentrates on other types of stocks, such as “growth” stocks.  Emerging markets are those countries that are classified by MSCI as emerging markets and generally consist of those countries with securities markets that are less sophisticated than more developed markets in terms of participation, analyst coverage, liquidity, and regulation. These are markets that have yet to reach a level of maturity associated with developed foreign stock markets, especially in terms of participation by investors. These risks are in addition to the usual risks inherent in U.S. investments. There is the possibility of expropriation, nationalization, or confiscatory taxation, taxation of income earned in foreign nations or other taxes imposed with respect to investments in foreign nations, foreign exchange control (which may include suspension of the ability to transfer currency from a given country), default in foreign government securities, political or social instability, or diplomatic developments which could affect investments in securities of issuers in those nations.  The government and economies of emerging markets feature greater instability than those of more developed countries. Such investments tend to fluctuate in price more widely and to be less liquid than other foreign investments. Investments in small companies generally carry greater risk than is customarily associated with larger companies.  This additional risk is attributable to a number of reasons, including the relatively limited financial resources that are typically available to small companies, and the fact that small companies often have comparatively limited product lines.  In addition, the stock of small companies tends to be more volatile and less liquid than the stock of large companies, particularly in the short term and particularly in the early stages of an economic or market downturn.

Diversification neither assures a profit nor guarantees against loss in a declining market.

The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS, and CMBS (agency and nonagency). Provided the necessary inclusion rules are met, US Aggregate-eligible securities also contribute to the multicurrency Global Aggregate Index and the US Universal Index, which includes high yield and emerging markets debt.

The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high-yield, fixed-rate corporate bond market.  Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.  Bonds from issuers with an emerging markets country of risk, based on the indices’ EM country definition, are excluded.  The US Corporate High Yield Index is a component of the US Universal and Global High Yield Indices.

The MSCI EAFE Index is an equity index that captures large and mid cap representation across 21 Developed Markets countries around the world, excluding the US and Canada. With 874 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI EAFE Small Cap Index is an equity index that captures small cap representation across Developed Markets countries around the world, excluding the US and Canada. With 2,354 constituents, the index covers approximately 14% of the free float-adjusted market capitalization in each country.

The MSCI Emerging Markets Index captures large and mid cap representation across 27 Emerging Markets (EM) countries. With 1,381 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI Emerging Markets Small Cap Index includes small cap representation across 27 Emerging Markets countries. With 1,692 constituents, the index covers approximately 14% of the free float-adjusted market capitalization in each country. The small cap segment tends to capture more local economic and sector characteristics relative to larger Emerging Markets capitalization segments.

The MSCI US REIT Index is a free float-adjusted market capitalization weighted index that is comprised of equity Real Estate Investment Trusts (REITs). The index is based on the MSCI USA Investable Market Index (IMI), its parent index, which captures the large, mid and small cap segments of the USA market. With 137 constituents, it represents about 99% of the US REIT universe and securities are classified under the Equity REITs Industry (under the Real Estate Sector) according to the Global Industry Classification Standard (GICS®), have core real estate exposure (i.e., only selected Specialized REITs are eligible) and carry REIT tax status.

The MSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market. With 620 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US.

The MSCI USA Small Cap Index is designed to measure the performance of the small cap segment of the US equity market. With 1,741 constituents, the index represents approximately 14% of the free float-adjusted market capitalization in the US.

The S&P GSCI index measures commodity market performance through futures. The S&P GSCI is weighted by world production and comprises the physical commodities that have active, liquid futures markets. There is no limit on the number of commodities that may be included in the S&P GSCI; any commodity whose contract satisfies the eligibility criteria and the other conditions specified in this methodology are included.

One cannot invest directly in an index.  Index returns do not reflect fees, expenses, or trading costs associated with an actively managed portfolio.