Thought Capital Resources | Bridgeway Capital Management

Cindy Griffin, CIPM

Jacob Pozharny Head of International Equity at Bridgeway bio image

Jacob Pozharny, PhD

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. To that end, in early 2021, we launched our first non-US equity strategy, Bridgeway Emerging Markets Small-Cap. At that time, we felt there was compelling evidence that small-cap stocks in emerging markets were an attractive asset class and that Bridgeway is uniquely positioned to maximize the opportunities in this asset class. More than two years after the launch of our Emerging Markets Small-Cap strategy, we revisited the reasons why, and they still ring true today:

Emerging markets small-cap equity has historically offered lower correlation not only to non-equity asset classes but also to other equity asset classes.
Emerging markets small-cap equity offers more diversification compared to other equity asset classes due to a less concentrated universe and revenue that is typically locally sourced.
Based on past history, active management has the potential to outperform in emerging markets small-cap equity.
A systematic, quantitative process can 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 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 our investment philosophy or process.
Bridgeway’s global research into intangibles and unique portfolio construction 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 other equity asset classes. This also holds true for emerging markets small-cap equity. The simplest way to confirm this is to view the correlation of the asset class versus other equity asset classes. We looked at rolling 36-month correlations using monthly returns for various MSCI indexes (to represent various equity asset classes) relative to the MSCI AC World IMI, an index that constitutes large-, mid-, and small-cap companies across 23 developed markets and 24 emerging markets. Since the common inception in 2001 of the indexes shown, the MSCI Emerging Markets Small Cap Index as a proxy for the emerging markets small-cap equity asset class has consistently been among the lowest correlated index relative to the MSCI AC World IMI.

Source: FactSet; Returns for the MSCI Emerging Markets prior to June 2007 are back-tested performance and do not reflect actual index performance. Back-tested index performance was calculated retroactively to show how the index might have performed and may be materially different than actual results would have been.

However, for the most recent three-year period, the lowest correlation has been between the MSCI Emerging Markets Index to the MSCI AC World IMI. To what can we attribute this sudden dip? The primary reason is the large weighting that China has in the MSCI Emerging Markets Index versus the MSCI Emerging Markets Small Cap Index. The following table shows each index’s average weight to China and overall index return all for the three years ending June 30, 2023.

Three Years as of 6/30/23	Average Weight to China	Overall Index Cumulative Return (Net)
MSCI Emerging Markets Small Cap Index	11.08%	47.06%
MSCI Emerging Markets Index	39.03%	7.12%

Source: FactSet

While the performance of Chinese stocks in the MSCI Emerging Markets Small Cap Index was worse on an absolute basis relative to the overall MSCI Emerging Markets Index, the lower weighting to China mitigated the negative effect to the overall performance of the MSCI Emerging Markets Small Cap Index. The MSCI Emerging Markets Index’s 3.5 times higher average weight to China had a significant negative effect on performance. This tells us that indeed, the MSCI Emerging Markets Index has lower correlation in the most recent period, but that correlation has come at a cost.

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 (Using Daily Returns) as of 06/30/2023

Asset Class	Index Representative	3 Year	5 Year	10 Year
US Broad Fixed Income	Bloomberg Barclays US Aggregate	0.03	0.01	-0.01
US High Yield Fixed Income	Bloomberg Barclays US High Yield – Corporate	0.50	0.62	0.58
US Real Estate	MSCI US REIT INDEX – Gross Return	0.22	0.38	0.33
Commodities	S&P GSCI Total Return	0.24	0.29	0.26

Source: FactSet

Lower correlations may also 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 Small Cap Index versus the MSCI Emerging Markets Large 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 7.32%, while defensive sectors (Consumer Staples, Energy, Health Care, Real Estate, and Utilities) had an average weight difference of 3.10%. 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 6/30/2023	MSCI Emerging Markets Small Cap Index	MSCI Emerging Markets Large Cap Index	Absolute Difference
Industrials	16.78	4.97	11.81
Financials	10.91	22.28	-11.37
Communication Services	4.02	10.81	-6.79
Materials	13.95	7.49	6.46
Health Care	8.89	2.79	6.10
Information Technology	17.09	22.49	-5.40
Real Estate	6.14	1.35	4.78
Energy	1.77	5.30	-3.53
Consumer Discretionary	11.10	13.20	-2.10
Utilities	3.19	2.28	0.91
Consumer Staples	6.12	5.93	0.19

Source: FactSet

As seen above with China, another potential contributor to lower correlations and drivers to return within emerging markets small-cap 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 06/30/2023

Country	MSCI Emerging Markets Small Cap Index	MSCI Emerging Markets Index	Absolute Difference
China	8.07	29.55	21.48
India	24.23	14.63	9.61
Taiwan	21.81	15.60	6.21
Korea	14.99	12.30	2.69
Thailand	3.22	1.92	1.30
Malaysia	2.37	1.33	1.04
Turkey	1.48	0.55	0.92
Mexico	2.37	2.80	0.43
South Africa	2.78	3.21	0.43
Saudi Arabia	3.80	4.22	0.43
Chile	0.89	0.54	0.35
United Arab Emirates	0.96	1.30	0.34
Philippines	0.98	0.65	0.33
Poland	1.12	0.85	0.27
Peru	—	0.26	0.26
Brazil	5.80	5.54	0.26
Kuwait	1.05	0.83	0.22
Hungary	0.04	0.24	0.20
Indonesia	2.19	2.00	0.19
Greece	0.64	0.45	0.19
Egypt	0.26	0.08	0.18
Czech Republic	0.06	0.15	0.10
Qatar	0.83	0.90	0.07
Columbia	0.10	0.10	0.00

Source: FactSet

As with China, the other top two largest country weight differences – India and Taiwan – have had an outsized effect on performance (and thus correlations). In the last three years, India has had a staggering 122.58% return in the MSCI Emerging Markets Small-Cap versus the MSCI Emerging Markets India return of 72.68%. The difference in weightings have also affected performance and correlation with the MSCI Emerging Markets Small-Cap Index having nearly 10% more in India relative to the MSCI Emerging Markets Index. And while the returns for Taiwanese stocks were similar between the two Indexes, the large positive return and relative overweighting in the MSCI Emerging Markets Small-Cap Index had a positive effect. 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.

In the updated chart below, we show the excess annualized gross return over the long-term (10 years) of the median and top quartile institutional manager in four equity universes from the eVestment database: Global Emerging Markets Equity, and Global Emerging Markets Small Cap Equity, US Large Cap Core Equity, US Small Cap Core Equity against a common benchmark for each universe.

Source: eVestment, Bridgeway analysis; the eVestment universe median and top quartile calculation is using the default reporting method and default vehicle for all universe constituents to determine the median for each universe. The benchmark used for the Global Emerging Mkts Equity manager is the MSCI Emerging Markets Index Net; the benchmark used for the Global Emerging Mkts Small Cap Equity manager is the MSCI Emerging Markets Small Cap Index Net; the benchmark used for the US Large Cap Core Equity manager is the Russell 1000 Index Total Return; and the benchmark used for the US Small Cap Core Equity manager is the Russell 2000 Index Total Return.

Over this long-term period, the median Global Emerging Markets Small Cap Equity manager provides the highest excess performance of any of the other median managers shown relative to their benchmarks. Narrowing it down to the top quartile in each universe shows a similar pattern: the Global Emerging Markets Small Cap Equity manager has the highest excess performance of any of the other top quartile managers shown relative to their benchmarks. 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.

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

More than two years has passed since we launched our own emerging markets small-cap strategy. At the time of launch, we believed it was an attractive asset class and continue to believe so now. However, a strong caveat: 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 were implemented.

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 plotted the distribution of tangible book-to-price ratios for the past 20 years and noted where each index stands as of June 1, 2023.

Source: FactSet, Bridgeway analysis

As the chart above on the left demonstrates, the MSCI Emerging Markets Small Cap Index generally has a distribution of book-to price ratios that are higher (meaning it represents a stronger value profile) than the other indexes represented. Further, within that distribution, the MSCI Emerging Markets Small Cap Index is currently cheap relative to its own history, making it an attractive opportunity for value investors. The chart on the right decomposes the MSCI Emerging Markets Small Cap Index into sectors and similarly plots the book-to-price ratios for each over the past 20 years. Except for the outlier of Information Technology, the chart shows that within MSCI Emerging Markets Small Cap Index, each sector is currently cheap relative to its own history demonstrating that the value opportunities in this space are broad based and not just driven by one particular sector.

For almost ten years, cheap stocks have lagged expensive stocks in terms of performance. This is a rare occurrence in the history of the market. Moreover, this trend is not limited to one region or country, but has affected the whole world. Therefore, we believe that emerging market small-cap stocks are poised to outperform, as they offer a great opportunity for value-focused investors. These stocks are currently trading at very attractive valuations, both compared to other global equities and to their own historical averages. Investors who are looking for the best bargains in the market should not miss the chance to invest in emerging markets small-cap stocks now.

Investing Quantitatively and Managing Capacity in Emerging Markets Small-Cap

In our 2021 piece, we discussed why a quantitative approach has some advantages over a non-quantitative approach. In summary, because a quantitative approach relies on data and can use modern programming and statistical analysis to evaluate companies, quantitative investment managers can cover the large number of names in the universe more quickly and efficiently than a non-quantitative manager. Further, because a quantitative approach allows an investment manager to cover all the names in the universe on a daily basis, there may be more potential opportunities for a quantitative investment manager than a non-quantitative manager may ever discover. Reviewing the data in eVestment appears to back up this hypothesis.

Source: eVestment, Bridgeway analysis; for each period, the average return of managers with a non-quantitative investment approach is subtracted from the average return of managers with a quantitative investment approach. The returns used are for the default reporting method and default vehicle for all universe constituents to calculate the average.

Over the trailing, 1-, 3-, 5-, and 10-year periods ending June 30, 2023, the average return for managers with a quantitative approach have outperformed their non-quantitative peers in the range of 1.01 – 4.47% annualized.

However, a good performing strategy is only good as long as it sticks to its mandate, which is why managing capacity is so important. 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.

Bridgeway’s experience in managing assets in capacity-constrained asset classes can help successfully guide our experience in the emerging markets small-cap universe. Additionally, Bridgeway’s international equity team, led by our Co-CIO and 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

In our last piece on “Why Emerging Markets Small-Cap?” we noted our innovative approach incorporating intangibles in our own Emerging Markets Small-Cap strategy. To summarize, 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.). We then contextually apply factors like value, quality, sentiment, and trend to shape stock selection.

Bridgeway further differentiates our approach to investing in emerging markets small-cap stocks through portfolio construction innovation. We use a unique approach to invest in emerging markets small-cap stocks that focuses on both picking the best stocks and building the best portfolio, emphasizing both equally.

Our portfolio construction is driven by sizing index-relative exposures using an innovative technique we call Active Share Proportionality rather than classical mean-variance optimization. Our research indicates that off-the-shelf optimizers that are based on mean-variance optimization depend on the stability of a covariance matrix and use too much turnover to adapt the portfolio to noisy volatility estimates. Unlike most investors who rely on these standard tools that adjust the portfolio based on how stocks move together, we construct our portfolio in a differentiated manner. Our method of Active Share Proportionality allows us to size our systemic risks directly based on how much they proportionally differ from the index, rather than how much stocks vary with each other. This way, we seek to avoid the problems of using unreliable and changing estimates of stock correlations, which often lead to unnecessary trading and higher costs. By not requiring a covariance matrix estimate, our portfolio construction technique reduces turnover requirements and transaction costs, thus turnover exists primarily to express stock preferences rather than adapt to covariance noise.

This technique is geared to source active return from idiosyncratic elements rather than systematic risks. Our method helps us to reduce the impact of market-wide factors, such as country, sector, size, and Beta, and to increase the contribution of stock-specific factors, such as company fundamentals, growth, and sentiment, to our performance. By doing this, we aim to generate more consistent and diversified returns from our stock selection and mute systematic exposures to improve the risk-adjusted excess return of our portfolio.

Conclusion

We have demonstrated some convincing reasons to invest in emerging markets small-cap equity including an attractive value profile and diversification opportunity. Most convincing, though, may be the emerging markets share of global GDP and global GDP growth. Currently, emerging markets countries “account for 50% of Global GDP and 66% of global GDP growth in the past 10 years (2012-2022).”[1] With this kind of representation globally, it is likely that most investors are underallocated to emerging markets. This evidence should compel investors to look at emerging markets more closely and potentially as a larger portion of an overall allocation.

With the Bridgeway Emerging Markets Small-Cap strategy, we combine an attractive asset class with established experience, expertise, and a reputation for maintaining integrity by managing capacity responsibly. The Bridgeway Emerging Markets Small-Cap strategy 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.

[1] https://www.worldeconomics.com/Regions/Emerging-Markets/

DISCLAIMER AND 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 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 which 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 which 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. Net total return represents reinvested dividends after the deduction of withholding taxes, using a tax rate applicable to non-resident institutional investors who do not benefit from double taxation treaties.

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. Net total return represents reinvested dividends after the deduction of withholding taxes, using a tax rate applicable to non-resident institutional investors who do not benefit from double taxation treaties. 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.

The Russell 1000 Index includes approximately 1,000 of the largest companies in the US equity universe. It includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 Index is constructed to provide a comprehensive and unbiased barometer for the large-cap segment and is completely reconstituted annually to ensure new and growing equities are included.

The Russell 2000 Index measures the performance of the small-cap segment of the US equity universe. The Russell 2000 Index includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 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. Index returns do not reflect fees, expenses or trading costs associated with an actively managed portfolio.

Andy Berkin Head of Research at Bridgeway bio image

Andrew L. Berkin, PhD

Ben Lanning

Christine Wang Portfolio Manager at Bridgeway bio image

Christine Wang, CFA, CPA

Exchange-traded funds (ETFs) have seen tremendous growth since their initial launch in 1993. As with mutual funds, they hold a collection of securities. Unlike mutual funds, which trade at the end of the day at net asset value (NAV), ETFs trade throughout the day on exchanges like individual stocks, but at a premium or discount to the NAV of the underlying securities.

Because ETFs trade throughout the day at prices which differ from the underlying value of the securities they hold, greater care should be taken to achieve best execution when trading them. In this paper, we provide a brief guide to trading ETFs. These points should be useful to both individual investors and advisors executing smaller trades on their own, and for larger institutional investors and advisors with access to institutional quality trading desks.

Liquidity. While ETFs trade on an exchange, their trading is different than individual stocks. Transactions for ETFs occur on both a primary and secondary market. The primary market is where Authorized Participants (APs) create or redeem shares in an ETF. These transactions are typically done via in-kind transfers and are the source of the increased tax efficiencies of ETFs. The liquidity in the primary market for APs is directly influenced by the liquidity of the underlying fund holdings. The secondary market is where individual trades of the ETF occur. The volume quoted for an ETF reflects this secondary market activity and doesn’t account for the primary market liquidity. An ETF with typically low secondary market volume can still have large transactions occur within the spread based on the primary market liquidity. Thus, for most ETFs, liquidity available is beyond what is quoted in the secondary market.
Avoid market open and close. Similar to individual stocks, prices tend to be more volatile around the open and close of the market, which can lead to wider bid-ask spreads in ETFs. Since the spread of an ETF reflects the spreads of the securities it holds, the price you trade at near the market open and close may be further from the NAV of those underlying securities. A good rule of thumb is to trade between 10:00 AM and 3:30 PM Eastern Time, avoiding the first and last 30 minutes of the trading day.
Use limit orders when possible. Market orders are certainly convenient, as you are guaranteed certainty of execution. But if there is insufficient interest on the other side of the trade for a market order, you can exhaust the limit order book and pay a substantial spread to fair value. Instead, place limit orders with your brokers, adjusting as needed for market moves. This is especially true for larger orders and at times of lower liquidity. While market orders demand liquidity, limit orders provide liquidity and thus can potentially take advantage of the spread.
Consider your overall trading. When cash is being invested or withdrawn, just a single ETF may be traded. But other times, such as during rebalancing or tax loss harvesting, multiple ETFs and mutual funds may be bought and sold. In this case, consider the timing and interaction of the trades to minimize slippage from market movement.
Make use of your advisory firm’s trading desk. As trades get larger and more complicated, selecting between various techniques and executing them well may appear daunting. But, many financial advisors are affiliated with a larger firm that provides trading services. The trading desk can aggregate the trades of multiple advisors to get a better understanding of liquidity and access methods available with scale. The trading desk has the time, experience, and tools to focus on the best methods for executing your ETF trades, allowing advisors to focus on what they do best. If you have access to a centralized trade execution team, they will be the preferred solution when trading ETFs. For larger orders, consider the following techniques:
- Use an RFQ with your broker for large orders. If you are placing a large order that exceeds a creation unit size (this varies by fund but can be 25,000 shares or more), consider getting in touch with the ETF trading desk you work with and receive a request for quote (RFQ). With an RFQ, an institutional investor solicits bids from several brokers for a larger trade to get better pricing.
- Place a direct creation/redemption with your broker. Some brokers are also APs. For a sufficiently large order, they can place direct creations and redemptions. Much like mutual funds, the ETF price will be market at closing NAV. This may result in lower costs, depending on the fees charged by the broker/AP.
- Utilize your custodian’s ETF desk. Many custodians maintain ETF trading desks. With their expertise, they can often uncover hidden liquidity and arrange trades to get great pricing and execution. Contact your custodian trading desk to request automatic review of any large market order, typically over 10,000 shares. Many custodians offer to watch your trading master for large orders. Once they identify the order, they will trade them for best execution.

ETFs have some notable advantages, which have led to their tremendous growth. The use of APs allows for the avoidance of capital gains within the fund. The transaction costs of cash flows into and out of the ETF are borne by those trading and not the ETF itself. But this also means that one must be careful when trading ETFs, to minimize slippage and achieve best execution. In this paper, we have provided tips that should be helpful when trading ETFs for the benefit of you and those you serve. After all, the purpose of trading ETFs is to invest in ETFs and realize the benefits they offer.

For a PDF download of this thought piece, please use the following link:
A Practitioners Guide to Trading ETFs

About the Authors

Andrew L. Berkin, PhD
Head of Research
Bridgeway Capital Management

Andrew Berkin, PhD, is head of research and oversees the development and implementation of Bridgeway’s statistically driven, evidence-based investment strategies. He also produces thought leadership material for clients and prospects as well as for external publications. Andrew joined Bridgeway in 2013. Prior to joining Bridgeway, Andrew was co-chief investment officer and director of research for Vericimetry Advisors. He previously was a senior member and director of the quantitative research group at First Quadrant, where he spent 14 years in a variety of responsibilities, including the development and implementation of stock selection models in both taxable and tax-exempt portfolios. Andrew has published numerous research articles on quantitative investing in peer-reviewed journals and co-authored two books. He is a reviewer for the Financial Analysts Journal and served two terms on its editorial board. Andrew earned his BS with honors in Physics from the California Institute of Technology and a PhD of Philosophy in Physics from the University of Texas, where he concentrated his studies in general relativity and astrophysics.

Ben Lanning
Director of Portfolio Management
Buckingham Strategic Wealth

When he joined Buckingham Strategic Wealth in 2005, Ben Lanning already knew he loved the investment business. What he discovered when he came to Buckingham was that he’d found the perfect place to do it. Ben serves as the director of portfolio management, working with Buckingham’s dedicated team of portfolio managers to monitor clients’ portfolios and ensure appropriate allocations. Previously, he was a relationship director and director of trading operations, working with both advisors and with clients to make sense of the technical, research-based philosophy behind the firm’s fixed income and equity trading approach. Ben started with the firm as an equity trader and fell in love with client-first, bottom line second attitude his colleagues espoused. Knowing he could make recommendations without bias, that his colleagues spent their days collaborating on how best to solve a problem for a client and being a part of the evidence-based movement keeps Ben excited and engaged. Prior to joining Buckingham, Ben was a senior trader with Raymond James. He is a graduate of St. Petersburg College and Eckerd College. He and his wife, Natalie, live in St. Louis with their two children.

Christine Wang, CFA, CPA
Portfolio Manager
Bridgeway Capital Management

Christine’s responsibilities include portfolio management, investment research, and statistical modeling. Prior to joining Bridgeway, she worked in public accounting with a focus on energy trading and risk management. Christine holds an MS in Accounting from the University of Virginia and a BA in Sociology and Managerial Studies from Rice University. She is a CFA charterholder and is licensed as a Certified Public Accountant in Texas. She participated in Bridgeway’s service trip to Peru. On Bridgeway’s service trips to Honduras and El Salvador, she helped build water wells with Living Water International.

DISCLOSURE

The opinions expressed here are exclusively those of Andrew L. Berkin, Ben Lanning, and Christine Wang. Information provided herein is educational in nature and for informational purposes only and should not be considered investment, legal, or tax advice.

Christine Wang, CFA, CPA

Andrew L. Berkin, PhD

Geoff Crumrine

Highlights

Small-cap value stocks have lagged the large-cap S&P 500 by significant amounts to start 2023.
This dispersion of returns has led to small-cap value stocks being extremely cheap compared to the S&P 500.
Combined with the narrowness of returns within the S&P 500, such conditions have historically provided an opportunity for strong reversion, with small-cap value stocks outperforming.

Waiting for the World to Change

As small-cap value investors, sometimes it feels like you are just Waiting on the World to Change. The Russell 2000 Value Index lagged the S&P 500 Index of large US companies by a significant margin four years in a row from 2017 through 2020. The Russell 2000 Value staged a comeback in early 2021 (see our piece R oom to Run), offering glimpses that we had turned a corner, but 2023 has reverted to the same chorus. It sometimes feels like we’re stuck with a broken record.

Source: Bloomberg

We at Bridgeway are firm believers in the small and value factors. These drivers of returns are integral parts of our investment process. Using the full history currently available from the Ken French data library (July 1926 – May 2023), we find small-cap value stocks have returned 14.1% annually, compared to 10.0% for the broad market. Not only do these factors historically provide a return premium, but they also meet our criteria of being persistent, pervasive, robust, investable, and intuitive. Furthermore, they provide useful diversification to the overall portfolio. (See the book Your Complete Guide to Factor-Based Investing by Andrew Berkin and Larry Swedroe for further discussion.)

Given small-cap value’s recent performance, where do we stand right now?

Using the standard academic definition of valuation, book-to-market (BtM), we can put into perspective where we are relative to history. The blue line in the chart below shows the ratio of median BtM for the Russell 2000 Value Index to median BtM for the S&P 500. The solid orange line shows the median ratio for the entire history of the Russell 2000 Value from 1978- June 2023. Ratios above this line signal that small-cap value stocks are cheaper than their historical average.

Median BtM Ratios Relative to S&P500
For the Period Ending 6/30/23

Source: Compustat, Bridgeway calculations

The first big spike when the Russell 2000 Value was cheaper than the S&P 500 was the dot.com era. Investors did Party Like It’s 1999, favoring high-flying growth stocks over value stocks. Valuations then reverted to the median (yielding five years of double-digit outperformance of the Russell 2000 Value vs. the S&P 500). The 2010s saw valuations creep back up, culminating in a new peak in 2020 of how cheap small-cap value had gotten relative to the S&P500. That reversed dramatically (and quickly) in 2021, bringing relative valuations down but still higher than historical levels. The relative underperformance of small-cap value in 2023 has stretched the ratio again, getting us close to, but not yet at the prior peak. This potentially sets the stage for a future reversal with strong small-cap value outperformance.

In the recent period, small-cap stocks, represented by the Russell 2000, have faced a similar relationship to the S&P 500 (grey line) as the Russell 2000 Value, becoming far cheaper than their median (yellow line). Small caps in general are now even cheaper than the historical median Russell 2000 Value to S&P 500 ratio.

So why stick to small-caps and value in particular? For one, the rally in the S&P 500 has been concentrated in a few stocks. While this is not new (see our piece on the Nifty Fifty), it does mean the rally has lacked breadth. The equal weight S&P 500 lagged the index by almost 10% to begin 2023. That’s in the worst 2% of six-month periods going back to 1990 when Bloomberg data starts. Small-cap value is incredibly cheap right now and while things could get worse before they get better, we encourage you to Don’t Stop Believin’. Stick with your allocation and rebalance. That would be music to our ears.

For a PDF download of this thought piece, please use the following link:
Waiting on the World to Change – Small-Cap Value Investors

DISCLOSURE

Past performance is not indicative of future results.

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.

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

Andrew L. Berkin, PhD

Sri Lakshmanan Director of Investment Systems and Research Analyst at Bridgeway bio image

Sri Lakshmanan, CFA

Hot stocks, even if resulting from strong financial performance, do not guarantee investing success if their prices have been bid up too high.

Many commentators have compared the recent stock market to the Tech Bubble [1] of the late 1990s. But we see a similarity with a more distant epoch, namely the Nifty Fifty fad of the late 1960s and early 1970s. So rather than evoking the Tech Bubble and partying like it’s 1999, we wonder if today’s market is partying like it’s 1972.

Back in the late 90s, the market experienced a boom in IPOs of speculative internet firms without profits. Today, the new boom is Special Purpose Acquisition Companies (SPACs). Back in the late 90s, the market had a burst of retail trading through low-cost online brokerages. Today, it is even lower cost and more accessible stock trading through apps on mobile devices. Back in the late 90s, stock market valuations were in the stratosphere, with several mega-cap stocks comprising a large share of the S&P 500 index. Today, valuations are also sky-high, and both Apple and Microsoft are over 5% of the index as of September 30, 2021, and several others are not far behind. Certainly, today’s market has similarities with the late 90s, but today’s market leaders^* arguably more closely resemble the Nifty Fifty.

^*Market leaders refers to large-cap stocks with high recent returns. In this piece we specifically examine the FANMAG stocks defined below.

In the late 1960s and early 1970s, the Nifty Fifty were stock market darlings comprised of a set of roughly 50 large companies. Investing in these firms was not considered speculative, unlike many of the tech firms that dominated the headlines in the late 1990s. Instead, the Nifty Fifty were typically quite successful, with strong earnings growth and profitability. But a great company is not necessarily a great stock, and starting in 1973, their returns disappointed for years. We see strong similarities with the market’s leading stocks today.

Chart returns relative to the S&P 500 of these three sets of stocks from different eras: an equal-weighted composite of the Nifty Fifty stocks, Tech Bubble stocks proxied by the NASDAQ 100, and an equal-weighted composite of FANMAG — *Source: Refinitiv, S&P Global Ratings, CRSP, Compustat, Bridgeway calculations*

As an illustration, consider the plot above. It shows returns relative to the S&P 500 of these three sets of stocks from different eras: an equal-weighted composite of the Nifty Fifty stocks, Tech Bubble stocks proxied by the NASDAQ 100, and an equal-weighted composite of FANMAG, which is an acronym for six of today’s hottest stocks: Facebook, Apple, Netflix, Microsoft, Amazon, and Google. We show 10 years of returns, with year five set at the peak calendar years of 1972 and 1999. For FANMAG, year five is 2020. We don’t know what will happen to FANMAG from here, but we do believe in the quip ascribed to Mark Twain that “history doesn’t repeat itself, but it often rhymes.”[2] In the spirit of relational investing, we stay curious about what we see in the market.[3] Therefore, we will compare the Nifty Fifty at their peak to FANMAG, showing how it provides a cautionary tale for today.

Nifty Fifty: Companies and Characteristics

There was never a fixed set of 50 companies comprising an “official” Nifty Fifty. Rather it was a designation given to a number of large-growth firms considered good investments and called one-decision stocks. Investors could supposedly buy them and never sell, despite high valuations. Siegel (1998) used 50 stocks identified by Morgan Guaranty Trust to claim that after 25 years, their returns justified those valuations. Fesenmaier and Smith (2002) pointed out that many of these stocks had more reasonable P/E ratios and thus might not be truly representative. Instead, they also considered a separate list provided by Kidder Peabody. They found that stocks on each list somewhat lagged the S&P 500 over the next 29 years; stocks on both lists underperformed more notably. Stocks with the highest P/E ratios had the lowest returns.

We examine the full set of stocks from both lists, a total of 76 names. 24 stocks were on both lists, termed the “Terrific 24” by Fesenmaier and Smith. That leaves 26 stocks on each of the Morgan Guaranty and Kidder Peabody lists that were not on the other. The ten largest stocks by market cap at the end of 1972 are shown in the table below. Most of these are still well-known names, although some such as Kodak and Sears have hit hard times. Younger folks might not recall having to buy and develop film. For that matter, the concept of a physical store may be a little fuzzy for the new generation. But that is part of the point about today’s hot stocks. In the future, the concept of buying items online or having a social network may seem equally quaint.

RANK	NAME	SOURCE
1	Int’l Business Machines	Morgan Guaranty
2	Eastman Kodak Co.	Both
3	General Electric Co.	Morgan Guaranty
4	Sear Roebuck & Co.	Morgan Guaranty
5	Xerox Corp.	Both
6	Minnesota Mining & Manuf’g	Morgan Guaranty
7	Procter & Gamble Co.	Morgan Guaranty
8	Coca-Cola Co.	Both
9	Avon Products Inc.	Both
10	Johnson and Johnson	Both

Returns and financial data come from CRSP and Compustat, respectively. While we now have almost 50 years of data since the apex of the Nifty Fifty at the end of 1972, our focus will not be on the super long term. Too many of those 76 stocks no longer exist, and any attempt at estimating returns for the group since 1972 involve assumptions about reinvesting when a stock vanishes because of bankruptcy, merger or acquisition. Instead, we look at their characteristics and returns in the years around the Nifty Fifty period.

And what a period it was for these stocks, at least initially. Through 1972 these firms had averaged over 22% annual earnings growth over the past five years, with over 30% growth in 1972. For the S&P 500, these numbers were just 4% and almost 13%, respectively.[4] These companies were profitable as well, with return on equity (ROE) over 22% on average, well above the historical ROE of 14% for the S&P 500.[5] Pretty nifty indeed! With financial results like these, investors flocked to these stocks, and at first, they were not disappointed. For the five years through 1972 average annual returns were almost 28%, with an average return of over 43% in 1972. In comparison, over the same five years, the S&P 500 averaged about 6.7%, with a return of just under 19% in 1972.

What could go wrong? Well, for one thing, these stocks had become quite expensive, with an average P/E of about 43 at the end of 1972. This was well more than double the P/E ratio of 18 for the S&P 500. And as noted, a great company is not necessarily a great stock. When a stock gets too expensive, it becomes prone to disappointment. The prices of the Nifty Fifty had become bid up amid expectations of continued exceptional growth, which proved unsustainable.

The recession of 1973 – 1975 ushered in a period of low economic growth, and with it a bear market. The chart below shows that the S&P 500 fell by over 14% in 1973 and lost over 26% in 1974. But the Nifty Fifty stocks fell even more, dropping over 19% and then 38% in those two years. Markets did recover somewhat after that, and the S&P 500 gained on average about 2.5% annually over the five years from 1973 – 1977. But the Nifty Fifty still lagged, with five-year average returns of -4.4%. Although not shown for brevity, those Nifty Fifty stocks with the highest P/E at the peak tended to have the lowest subsequent returns.

*Source: Refinitiv, S&P Global Ratings, CRSP, Compustat, Bridgeway calculations*

FANMAG Stocks

Fast forward to today, and once more, a set of great companies are also considered great stocks. We personally use the products and services of the FANMAG stocks, and we are not alone. For the five years through the end of 2020, these stocks had average annual earnings growth of almost 60%. For comparison, over this same time period the S&P 500 averaged not quite 4% annual earnings growth. A chunk of this difference is explained by the pandemic-induced recession of 2020 when S&P 500 earnings fell by over 32%.[6] In that same year, the FANMAG grew earnings by over 37%, led by Amazon at 84%. Just as with the Nifty Fifty decades earlier, profitability is also sky-high, with ROE averaging over 29% for the past five years.

What could go wrong for the FANMAG stocks? After all, they made it through a recession with flying colors, unlike the Nifty Fifty. But as Roseanne Roseannadanna said, “It’s always something.”[7] And something FANMAG has in common with the Nifty Fifty of yore are high relative valuations. At the end of 2020, the average P/E for the FANMAG stocks was over 48. This is not too much higher than the P/E for the S&P 500 of just over 39 from Robert Shiller’s data. The valuation for the broad market is currently inflated by the fall of earnings associated with the pandemic and the recovery of stock prices off bear market lows early in 2020 in expectation of a broad earnings recovery. Aside from the current COVID-influenced situation, relative valuations have recently been much further apart. For instance, at the end of 2019, the P/E for FANMAG was 43.5 while the S&P 500 was at 22.8.

One issue for stocks with high P/E ratios is that subsequent earnings can’t just be good, they have to continue to be great. From the peak of the Nifty Fifty, their earnings still tended to surpass those of the S&P 500. But they simply weren’t good enough to justify valuations. So what could cause problems for the growth of FANMAG earnings? One possibility is competition from other companies, as those who are out front have a visible target on their back. Another possibility is competition among themselves, as business lines increasingly overlap. A third possibility is lack of competition, as several governments investigate these firms for monopolistic behavior as well as privacy concerns.

We don’t know which of these it may be, if anything at all. After all, the FANMAG firms have made a number of deft moves over the years to reach the position they are in today. But another Wall Street saying is that trees don’t grow to the sky. As a company gets bigger and bigger, growth becomes harder to maintain. And one thing we do know from historical evidence is that those stocks with the highest growth expectations tend to lag over the long run, while value stocks tend to outperform. This is the basis for the value premium.

Key Takeaways

The FANMAG stocks that have led the market over the past several years are truly great companies. They are household names with products used by a large chunk of the population. This has enabled them to have remarkable earnings growth and valuations to match. But as we have seen before in eras such as the Nifty Fifty, a great company does not necessarily make a great stock. Exceptional growth is hard to maintain, and valuations matter. When a small set of stocks drives the market, subsequent returns have tended to ultimately disappoint. Investors may want to consider other market segments, such as smaller and cheaper stocks. And they certainly should consider a broader and well-diversified portfolio.

We certainly enjoy parties. But over the years, we have gained experience. When it gets too late or too exuberant, we decide to leave. We may miss out on some fun, but we also reduce our chances of a painful hangover the following day. Bear this in mind when you decide how to party as we head into 2022.

[1] The Tech Bubble, also known as the Dot-Com Bubble, was a stock market bubble caused by excessive speculation of Internet-related companies in the late 1990s, a period of massive growth in the use and adoption of the Internet.

[2] See https://quoteinvestigator.com/2014/01/12/history-rhymes/ for a discussion of the source of this quote.

[3] See https://bridgeway.com/perspectives/relational-investing-in-action/

[4] http://www.econ.yale.edu/~shiller/data.htm

[5] https://www.investopedia.com/terms/r/returnonequity.asp

[6] Calculated from the source in footnote 4.

[7] https://en.wikipedia.org/wiki/Roseanne_Roseannadanna

References

Fesenmaier, Jeff and Gary Smith. 2002. “The Nifty-Fifty Re-Revisited.” Journal of Investing 11 (3): 86-90.

Siegel, Jeremy. 1998. “Valuing Growth Stocks: Revisiting the Nifty Fifty.” AAII Journal October: 20-24.

DISCLOSURE

Past performance is not indicative of future results.

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 Nasdaq-100 is a stock market index made up of 102 equity securities issued by 100 of the largest non-financial companies listed on the Nasdaq stock market. It is a modified capitalization-weighted index.

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.

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

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.

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, 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.

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

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

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.

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

Past performance is not indicative of future results.

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, 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 Class	Index Representative	3 Year	5 Year	10 Year
US Broad Fixed Income	Bloomberg Barclays US Aggregate	0.12	0.16	0.10
US High Yield Fixed Income	Bloomberg Barclays US High Yield – Corporate	0.82	0.78	0.79
US Real Estate	MSCI US REIT INDEX – Gross Return	0.76	0.60	0.61
Commodities	S&P GSCI Total Return	0.63	0.56	0.56

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 Services	11.74	3.67	8.07
Consumer Discretionary	17.65	12.58	5.07
Consumer Staples	5.63	5.67	0.04
Energy	4.83	2.10	2.73
Financials	18.24	10.73	7.51
Health Care	4.46	8.99	4.53
Industrials	4.30	14.95	10.65
Information Technology	20.92	17.65	3.27
Materials	8.08	12.46	4.38
Real Estate	2.15	6.88	4.73
Utilities	2.00	4.32	2.32

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

Country	MSCI Emerging Markets Index	MSCI Emerging Markets Small Cap Index
Argentina	0.11	0.55
Brazil	4.46	6.05
Chile	0.57	0.95
China	37.91	10.80
Colombia	0.16	0.24
Czech Republic	0.10	0.03
Egypt	0.08	0.26
Greece	0.11	1.40
Hungary	0.21	0.08
India	9.65	16.98
Indonesia	1.22	1.80
Korea	13.33	18.00
Kuwait	0.50	0.73
Malaysia	1.37	3.06
Mexico	1.74	1.83
Pakistan	0.02	0.45
Peru	0.21	0.11
Philippines	0.64	0.73
Poland	0.63	1.17
Qatar	0.68	0.88
Russia	3.11	0.83
Saudi Arabia	2.77	2.42
South Africa	3.81	3.58
Taiwan	13.84	21.49
Thailand	1.88	3.66
Turkey	0.29	1.37
United Arab Emirates	0.58	0.52

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 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

Past performance is not indicative of future results.

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

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 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.

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

Amitabh Dugar Research Analyst at Bridgeway bio image

Amitabh Dugar, PhD, CPA

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:

Cover art for Financial Analysts Journal

Disclosures

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

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

Past performance is not indicative of future results.

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.

Index returns do not reflect fees, expenses, or trading costs associated with an actively managed portfolio.

Why Emerging Markets Small-Cap?

Executive Summary

Comparing Emerging Markets Small-Cap Correlation

Active Management in Emerging Markets Small-Cap

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

Investing Quantitatively and Managing Capacity in Emerging Markets Small-Cap

Bridgeway in Emerging Markets Small-Cap

Conclusion

A Practitioner’s Guide to Trading ETFs

About the Authors

Waiting on the World to Change – Small-Cap Value Investors

Highlights

Waiting for the World to Change

Party Like It’s 1972: What Can the Nifty Fifty Teach Us About Today’s Market?

Emerging Markets Small-Cap Investment Landscape: August 2021

Emerging Markets Small-Cap Investment Landscape: May 2021

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

Summary

What a Difference a Year Makes

Is This a Timing Factor?

Why Emerging Markets Small-Cap?

Executive Summary

Comparing Emerging Markets Small-Cap Correlation

Active Management in Emerging Markets Small-Cap

Quantitative Management in Emerging Markets Small-Cap

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

Responsibly Managing Capacity in Emerging Markets Small-Cap

Bridgeway in Emerging Markets Small-Cap

Conclusion

Equity Investing in the Age of Intangibles

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

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