Amitabh Dugar Research Analyst at Bridgeway bio image

Amitabh Dugar, PhD, CPA

Jacob Pozharny Head of International Equity at Bridgeway bio image

Jacob Pozharny, PhD

The following article originally appeared in the Financial Analysts Journal, Volume 77, Issue 2, dated March 18, 2021. The article is posted here by permission of the Financial Analysts Journal and the CFA Institute.

The value relevance of financial variables, such as book value and earnings, has decreased for particular industries of high “intangible intensity.”

Overview

Expenditures on the creation of intangible capital have increased, but accounting standards have not kept pace. We investigated whether this has affected the value relevance of book value and earnings. We constructed a composite measure of intangible intensity by which to classify industries. The measure is based on intangible assets capitalized on the balance sheet; research and development expenditures; and sales, general, and administrative expenditures. We show that the value relevance of book value and earnings has declined for high-intangible-intensity companies in the United States and abroad, but for the low-intangible-intensity group, it has remained stable in the United States while increasing internationally.

Please use the click on the following image to read the full article:

 

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.

David Jennings Trader at Bridgeway bio image

David Jennings

I promised myself I would not use the word “unprecedented” when talking about financial market conditions in 2020.  In fact, I googled it to try and find alternatives.  There are over 30 synonyms for unprecedented. Unfortunately, unprecedented sums up financial market conditions in 2020 accurately.  Here is a quick recap of the market this year (all references are to the S&P 500):

  • The S&P 500 hit a record high on 2/19/2020, and it took only six trading days to decline 10%, the fastest 10% decline from the all-time high on record
  • On Monday, March 9th, S&P Futures triggered a 7% down single session circuit breaker that hasn’t been triggered since 1997
  • A Bear market that lasted 4 weeks and had a peak to trough decline of -33.8%
  • The S&P ended up 18.4% on the year
  • There was record-setting trading volume in equity, options, and futures

The media have well covered the list above, so now I’d like to mention a couple of things you probably haven’t heard about that I think should have gotten a lot more attention.

2020- The Year that Gamma became mainstream.  Gamma??  What the heck is Gamma, and why is everyone on Twitter talking about it?  I’ll summarize, Gamma is the rate of change of an options delta.  Another way of thinking about it is how fast does an options price change in relation to the move of the underlying security, both up and down.  Option market makers must delta hedge their options positions to remain risk-neutral.  If they are long Gamma, they typically must buy the underlying asset as it goes down, and sell it as it goes up, which tends to limit volatility as there is two-sided order flow.  If, however, they are short Gamma, they typically must sell more of the underlying asset as it goes down and buy more of it as it rises.  This can lead to exacerbated price moves on both the upside and downside, resulting in a feedback loop of sorts.  This Gamma flow has become much more mainstream since 2020 as it is one of the larger nonfundamental sources of trading flow in the market.

As a former derivatives trader, it warms my heart to hear “Gamma” and its potential flow-driven impact on financial markets becoming more mainstream.  The most simplistic way to think about understanding its implications is this:  Gamma creates a feedback loop where market participants are forced to buy or sell more of an asset the more it moves in price to maintain a risk-neutral position.  If you combine this with high-speed algorithmic trading in financial assets where liquidity is rapidly declining, you can easily see how the magnitude and velocity of the market moves in 2020 are easier to understand.

2020- The year that liquidity vanished!   “Wait…. What?”  “Didn’t you just say above that equity and option trading volumes were at record highs?”  Why, yes, I did, but volume does not mean a market is liquid.  Liquidity is typically how much of something you can trade at a certain price point before the market participants require the price point to change to transact more.  Liquidity and volatility are linked, creating another one of those feedback loops.  When volatility increases, liquidity tends to decline.  If I could point to the most compelling/concerning statistic I saw all year it would be this one sentence from a March 12th, 2020 report from Goldman Sachs concerning liquidity in the S&P 500 E-mini futures:

As volatility has spiked, though, electronic futures liquidity has fallen to the point where there has been a median of just ten contracts, representing $1.5mm notional, on the bid and ask of E-mini futures screens over the past week (compared with a median of 120 contracts, representing $18mm notional, in 2019). (Rocky Fishman J. M., 2020)

The S&P 500 product complex, consisting of SPX Index Options, SPY, SPY Options, and E-mini S&P 500 futures and options, is the most widely traded deepest market in the world.  The E-mini futures drive the trading in this entire complex and represent over $100 Billion of daily notional value.  Now that I’ve set the scene, let’s incorporate the quote above.  The most widely traded, deepest market in the world became INCREDIBLY illiquid, with just $1.5 million of notional value offered at its regular trading increment.  I don’t know how many ways I can say this to emphasize it enough, a trader with as little as $150,000 could have moved “the market” a tick, or possibly more when we were at the depths of the March 2020 sell-off.  A simple 50 lot to buy or sell could have moved through 5 price points or 1.25 points in the S&P.  The trouble is it doesn’t work quite so simply.  When markets are this illiquid, high-speed traders will pull their quote and revise it in order to transact at a better price as soon as the first execution at the bid or offer takes place.  High-speed trading, combined with Gamma-induced feedback loops, in markets with rapidly deteriorating liquidity and large market-on-close (MOC) imbalances in the next 15 minutes. What more could a trader ask for?

I just completed my 22nd year as a trader; I’ve seen a few things……as the saying goes.  As a former floor trader, I learned what forced selling felt like, when a clearing firm liquidates accounts, prices be damned, they just need out.  It feels different, it sounds different, it looks different, but this…. this was like nothing I’ve seen in my career.  The ferociousness, the velocity, even in a world where the screen has replaced trading floors, you could feel it through the screen; it was amazing.  I know that at a quant firm, I’m not supposed to describe things by what it feels like; I think the liquidity data cited above backs up what I thought it felt like.  Besides, I’ve never heard anyone describe that feeling they get in their belly right when their rollercoaster car tips over the edge of that big downhill slope strictly by the angles and rate of acceleration, so I’m rolling with it!

Summary

So, what the heck does all of this have to do with Bridgeway and its trading, you may be asking? Well, a lot, actually. It’s not just Bridgeway either; every investor from retail to institutional should fully understand the cost of their investments. It’s easy to look at explicit costs; they are stated with a great deal of visibility. Trading costs are implicit and not included in any expense ratio, so it’s wise to pay attention. Our role is to interact as intelligently as possible with the circumstances we must trade in to execute our strategies as designed.  Our sole goal is to limit explicit (commissions, fees) and implicit (market impact/unfilled orders). What this means at Bridgeway is a process based on logic, evidence, and data. We all know the importance of research/design and portfolio management, but many ignore the fact that trading is the third, final, and crucial leg of the investment process where value can be destroyed…

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

Trading Review of 2020 That You’ve Heard About…and the One You Haven’t

REFERENCES

Rocky Fishman, J. M. (2020). Index Volatility: Wider Equity Future Markets Latest Sign of Weakened Liquidity. NYC: Goldman Sachs.

DISCLAIMER AND IMPORTANT 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 mutual funds. 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. S&P 500 Index Options are option contracts in which the underlying value is based on the level of the S&P 500 Index. SPY options are American-style options and can be exercised anytime between the time of purchase and the expiration date. The S&P 500 E-mini is a futures contract representing 1/5 the value of a standard S&P 500 futures contract. It is not possible to invest directly in an index.

John Montgomery Founder and CIO of Bridgeway bio image

John Montgomery

Devin Benton Director of Institutional Relations at Bridgeway bio image

Devin Benton

After a year of uncertainty, historical data suggests looking to the smallest stocks for full exposure to the small-cap premium

With well over 50 combined years of investment experience, we’ve both lived through some monumental world events in our careers. Even with that perspective, it’s still hard to fully comprehend the events of 2020. The global impact of the Covid-19 pandemic, both financially and health-wise, was truly unprecedented. From our headquarters in Houston to Central Africa, where the Bridgeway Foundation performs some vital work, we’ve seen few lives untouched by what has unfolded.  Having said that, the business of investing for pensions, insurance companies, foundations, endowments, and individuals must continue. The assets we are privileged to steward at Bridgeway perform vital functions like paying pensions and life insurance settlements, funding philanthropic work, and providing for individual retirees in their golden years. So, despite the challenges we’ve all faced during the pandemic, Bridgeway continues to focus on this critical work, while also funding organizations serving those in need.

From an investment perspective, the shock to markets in Q1 2020 was followed by an equally astounding whipsaw recovery and rally. Now, well into Q1 2021, we see the broad market at new highs nearly every day. Growth stocks have outperformed value stocks for the past 10 years, and large caps still outpace small caps over the decade, despite strong returns for small-cap stocks in Q4 2020. As in previous periods of uncertainty and anxiety, like the 2000 Tech Bubble and the 2008-2009 Global Financial Crisis, we are regularly asked about markets, sectors, earnings, inflation, and other financial concerns. But the real question behind most of these questions boils down to the same thing: “Where do we see opportunities to invest?”

Although we certainly see several attractive areas, US small-cap stocks appear to be poised for a potential once-in-a-decade opportunity.  As contrarians and practitioners of factor-based investing, our optimism on US small-cap stocks should be no surprise given their most recent decade-long underperformance relative to US large-cap stocks. Many investors are aware that over long periods, small caps have outperformed large caps (the small-cap premium)—but this hasn’t been the case for the past decade.  We believe this presents a compelling opportunity in terms of reversion to long-term levels.  

While US small-cap stocks present an attractive opportunity, we are especially excited about the “ultra-small” portion of the US small-cap market; at Bridgeway, we define these companies as “the smallest-of-small caps.” To make the case succinctly, the following chart reflects performance data going back to 1926 for stocks in different market caps, compiled by the Center for Research in Security Prices (CRSP).

As you can see from the CRSP data, the smallest decile of publicly traded US companies (CRSP 10) have a nearly century-long track record of outperformance relative to the largest, mega-cap firms (CRSP 1). Contrast that with the last decade (as represented by the yellow bars above), which has seen this smallest decile of companies lag their largest counterparts by nearly four percent on an annualized basis. As ardent contrarians, this dislocation between large and ultra-small stocks over the past 10 years shouts “Big Opportunity” because historically, after dramatic periods of underperformance, we regularly see a reversion to long-term levels.

And while we think the ultra-small segment of the market is especially attractive now, we saw this opportunity years ago and began buying ultra-small stocks in the early 1990’s. Understanding that this opportunity could be attractive to institutional investors, we launched our first strategy focused on this segment in 1994. The investment thesis then, as now, was to build a portfolio focusing primarily on the CRSP 10 portion of the market to capitalize on the premium offered there.

Today, just like in 1994, another BIG reason we think US ultra-small stocks are a great opportunity is because so few investors, especially institutions, allocate here. It’s a hole in most portfolios, and frankly, this omission is perplexing. When we recently reviewed allocations of some large public pension funds, we observed allocations to Eastern European private equity, emerging markets infrastructure, and a commitment to Latin American private credit, to name just a few. While we applaud these investors’ efforts to diversify returns, we also find it head-scratching that many investors have overlooked a not-insignificant portion of the largest, most shareholder-friendly public equity market right in their own back yard.

For some investors, the decision to bypass investing in ultra-small stocks is simply, “I don’t know where this goes in my portfolio.” This question is certainly appropriate, as investors should ask themselves what role every investment has in their portfolio. For those considering what role ultra-small stocks should play in their portfolio, we believe there are two approaches that are most appropriate: a liquid alternative to private equity or an extension of a small-cap allocation. While we believe there are many parallels with private equity, particularly when it comes to the size of these companies, for the sake of this piece, we’ve focused on how ultra-small stocks complement a broader small-cap portfolio.

A “completion strategy” makes sense once we take a closer look at the composition of the Russell 2000 Index (“Russell 2000”), the benchmark for most investors’ US small-cap investments. As shown in the chart below, reviewing the Russell 2000 composition by CRSP decile reveals that CRSP 9 and 10—the smallest of small-cap stocks—have scant representation. In comparison, our Ultra-Small Company Market strategy is almost entirely allocated to the two smallest deciles.

Most investors allocate to small caps because they believe in diversification and the small-cap premium. Yet, many have overlooked one of the most historically robust segments of the US small-cap universe that contributes to that premium. Adding an ultra-small stocks sleeve to a typical Russell 2000 allocation simply fills out a small-cap portfolio and more comprehensively exposes those investments to that small-cap premium.

We would be remiss if we did not address another common objection we encounter when discussing investing in this sub-set of the market: liquidity. At a high level, this is a valid concern. For institutions with billions of dollars, investing in ultra-small companies can present liquidity challenges in terms of building or redeeming positions or being too large of a holder of an individual company. That said, we would point back to the private market investments we mentioned earlier.  Institutions regularly allocate capital to private equity and then slowly (often over quarters or even years) see that capital called and put to work, then agreeing that those funds will be tied up for years; this is the very definition of illiquidity.

However, in our experience, even the largest investors could build out a portfolio of ultra-small stocks over the course of days or weeks (not quarters or years)  without unduly moving markets or being too large of a stockholder. It would require a transparent conversation between investor and manager, with expectations and targets set accordingly. Certainly, a little patience would be required, too. However, as long-term investors, the “patient capital” should be able to withstand a minuscule amount of liquidity concerns particularly if they are already investing in inherently illiquid, seldom-priced strategies elsewhere across the portfolio.

In summary, we are optimistic about opportunities now in the ultra-small segment of the US equity market. Very likely, there are other attractive opportunities in the market; a casual look across the industry shows no shortage of investors considering allocations to distressed debt and real estate, to name a few. There may be some compelling stories in those parts of the market and others. However, we come back to one simple observation: How have US investors grown comfortable with increasingly complex, illiquid, and esoteric strategies without fully capitalizing on the full spectrum of the domestic equity market right in their own backyard?

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

Crisis and Opportunity: The Overlooked Role of Ultra-Small Stocks

 

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 the mutual funds. 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 Russell 2000 Index measures the performance of the small-cap segment of the US equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 Index is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set. One cannot invest directly in an index.

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.

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

Tammira Philippe, CFA

Resilience

We have been heartened to hear from clients and friends of Bridgeway concerned about the situation in Texas and asking how to help. Bridgeway is resilient, operational, and grateful. 

The Houston area and entire state of Texas experienced freezing temperatures and interruptions in electricity, communications, and clean water. Throughout, Bridgeway maintained its operations uninterrupted, thanks to our business continuity procedures and resources and dedicated staff and business partners. Our staff also largely avoided severe impact from this event, but our broader community has not been so fortunate.

While this adds yet another unprecedented tragedy to too many the world has had lately, we have also witnessed and experienced unprecedented kindness and strive to contribute to more of that in the world.  Outside of continuing operations, we are seeking to provide immediate support to those impacted—as well as looking ahead to long-term recovery facing our home state of Texas and others. We remain engaged with partners in our local and global community who need our support and ask you to do the same.

We are soliciting ideas from colleagues and friends about organizations doing important work in Texas and surrounding areas during this time of need, and we welcome yours as well.

Thank you for your thoughts and support. We see the world differently at Bridgeway.  As leaders in relational investing, we seek to bridge the gap between results for investors and returns for humanity.  Join us.

If you have any questions and would like to contact Bridgeway, please refer to the following link: Contact Us

DISCLAIMER
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.

Andy Berkin Head of Research at Bridgeway bio image

Andrew Berkin, PhD

John Montgomery Founder and CIO of Bridgeway bio image

John Montgomery

Christine Wang Portfolio Manager at Bridgeway bio image

Christine Wang, CFA, CPA

Unless you have been living in your bed, bath, and not much further beyond, you may have noticed some unusual stock activity recently. Whether it’s single stocks that jump in multi-fold like a game that won’t stop or just sitting back watching the movie plot unfold, it seems like everyone wants to express an opinion one way or the other.

We’ve been getting many questions about how this activity has impacted our portfolios and wanted to summarize our viewpoint as a statistical, evidence-based manager.

Statistical, evidence-based investing may sound intimidating, but at the most basic level, it’s defining quantitative rules and then systematically applying those rules in your investing process. At Bridgeway, we believe that factors shape returns. Factors are nothing more than themes or characteristics of groups of securities, such as stocks. We have followed a systematic process for the past 28 years.  That doesn’t mean crazy stuff can’t happen in the short term, but we believe that fundamental characteristics explain stock returns over the long term. Thus, the reason why we would enter a position is not going to be based on speculation, but due to a factor or theme that we believe in, such as value, company financial health, momentum, and size.

We also believe in diversification in many aspects. That means we diversify not only our factor exposures, models, and holdings but our team. One of the main reasons for diversification is risk management. A well-diversified portfolio limits the potential downside exposure to any specific name. This would also apply to the upside as well. If a stock has a large move up, we will consider trimming it for risk considerations to continue to meet the portfolio’s desired exposures.

While we get most asked about how stocks enter our portfolio, determining how names exit is just as important. Every position established at Bridgeway adheres to a set of disciplined sell rules. Does that mean that we just set it and forget it? Of course not. We are continually monitoring positions and movements. There’s the chance that earlier action will be taken due to risk considerations, tax consequences, or other portfolio changes, such as if the reason why we bought the stock no longer holds. These considerations are quantified and set ahead of time; decisions are not made on the fly when emotions and other behavioral biases may be at play.

This rules-based flexibility highlights a benefit of systematic investing versus pure indexing. If you are tied directly to an index, by and large, that flexibility no longer exists. To track an index, you must buy and sell precisely when the index dictates, even if that means buying at the high and selling at the low.

Does this mean we will get it exactly right every single time? It might be surprising to say – but probably not. Especially with speculative cases, it may be tough to nearly impossible to hit the top. But the discipline of our investment process allows us to have a set process in place, realizing gains along the way without putting the portfolio at extreme risk. We humbly know that there’s always more to learn and believe in the process of seeking continuous improvement.  We stay curious, in line with our principles of relational investing.

I know we all love stories, and often that extends to story stocks. But a disciplined, systematic process will allow you to invest well, sleep well, and leave the entertainment in the theatres.

If you would like to share a story or have a question for a member of our Client Service and Marketing team, email us at info@bridgeway.com or call 713-661-3500, option 1.

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

A Systematic Approach to Extreme Stock Moves

DISCLAIMER
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

As we kick off this new year, like many of you, I have been thinking “how do we turn more ideas into action?”, and I am looking forward to doing that with relational investing in 2021.  In September 2020, in our Open Letter on Relational Investing, I shared how Bridgeway is a leader in this modern approach to investing.  Our approach to relational investing is statistical and evidence-based motivated by a passion for servant leadership and global impact, which we accomplish by donating 50% of our firm’s earnings to organizations making a positive impact for humanity. 

Relational investing is a different approach to investing that bridges the gap between results for investors and returns for humanity.  To help everyone who wants to adopt a relational investing approach, we have identified five principles for success: 

  1. Be intentional
  2. State where you stand
  3. Invest in your outcome
  4. Discover power in the paradox
  5. Stay curious

So, how do individuals, financial advisors, and institutional clients put relational investing into action?  We believe investors can turn these five principles of relational investing into action by enhancing the four-step planning process that they typically already follow.

The best investors that we know follow this four-step plan for investing: 

  1. Structure an asset allocation plan that matches your goals, investing time horizon, and tolerance for risk (getting help from a qualified financial advisor or investment consultant, as appropriate)
  2. Write the plan down
  3. Implement the plan
  4. Rebalance to the plan approximately annually (or as lifestyle changes occur)

Practicing relational investing with this four-step plan is simple but not easy.  Be intentional by structuring a plan that matches your intentions (e.g., goals, investment horizon, risk tolerance, liquidity needs).  Get help when needed from a professional to clarify intentions and take the next step to state where you stand.  Write the plan down.  Third, invest in your outcome by implementing the plan, and discover power in the paradox yourself or by using investment managers that practice relational investing, an approach that bridges the gap between results for investors and returns for humanity.  Finally, stay curious– rebalance to your plan and revisit your intentions at least annually and as lifestyle or other changes occur.  This four-step plan aligned with the principles of relational investing works for individuals and institutional investors and is shown in the image below.

At Bridgeway, we have put these principles of relational investing into action with how we run our organization and an investment philosophy that drives our portfolios to produce results for investors and returns for humanity.  Here is some of what we have learned about each principle: 

Be intentional – The best investors put this into practice by developing financial goals and understanding their willingness and ability to take risk before making any investment decisions.  At Bridgeway, we do this in our investment portfolios through a disciplined research process that drives every investment decision and a mission statement that guides every business decision. 

State where you stand – Relational investors state where you stand by having a clear plan and writing it down.  As leaders in relational investing, we have found that to state where you stand requires candor and kindness.  Stating where we stand allows us to attract clients who we can truly help and colleagues who can thrive and serve at their highest potential in our organization.  We state where we stand in our mission statement and by investing according to a statistical, evidence-based process rather than the opinions or whims of the day of an individual.  We also state where we stand with a commitment to donate 50% of our company’s profits since inception to organizations making a positive impact for humanity. 

Invest in your outcome – For institutions and individuals, investing in your outcome requires avoiding behavioral pitfalls and staying the course.  In relational investing, investing in your outcome includes investment results and returns for humanity.   Returns for humanity can take many forms and each relational investor decides what those will be.  We have learned that the discipline of relational investing often frees time to invest in your outcome in other aspects of life too – like relationships with family, friends, and community organizations.  At Bridgeway, we invest in your outcome by always putting client interests ahead of our own and focusing on stewardship, which we define as having the passion and the discipline to care for an asset for the benefit of others.  For us, investing in your outcome is also about knowing why investment returns matter for clients and keeping a broader perspective on the world.   

Discover power in the paradox – Relational investors see power in the paradox that spending less time acting on investments often leads to better outcomes not just in portfolios but also in the world.  This is where relational investing differs the most from other types of investing.  By focusing on results for investors and returns for humanity, outcomes are multiplied.   

Stay curious – Staying curious is about measuring progress against goals and being open to new ideas.  At Bridgeway, we stay curious about the principles that drive our investment portfolios, about client needs, about how to learn and grow with our colleagues, and about how we can make more positive impact in the world. 

We see the world differently at Bridgeway and believe that principles are the foundation of prosperity.  Prosperity is more than financial success; it also includes a wealth of relationships. Relational investing is grounded in strong relationships – in the data and with clients, colleagues, and community.  It is an approach that any investor can adopt by following key principles.   As leaders in relational investing at Bridgeway, we bridge the gap between investment results and returns for humanity by taking an innovative approach to asset management. Join us. 

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.

Jacob Pozharny Head of International Equity at Bridgeway bio image

Jacob Pozharny, PhD

Amitabh Dugar Research Analyst at Bridgeway bio image

Amitabh Dugar, PhD, CPA

Andy Berkin Head of Research at Bridgeway bio image

Andrew Berkin, PhD

Bridgeway’s research leads to a new framework for addressing intangible assets in equity portfolios.

Stay curious is one of Bridgeway’s principles of relational investing.1  In keeping with our principles, our team has investigated and developed a new framework for analyzing intangible assets in equity portfolios.  For decades, equity investors have relied on stock valuations, as well as the growth, profitability, and risk characteristics of companies. Yet the economy has undergone structural changes in recent years that have opened up opportunities for investors seeking to enhance their investment strategies.

Specifically, companies increasingly rely on intangible assets to drive their business models. Across a broad swath of industries around the world, we’ve seen intangible assets displacing traditional, physical assets on corporate balance sheets and affecting income statements. What’s more, differences in accounting standards between the US and international markets mean that companies are not following the same requirements for expensing or capitalizing many types of spending that create intangible assets, creating potential differences in statements of a company’s book value.

In response to this trend, investment researchers and practitioners have been investigating the potential impact of intangibles on stock prices. Some studies have attempted to quantify the impact of spending on intangibles on contemporaneous stock prices and future returns. Other studies have looked at techniques for adjusting fundamental metrics to account for the effects of specific types of intangibles.  Above all, most research has focused only on US stocks, and international research on this issue is sparse.  For Bridgeway’s detailed review of existing research into the effect of intangible assets on stock prices, please request a copy of our white paper “Equity Investing in the Age of Intangibles” by Amitabh Dugar and Jacob Pozharny.

As Bridgeway began designing our international developed and emerging market equity strategies, we saw an opportunity to investigate a different approach for dealing with the rise of intangible assets. Rather than attempting to adjust valuation metrics, we explored the idea of analyzing and ranking companies based on the degree to which they create and rely on intangible assets—known as Intangible Capital Intensity.  And we included a global set of companies in our study. That way, we could then examine which fundamental metrics are most relevant for various companies and industries according to their degree of Intangible Capital Intensity.

Our research in this area has allowed us to create a new composite metric we call Intangible Capital Intensity. We believe this framework is flexible enough to accommodate different forms and magnitudes of intangible capital across the global economic landscape, and capable of evolving through time to reflect structural changes in the economy. We also discovered that this ranking system may be especially useful for international investors, because the impact of Intangible Capital Intensity on the association between stock prices and fundamental financial variables such as earnings and book value is strongest for international companies.

Defining Intangible Capital Intensity Metrics

Based on our study of accounting theory and our review of existing intangible research, Bridgeway designed its Intangible Capital Intensity composite to capture the impact of three types of intangible capital:

  • Intangible assets reported on the balance sheet (excluding goodwill)
  • Innovation capital created by research & development expenditures
  • Organization capital resulting from sales, general & administrative expenses.

Intangible Assets (Excluding Goodwill)

In theory, any intangible assets reported on the balance sheet are already included in book value, so it may seem counterintuitive to include them in a composite Intangible Capital Intensity measure. In practice, however, spending on these intangible assets can still understate a company’s book value because those expenditures—and their impact on earnings—have increased dramatically. For example, the Telecom Services industry has had some of the highest growth in intangible assets on the balance sheet. This reflects spending on assets such as wireless licenses and subscriber lists, and costs of customer retention. We also reviewed research evidence from around the globe demonstrating that several types of intangible expenditures that were capitalized and reported on the balance sheet were value relevant, both in aggregate and individually.2

We choose to exclude goodwill from our measurement because our objective is to focus on forms of intangible capital investments that have become more important amid the rapid transformation in corporate investment and business models during the past few decades; in contrast, goodwill is an accounting by-product of business combinations. In addition, prior evidence regarding the value relevance of goodwill is mixed.

Research & Development Expenses

While US accounting standards require the cost of both research and development (R&D) to be expensed, International Financial Reporting Standards (IFRS) are a bit less restrictive, allowing the capitalization of development costs. Nevertheless, we see evidence in both international and US research to indicate that R&D expenditures create (intangible) innovation capital that is reflected in equity market values.3

Sales, General & Administrative Expenses

Viewed broadly, expenditures to create intangible capital can lead to a variety of assets such as human capital, customer lists, and proprietary IT systems/software that enhance efficiency, productivity, sales, or customer satisfaction. Sales, General & Administrative (SG&A) expenditures may capture many of these types of intangible capital— collectively dubbed as organization capital.

Our framework seeks to measure the recorded intangible assets, innovation capital, and organization capital (i.e., the composite Intangible Capital Intensity) of firms around the globe in all industries, excluding banks, insurance and diversified financials. We excluded these three industries because their atypical financial reporting practices affect the metrics, we use to gauge Intangible Capital Intensity. For example, due to the nature of their business, banks bundle and report several types of operating expenses in the category of SG&A expenses.

Ranking Industries According to Intangible Capital Intensity

To create our Intangible Capital Intensity composite rankings, we examined a global sample of companies from among the top 15 countries in the world ranked by their 2018 GDP (according to the World Bank). For each of those companies, we computed total intangible assets excluding goodwill relative to total assets; and research & development and SG&A expenses relative to total revenues for the years 1992-2018.4

Those company-specific calculations allowed us to compute the median Intangible Capital Intensity for our three metrics across all firms within each of 21 GICS industries, so we could rank those industries annually according to their median Intangible Capital Intensity in both the US and international markets. Finally, we combined each industry’s annual rank on the three Intangible Capital Intensity metrics to obtain its equally weighted composite Intangible Capital Intensity rank for each of the 27 years in our sample period. Tables 1 and 2 show the 27-year average composite Intangible Capital Intensity ranking of industries for the US and international investment universes. You’ll see that the order of industries according to their average composite Intangible Capital Intensity ranks is remarkably similar.

The results in Tables 1 and 2 demonstrated to us that these intangible metrics are pervasive. We also found that the average of the 21 industries were remarkably consistent over time. Figures 1 and 2 below show the 27-year trend of those average ranks within a one standard deviation band. This is an important finding, because the pace of evolution of Intangible Capital Intensity for each industry and for each type of intangible capital varies during that decades-long time period. Because of that persistence, we believe that our composite measure of Intangible Capital Intensity provides some assurance that investment strategies based on the choice or weighting of factors according to Intangible Capital Intensity are likely to be stable and replicable.

USA Average Composite Intangible Intensity Ranks
Source: S&P Capital IQ, Bridgeway Analysis
International Average Composite Intangible Intensity Ranks
Source: S&P Capital IQ, Bridgeway analysis

Despite these similarities in the average Intangible Capital Intensity, we also observed a key difference: The difference in the book value and earnings to explain contemporaneous stock prices in high versus low Intangible Capital Intensity groups is greater in international markets than in the US market.5 That divergence has also become greater among international companies, while it has remained stable in the US. Therefore, this framework may be especially useful for international investment strategies that want to adapt traditional equity investment analysis techniques to handle the effect of variations in Intangible Capital Intensity across firms and industries within the confines of the current financial reporting framework.

The Benefits of Categorization

Bridgeway’s research on intangibles makes three important contributions. First, because investors rely on book value and earnings to assess valuation ratios and various profitability, growth, and risk measures, our research finding that the relationship between these financial variables and contemporaneous stock prices has weakened for high Intangible Capital Intensity companies and has implications for many types of investment strategies. Second, our finding that this has occurred for both US and international companies in the largest fourteen economies of the world is a noteworthy advancement. Third, our composite measure of Intangible Capital Intensity captures the aggregate impact of three different types of intangible capital and can help investors consistently rank and classify industries over time and across countries. 

Our research provides a repeatable framework to help investors choose or weight factors based on Intangible Capital Intensity when constructing global investment strategies.  Importantly, our conclusions about the impact of Intangible Capital Intensity on the relevance of earnings and book value are stronger for international companies in that the divergence between the low and high Intangible Capital Intensity groups of industries is greater and has continued to increase over time.

Thus, our research shows that the Intangible Capital Intensity composite can be an effective tool for our international and emerging market equity strategies. That work has also laid the groundwork for further areas of research, motivated by a variety of questions. Can equity investors improve their assessments of a firm’s profitability, quality, growth, and risk by accounting for cross-sectional variations in Intangible Capital Intensity? Do we expect performance of value, quality and trend factors to be different based on Intangible Capital Intensity category? How should an investment manager think about factor applications using an Intangible Capital Intensity framework? Based on the broad relevance of this topic for investors, we believe these are important questions to study. As the economic landscape continues to emphasize intangible assets in addition to physical ones, investors will increasingly need new insights to help guide investment strategies, and Bridgeway will stay curious in line with our principles of relational investing.

For a PDF download of this thought piece, please use the following link: https://bridgeway.com/wp-content/uploads/2021/01/Intangible-Intensity-Paper-FINAL-20200119.pdf

1Relational investing bridges the gap between results for investors and returns for humanity with a modern approach to asset management. As a leader in relational investing, Bridgeway takes 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. For more detail, please see https://bridgeway.com/perspectives/an-open-letter-on-relational-investing/

2Oliveira, Rodrigues and Craig (2010) for a sample of Portuguese firms, Ritter and Wells (2006) and Dahmash, Durand and Watson (2009) for the Australian market, and Lev and Aboody (1998) in their study of capitalized software development costs in the US.

3Ahmed and Falk (2006) for a sample of Australian firms, Zhao (2002) for firms in France, Germany, UK and US, Smith, Percy and Richardson (2001) based on data from the Australian and Canadian markets, and the seminal paper by Lev and Sougiannis (1999), who estimate the R&D capital of a sample of more than 800 manufacturing companies.

4Analysis begins in 1992 as the company-level financial statement data available in S&P Capital IQ’s database was insufficient to permit construction of reliable intangible intensity ranks for prior years.

5For more detail and supporting evidence, please request Bridgeway’s white paper “Equity Investing in the Age of Intangibles”.

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.

Andy Berkin Head of Research at Bridgeway bio image

Andrew Berkin, PhD

Christine Wang Portfolio Manager at Bridgeway bio image

Christine Wang, CFA, CPA

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

Tammira Philippe, CFA

Heard enough already about value’s underperformance and why the evidence suggests staying the course?  Just in case not, we will live our relational investing1 principle of stating where we stand and briefly summarize our research on value overall in the US market.  More importantly, we will move from Wall Street down a different street with a focus on US small-cap value for a discussion of One of These Is Not Like the Others2.

Overall US Value

Looking at the US stock market back to 19263, it’s pretty obvious to see that One of These (Columns) Is Not Like the Others. In general, over the entire period of history, the right most column with the deepest value exposure has had distinctly higher returns than others.

US Stock Market Since 7/1926 (Annualized, %), as of 9/30/2020

GrowthMid-GroMidMid-ValValue
Big9.979.5410.278.6510.44
Med-Big10.3810.7611.6112.3711.62
Medium9.2112.2812.2213.3712.66
Med-Sml7.5511.7712.4813.0614.29
Small2.626.6711.0413.8615.39

Source: Bridgeway, Ken French data library4, total US stocks formed into 25 portfolios based on size exposure defined by market capitalization and value exposure defined by price to book ratios.

For most value investors though, the past one, five, and 10 years has proven instead that One of These (Time Periods) is Not Like the Others. Notably, the results in the most recent decade are the opposite of the results back to 1926.

US Stock Market Last 10 Years (Annualized, %), as of 9/30/2020

GrowthMid-GroMidMid-ValValue
Big18.1113.4111.627.247.48
Med-Big16.6613.7310.297.986.45
Medium13.7214.069.3410.423.47
Med-Sml14.6013.039.786.766.86
Small7.9212.128.277.837.66

US Stock Market Last 5 yr (Annualized, %), as of 9/30/2020

GrowthMid-GroMidMid-ValValue
Big21.7513.319.722.704.94
Med-Big18.4812.989.170.361.80
Medium13.2111.146.577.09-1.52
Med-Sml15.8012.896.791.253.35
Small12.1911.607.843.494.20

US Stock Market 1 Year (%), as of 9/30/2020

GrowthMid-GroMidMid-ValValue
Big40.8313.57-2.01-20.60-16.12
Med-Big33.358.53-4.78-18.65-26.69
Medium22.6414.73-12.12-6.20-26.65
Med-Sml27.584.78-8.38-22.00-10.05
Small31.4930.962.44-15.21-8.49

Source: Bridgeway, Ken French data library4, total US stocks formed into 25 portfolios based on size exposure defined by market capitalization and value exposure defined by price to book ratios.

Based on the long-term evidence, the long and deep drawdown of value in the US is not surprising (though it’s still not fun). It has happened before with value, the overall stock market, and other factors.  While challenging to endure, underperformance provides confirming evidence of exposure to different sources of risk that investors should seek. Put another way, this underperformance is a manifestation of the “risk” portion of “risk premium” that ultimately has been rewarded; the higher historical returns of value are not a free lunch and require a strong stomach. 

On the positive side, historical evidence for value gives us optimism for the coming decade.  In the US, value5 has outperformed growth6 91% of the time over rolling 10-year periods going back to 1926.  Over those same periods, the US stock market7 has only outperformed the risk-free rate 86% of the time; thankfully, investors don’t typically question the benefits of staying the course with stocks over cash, and we believe the same holds for staying the course with value stocks.

We don’t know when value will recover, but when it does, history shows it has typically been strong.  Long-term evidence for the US shows that not only has using deeper value exposure and multiple measures produced higher returns when times are good, but also has helped in drawdowns and recovery.  For more on value overall, see Factoring in Bear Markets, Stress Test: How Factors Perform Before, During, and After Recessions, Value’s Defining Moment or Does Value Just Need Some Growth?, or email advisors@bridgeway.com.

A Deeper Look Into US Small Value

So, what about small-cap value in the US?  As with value in the market overall, the results for small-cap value over the last decade are starkly different than long-term results back to 1926. 

As the tables above and chart below shows for the period back to 1926, there has been a 2.33% annualized benefit in return for the very smallest and most value companies (15.39%) shown in the bottom row and last column of each table, compared to the next smallest and next deepest value companies (13.06%) shown in the fourth column and fourth row of each table for almost 95 years.  On the other hand, for the last 10 years, the benefit was only 0.90% annualized for the additional small value exposure even after including a 13.51% advantage in the last year. 

US Small Value Stocks, Annualized Returns as of 9/30/20

Source: Ken French data library and Bridgeway calculations. See disclosures for more information.

This concept is important to remember as we think about if One of These (Portfolios) Is Not Like the Others. The variation of returns reminds us that the level of capitalization and value exposure truly matters even among different small-cap value strategies. 

When a segment of the market does well, investors should expect the portfolio with the most exposure to the factors explaining the segment’s outperformance to have the highest return. And when a segment of the market does poorly, investors should expect that same portfolio with the most exposure to the factors will underperform.  

Performance across small-cap value portfolios can diverge significantly, particularly when the asset class is either doing significantly better or worse than the overall US market.  This has definitely been the case over the last decade.  Divergence is usually driven by meaningful differences in size of companies held, valuation of companies held, measures of value used, and differences in allocations across sectors like REITs and utilities. These performance differences rarely indicate that a portfolio is not efficiently delivering the expected returns. Instead, performance differences arise because of differences in portfolio design. A portfolio focused on the stocks with smaller size and deeper value will indeed not look like other small cap value portfolios lacking that depth of exposure.

Conclusion

So, as we sit in one of those periods that has not been like the others, what can investors do? We at Bridgeway focus on the intersection of what matters and what we can control and have discovered the power in the paradox that often the best thing for investors to do is “very little”

As leaders in relational investing, we suggest being guided by principles and staying invested in your outcome.  Diversification is a crucial concept for all investors, and for Bridgeway it includes not just the way we invest but also how we run our firm and the people we hire.  We do not make dramatic changes to our portfolios because we are in a pandemic, recession, bear market, or other challenging time, and we think all investors should avoid the temptation. These moves are potentially costly in terms of trading needed to implement those changes and the substantial risks of not getting that timing call exactly right.

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

https://bridgeway.com/wp-content/uploads/2020/11/Bridgeway-One-Is-Not-Like-The-Others-THOUGH-PIECE-1.pdf

.

1Relational investing bridges the gap between results for investors and returns for humanity with a modern approach to asset management.  As a leader in relational investing, Bridgeway takes 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. For more detail, please see https://bridgeway.com/perspectives/an-open-letter-on-relational-investing/

2If this reference is lost on you, at least one of the authors grew up on Sesame Street and fondly remembers the song “One of These Things”

3US stocks as defined by the Ken French Data library. See disclosures for more information.

4See disclosures for more information.  The portfolios shown in each row and column are the intersections of 5 portfolios formed on size (market capitalization) and 5 portfolios formed on the ratio of price/book as constructed in the Ken French data library. The size breakpoints for each year are the NYSE market capitalization quintiles at the end of June of each year shown in each row of the table. Big refers to the largest quintile in terms of market capitalization, Med-Big refers to the 2nd largest, Medium refers to the 3rd largest quintile, Med-Sml refers to the 4th largest quintile, and Small refers to the smallest quintile.  Price/book for June of each year is the market capitalization in December of the prior year divided by book value for the previous year’s fiscal year end. The breakpoints for each column are NYSE quintiles. Growth refers to the highest price/book quintile which have the least value exposure, Mid-Gro refers to the 2nd highest price/book quintile, Mid refers to the 3rd highest price/book quintile, Mid-Val refers to the 4th highest price/book quintile, and Value refers to the lowest quintile in terms of price/book which have the strongest value exposure.

5Using HML (high minus low) for value and growth and US stock market defined as Rm-Rf with the data and methodology from the Ken French data library. See disclosures for more information. Rm-Rf includes all New York Stock Exchange, NYSE American, and Nasdaq firms. HML for July of year t to June of t+1 includes all New York Stock Exchange, NYSE American, and Nasdaq stocks for which they have market equity data for December of t-1 and June of t, and (positive) book equity data for t-1.

6See Footnote 5

7See Footnote 5

 

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.  All returns are gross of any fees and expenses an investor would pay.

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 mutual funds. 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.

Data sourced from the Ken French data library uses their definitions and methodology although Bridgeway has used our preferred terminology in some cases.  Price/book is Bridgeway’s preferred term which refers to the reciprocal of book equity to market equity data from the Ken French data library.  US portfolios include all New York Stock Exchange, NYSE American, and Nasdaq stocks for which they have market equity data for the prior December and June, and (positive) book equity data for the prior year.

Andy Berkin Head of Research at Bridgeway bio image

Andrew Berkin, PhD

Geoff Crumrine

Geoff Crumrine

Bear markets and recessions are not identical, but investor responses should be.  Staying the course with multi-factor diversification through bears and recessions is our suggested course of action based on a review of the evidence.  This thought capsule is a follow-on to our analysis of recessions and factor performance.

By Andrew L. Berkin, Ph.D., Head of Research, and Geoffrey G. Crumrine, Head of Client Service and Marketing

In the early spring of 2020, investors found themselves in a situation they hadn’t experienced for a decade: Confronting a bear market. Global stock markets tumbled in February and March over concerns about the economic impact of the coronavirus pandemic. The S&P 500 Index, which had reached a high on February 19, ultimately fell more than 33% from its peak until bottoming out on March 23—putting the index well into bear territory.

Subsequent economic stimulus efforts from the U.S. government helped improve investor sentiment and stocks began to recover over the following months. Those gains drove the S&P 500 back to a new record high in late August 2020, signaling the end of the bear market. Despite the apparent short duration of the latest bear, stocks remain volatile and many investors are still wary about the future. However, bull and bear market cycles are to be expected when pursuing a long-term investing strategy. Unfortunately, we can’t predict when bear markets will occur or how long they will last, and we can’t control the external factors that help dictate broad market movements. But we can examine historical data to understand how portfolios have performed during past bear markets.

Following up on our recent analysis of recessions and factor performance, we wanted to take a similar deep dive into the phenomenon of bear markets and the performance of the underlying factors that shape stock returns. Bridgeway’s previous research into past recessions uncovered data that emphasizes the fact that it’s risky to try to time both the economic cycle and the market’s performance. Individual factors don’t move in lockstep during recessions. It’s not surprising, then, that we observe similar patterns in the historical record for factor performance before, during and after bear markets. But just as recessions and bear markets are distinct events, factor performance isn’t identical during each.

A Broad Look at Bear Markets Throughout History

Markets typically are considered to be in bear territory when they have fallen by 20% from their highs. Since 1926 through February 2020, we’ve identified eight bear markets according to this 20% peak-to-trough decline convention (not including the most recent February-March downturn)1.

The chart below illustrates this history. The line shows the growth of $1 invested in the broad stock market, with red sections representing bear markets and blue sections representing bull markets. Overlaid on this graph, we’ve also plotted economic recessions, represented by grey bars.

Growth of $1

Sources: Ken French Data Library, NBER, and Bridgeway calculations

First, we note that one dollar invested in the stock market in July of 1926 would have grown to more than $7,500 by the start of 2020. Despite recessions and bear markets, many stocks have been an excellent investment over the long term. In fact, we could replace the word “despite” in the previous sentence with the phrase “because of.” Stocks are a risky investment, but this risk comes with the potential for the higher rates of return that reward investors.

Interestingly, we also see that bear markets and recessions often—but not always—overlap. Since 1926, the market experienced 15 recessions and 8 bear markets. Even when recessions and bear markets coincide, they don’t share exact start and end dates. And sometimes, we have recessions without bear markets or bear markets without recessions. One example is the 1987 bear market, which includes the October 19 market crash often referred to as Black Monday. Although a painful bear market, it did not have a corresponding recession attached.

What are Factors?

Factors are the specific characteristics of stocks and other securities that both drive their returns and explain their performance across different market conditions and business cycles. For further discussion, please see the book “Your Complete Guide to Factor-Based Investing” by Andrew L. Berkin and Larry E. Swedroe.

Factor Performance and Bear Markets

While the data above displays how the overall market has performed since 1926, we also analyzed how individual factors performed before, during, and after bear markets. Table #1, below, shows average factor returns for Fama-French factors and momentum relative to market environment.

Table #1: 8 Bear Markets Going Back to June 1926

Fama-French Plus Momentum Factors, Average Monthly Returns (%)

 Market premium (Mkt-RF)Small size (SMB)Value (HML)Momentum (MOM)Profitability (RMW)Conservative investments (CMA)
All Months0.670.190.350.660.260.27
Bull Markets1.270.270.290.520.140.12
Bear Markets-3.70-0.340.761.641.101.32
12M Pre Bear Mkt1.760.14-0.031.44-0.240.21
12M After Bear Mkt3.251.021.16-2.06-0.240.26

*Average returns through January 2020. Mkt-RF, SMB, and HML data starts in July 1926. Momentum data starts in January 1927, and profitability and investment factors data start in July 1963
Source: Ken French Data Library and Bridgeway calculations

As we see in the second row, all factors did well in the more prevalent bull market months, although the company financial health related metrics of RMW and CMA were weaker than typical. Row three shows that, as expected, the market factor (Mkt-RF) was strongly negative during bear markets but recovered especially well in the 12 months following. Stocks tend to rebound dramatically after a bear market. There is an old saying that no one rings a bell at the top or the bottom of the market. Timing the markets is difficult, and as the recovery from bear markets shows, missing out can be quite costly.

The performance of other factors is quite different depending on the period. Small stocks suffered during the risk-averse times of bear markets but performed strongly in the recovery. In contrast, value stocks held up quite well during bear markets. Noting that value is negative on average in the 12 months beforehand provides some insight into this behavior. The market environment before the onset of a bear is often characterized by exuberance, with growth-led rallies. However, value has come back into favor during the ensuing downturn and subsequent recovery. The aftermath of the late 1990’s technology bubble is a well-known example of this pattern.

Perhaps somewhat surprising is the behavior of momentum, which generally holds up quite well during bear markets but fails miserably afterwards. This pattern was first described by Cooper, Guillen and Hamid.2 When markets bounce back, those stocks that have lost the most often lead the recovery, and momentum suffers. (For more in-depth analysis, see the Bridgeway white paper “When and Why Does Momentum Work – and not Work?” by Andrew L. Berkin.)

When we compare these returns to our previous analysis of factor returns during recessions, we see many similarities—but also important differences. For example, factors related to company financial health (RMW and CMA) perform strongly in both recessions and bear markets, as investors favor higher quality companies in both environments. In fact, the returns for RMW and CMA are even stronger in bear markets than they are in recessions. However, the performance of these two factors diverges in the aftermath of the different events. The profitability factor RMW, which has stronger-than-average returns in the 12 months following recessions, is actually negative in the 12 months after bear markets.

Another difference is the relative effectiveness of the value factor during and after bear markets. Value’s returns are reduced (but still slightly positive) during recessions, and its outperformance in the 12-months following not quite as strong as the substantial turnaround we see following a bear market.

Critically, we see that factors don’t move in lockstep around these two distinct market and economic events. And in both cases, we see dramatic reversals in leading and lagging factors before, during and after both recessions and bear markets. As we said earlier, trying to time these shifts is difficult, which is why we emphasize the importance of maintaining diversification across multiple factors.

Case Study: Bear Market of 2000-2002

Moving down from the 30,000-foot view, let’s examine the bear market of 2000-2002. Previously, we analyzed the recession of 2001 to show that factor performance during that event did not line up with long-term historical averages. For this reason, we thought it would be interesting to look at a bear market that occurred around the same time.

The recession of 2001 started in March and lasted for 8 months, ending in October of the same year. In contrast, the bear market predated the recession (beginning in September 2000) and ran for 25 months (ending in September 2002). It was the second-longest bear market after the one that coincided with the Great Depression.

Table #2: Bear Market of Sept 2000-Sept 2002 (25 months)

Fama-French Plus Momentum Factors, Average Monthly Returns (%)

 Market premium (Mkt-RF)Small size (SMB)Value (HML)Momentum (MOM)Profitability (RMW)Conservative investments (CMA)
During Bear Market-2.510.732.401.513.001.97
12 M Pre Bear Mkt1.311.48-1.304.09-1.550.04
12 M Post Bear Mkt1.991.45-0.54-2.47-1.701.04

Source: Ken French Data Library and Bridgeway calculations

The data for the bear market of 2000-2002 offers a good example of the risks of attempting to time a bear market and tactically adjust factor exposure. While value’s positive performance on average during bear markets hasn’t been as strong as the returns for momentum, profitability, and conservative investments, the bear market of 2000-2002 saw value delivering substantial gains. Recall that growth stocks had been dominant in the tech bubble of the late 1990s and the first quarter of 2000. For the 12 months before this particular bear market, value lagged by an average of 1.30% monthly. The collapse of formerly high-flying growth stocks not only helped usher in the bear market and subsequent recession, but also set the stage for historically discounted and beaten down value stocks to recover strongly. Many investors who had abandoned value stocks during the run-up of tech stocks likely missed out on a substantial portion of value’s gains.

Key Takeaways

As noted earlier, we can’t predict whether a modest drop in stocks presages a dramatic slide into bear market territory. Likewise, we never know if a bounce from market lows will lead to a full recovery or is merely a temporary rally. Examining how factors have performed historically around bear markets is instructive, but also shouldn’t be taken as a prescription for portfolio changes. Remember, the factor returns shown in Table #1 are averages across multiple bear markets, and as we saw when examining the bear market of 2000-2002, they don’t hold every time.

For those reasons, investors should avoid making dramatic changes to their portfolios based on where they believe we are in the market cycle—just as we cautioned against making changes around recessions. Remember that factors have worked over long periods. They don’t always deliver positive returns, but when one is lagging others often provide a positive return cushion. What’s more, those lagging factors have rebounded in the past. For example, small size and value underperformed large growth in the run-up to the most recent bear market and continue to lag. But historical data showing that small size and value have recovered strongly after past bear markets gives us confidence that they will again — we just can’t predict when the turn will happen and how robust the recovery will be.

Considering this evidence, we believe building a well-diversified portfolio with exposure to multiple factors and rebalancing to return to those targets when a factor or asset class moves out of line with your chosen allocation target. That strategy may help investors avoid the costs associated with excessive trading and the substantial risk of missing out on gains by getting the timing wrong as the markets move through their inevitable cycle of bulls and bears.

1 As in our analysis of recessions and factor returns, we have not included the current recession or the 2020 bear market because we have not completed a full market cycle.

DISCLAIMER
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.

Mkt-RF or the equity risk premium is the expected excess return of the market portfolio beyond the risk-free rate. SMB or the size premium measures the additional return investors have historically received by investing in stocks of companies with relatively small market capitalization. HML or the value premium measures the additional return investors have historically received for investing in companies with high book-to-market values. MOM or the momentum premium measures the additional return investors have historically received for investing in companies with positive acceleration in stock price. RMW or the profitability measure is the difference between the returns of firms with robust (high) and weak (low) operating profitability. CMA or the investment factor is the difference between the returns of firms that invest conservatively and firms that invest aggressively.

Before investing you should carefully consider the Bridgeway mutual funds’ investment objectives, risks, charges and expenses. This and other information is in the prospectus, a copy of which may be obtained by calling 800-661-3550 or visiting the Funds’ website at bridgeway.com. Please read the prospectus carefully before you invest.

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 mutual funds. 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. One may not invest directly in an index. Index returns are gross of trading and advisory fees and expenses.

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

The Bridgeway mutual funds are distributed by Foreside Fund Services, LLC, which is not affiliated with Bridgeway Capital Management, Inc. or any other affiliate.

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

Tammira Philippe, CFA

We see the world differently at Bridgeway.  We are trailblazers in relational investing which bridges the gap between 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.  For decades now, our clients and partners have chosen us because we value independent thought and relationships, embrace a long-range mindset, and our profits directly benefit humanity.

We believe principles are the foundation of prosperity.  This belief pulses deeply through and beyond Bridgeway, in the work we do with our clients, our colleagues, and our community.

What is prosperity?  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.  It’s time to reclaim prosperity for all.

For clients, Bridgeway helps achieve prosperity through the discipline and conviction we have in investment principles that are enduring.  We build portfolios grounded in principles that are well researched, well developed and overall have withstood the test of time.  As our Head of Research, Dr. Andrew Berkin, explains in The Complete Guide to Factor-Based Investing, the factors we use in our portfolios must be persistent, pervasive, robust, investable, and intuitive.  These are some of the principles of relational investing that drive the portfolios we build for clients.

We draw upon our expertise in relational investing to analyze relationships in financial statements and market prices to understand how these relationships drive investment returns.  We then derive a set of principles and rules to govern how we systematically manage portfolios.  Principles and research give us conviction in our investment portfolios. Bridgeway is constantly investing in a methodical, intellectually disciplined way to continually confirm the relationships we’ve already tested. When new information is presented, we adapt and adjust. We have set up an environment and culture where questioning is the norm.  Our conviction has been tested over the last 25 years, and we are convinced that we can stick to those principles.  Moreover, principles govern how we think about decisions big and small at Bridgeway, asking “what is in the best long-term interest of our current clients?” to guide our actions.  We commit ourselves to the principles of stewardship in all that we do which we define as having the passion and discipline to care for an asset for the benefit of others.  Stewardship applies to the assets we manage for clients, the people at Bridgeway which our mission states are our greatest resource, the communities we serve, and beyond.

As colleagues at Bridgeway, we prosper as professionals by embracing and implementing leadership principles and a special culture that we’ve intentionally built since the first day we opened our doors in 1993.  Collectively, we are curious and purposeful servant leaders.  We strive for a different kind of commitment and relationship among colleagues, which is why we refer to all long-term staff members as Partners, and this is crucial to our leadership in relational investing. Elevated by our commitment to servant leadership, our principles guide difficult decisions and how our teams work.  We ask everyone at Bridgeway to find a place to lead and follow. Leaders ask “how can I serve?” first.  When there are team challenges, leaders ask “how am I contributing to the problem I don’t want?”.  We apply Robert Greenleaf’s Best Test to our actions asking “Do those served grow as persons?  Do they, while being served, become healthier, wiser, freer, more autonomous, more likely themselves to become servants? And, what is the effect on the least privileged in society? Will they benefit or at least not be further deprived?”  These are the principles at the foundation of prosperity and relationships with our colleagues at Bridgeway.

In communities, we invest in relationships with experts in the field to ensure that our contributions are making an impact and contributing to prosperity.  Shannon Sedgwick Davis, CEO of Bridgeway Foundation, highlights some of our heroes in her book To Stop A Warlord.  Moreover, in her article, The four strategies I used to help stop a warlord, Shannon highlights the principles at the foundation of prosperity in our work in communities including: 1) thoroughly dissect the goal or mission statement, 2) rethink the approach, start by listening, 3) ask what you’re willing to risk for what you believe in, and 4) step “out of bounds”.  Shannon says, “joining forces with diverse partners allows us to fill gaps and augment capabilities.”  Certainly, these principles are at the foundation of prosperity in communities and also with our clients and colleagues.

But it’s important to recognize principles must never become stagnant. They must be tended to, nurtured and present in our everyday lives in order to stay alive and effective. Principles also need to be challenged and tested.

How do we test our principles as an organization? We stay curious. We question and confirm everything we believe to be true, beginning with our investments.  Questioning principles is intrinsic to our organization.  Diversity of thought is celebrated, and we intentionally create our teams to foster that diversity. We stay open to criticism, and we wholeheartedly listen.

My heart is in this work.  Even as a little girl, I felt called to serve at my highest potential. Today, I feel fulfilled waking up every day knowing that I can take my deeply held principles and contribute to prosperity for our clients, our team and the world.  I am excited every day to lead a group of individuals positioned to help clients prosper, make a positive impact for humanity and, at the same time, to make our principles so prominent it changes our industry.

Wealth and other forms of success may be achieved, but prosperity can only be achieved through living and breathing our principles.  This is a cornerstone of the relational investing approach at Bridgeway designed to fulfill our extraordinary commitment to clients, colleagues, and community.  We are not at the end. We’re at the beginning. We are creating a new world of prosperity. Join us.

DISCLAIMER
Before investing you should carefully consider the Bridgeway mutual fund’s investment objectives, risks, charges and expenses. This and other information is in the prospectus, a copy of which may be obtained by calling 800-661-3550 or visiting the Fund’s website at bridgeway.com. Please read the prospectus carefully before you invest.

Investing involves risk, including possible loss of principal.

The Bridgeway mutual funds are distributed by Foreside Fund Services, LLC, which is not affiliated with Bridgeway Capital Management, Inc. or any other affiliate.