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[BRIDGEWAY LETTERHEAD]
April 28, 2000
Dear Fellow Micro-Cap Limited Shareholder,
Our meager 1% March quarter return lagged our benchmarks. Even though we have
significantly outperformed these benchmarks over the last year and since
inception, I never like underperforming the market.
Performance Summary
TRANSLATION: Our rebalancing of the Portfolio to include more underpriced stocks
(see our January 25 letter) worked against us in the last three months. The more
highly priced growth stocks continued to outperform the rest of the market. Some
of our individual stocks were also significant drags on the Portfolio.
The table below presents our March quarter, one-year and life-to-date financial
results according to the formula required by the SEC.
<TABLE>
<CAPTION>
March Qtr. 1 Year Life-to-Date
1/1/00 4/1/99 7/1/98 to
to 3/31/00(4) to 3/31/00 to 3/31/00(5)
---------- ---------- ----------
<S> <C> <C> <C>
Micro-Cap Limited Portfolio 1.2% 73.2% 32.0%
Lipper Small-Cap Stock Funds(1) 12.4% 58.2% 21.8%
Russell 2000 (small growth stocks)(2) 7.1% 37.3% 11.3%
CRSP Cap-Based Portfolio 9 Index(3) 8.5% 57.2% 20.4%
</TABLE>
(1) The Lipper Small Cap Stock Funds is an index of small-cap funds
compiled by Lipper Analytical Services, Inc. (2) The Russell 2000 is an
unmanaged index of small stocks, with dividends reinvested. (3) The CRSP
Cap-Based Portfolio 9 Index is an unmanaged index of 853 micro-cap
companies compiled by the Center for Research in Security Prices, with
dividends reinvested. (4) Periods less than one year are not annualized.
(5) Periods longer than one year are annualized. Past performance does
not guarantee future returns.
Detailed Explanation of Quarterly Performance
TRANSLATION: Six of our companies from various industries appreciated more than
50% in the March quarter. Unfortunately, they weren't enough to make up for the
ones that declined.
Our rallying stocks in the March quarter were broad-based by industry and
focused more on growth (companies which are not so cheap but are growing more
rapidly from a company financial perspective). The top stock for the quarter,
Corsair Communications, provides hardware and software for wireless
communications companies. We purchased this company at a cost of $7.375 in early
January. The company benefited from successful new products as well as Wall
Street's recent infatuation with telecommunications companies, carrying the
stock price to $19 by the end of the quarter. The 159% appreciation added two
and a half percentage points to our quarterly return to boost Corsair into the
number eight spot on our top ten list. Altogether, six stocks appreciated by
more than forty-five percent during the quarter:
<TABLE>
<CAPTION>
Rank Description Industry % Gain
---- ----------- -------- ------
<S> <C> <C> <C>
1 Corsair Communications Inc. Telecommunications 159.3%
2 TTI Team Telecom International Ltd. Telecommunications 82.1%
3 Belco Oil & Gas Corp. Oil & Gas 58.1%
</TABLE>
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<TABLE>
<S> <C> <C> <C>
4 Tecnomatix Technologies Ltd. Data Processing/Software 50.9%
5 Creative Computers Inc. Retail Stores 49.6%
6 Richardson Electronics Ltd. Electronics/Electric 46.7%
</TABLE>
Only two stocks declined by as much as the gaining stocks above:
<TABLE>
<CAPTION>
Rank Description Industry % Loss
---- ----------- -------- ------
<S> <C> <C> <C>
1 Power Integrations Inc. Electronics/Electric -47.8%
2 Steel Technologies Inc. Iron/Steel -45.3%
</TABLE>
Power Integrations, our second largest position at the beginning of the quarter
(7.9% of the Portfolio), dropped off a cliff after the company warned of a
slowdown in revenues for the first quarter. Fortunately, our models had us do
some serious trimming of this stock before the announcement. What would have
been a 3.8% hit to our Portfolio was still hard felt - it cost us 2.5% of our
quarterly return. Our models gave us no such cushioning against the fall of
Steel Technologies, a somewhat smaller diversifying position in the "old
economy." This stock cost us one and a half percentage points of return.
Top Ten Holdings
Here are the top ten holdings at the end of March. We significantly trimmed most
of our top holdings during the quarter, so that the top ten positions
represented 39% at the quarter end versus an unusually large 50% at the
beginning. This improved diversification helped during the market downturn in
March. Four companies comprised more than 5% of net assets at the end of
December, but only one was that size at the end of March.
<TABLE>
<CAPTION>
Percent of
Rank Description Industry Net Assets
---- ----------- -------- ----------
<S> <C> <C> <C>
1 Titan Corp. Electronics/Electric 7.7%
2 Chico's FAS Inc. Retail Stores 4.3%
3 Candela Corp. Electronics/Electric 4.2%
4 Pope & Talbot Inc. Paper / Products 4.0%
5 Unify Corp. Data Processing/Software 3.6%
6 Arkansas Best Corp. Trucking 3.4%
7 Steven Madden Ltd. Textiles 3.2%
8 Corsair Communications Inc. Telecommunications 3.0%
9 Petco Animal Supplies Inc. Retail Stores 3.0%
10 Patina Oil & Gas Corp. Oil & Gas 2.8%
----
Total 39.2%
</TABLE>
Disclaimer
The following is a reminder from the friendly folks at your fund who worry about
liability. The views expressed here are exclusively those of Fund management.
They are not meant as investment advice. Any favorable (or unfavorable)
description of a holding applies only as of the quarter end, March 31, 2000;
security positions can and do change thereafter.
I Hate High Expenses--or Just Say No
TRANSLATION: Our policy of avoiding soft dollar commissions (higher brokerage
commissions that pay for research, terminals, and news services) continues to
save the Portfolio money. It also helps us focus on what is really important.
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At the beginning of the current fiscal year, I committed to our Board of
Directors to continue to improve our accounting controls, specifically to
prepare for being a fund company three times larger than we are currently. One
project that we have completed this quarter is installing new hardware and
software for placing trades (purchasing stocks). The new system is improving the
efficiency of our trading process, helping us to eliminate paper, and increasing
our capacity for growth. The software is rather costly, and I got a very
interesting reaction from our vendor when it was time to talk about payment.
Most investment advisory firms pay for these items with soft dollars.
Specifically, according to a survey by TheStreet.com, only six of the largest
thirty mutual fund families could represent to a journalist that they don't use
some form of soft dollars. "Soft dollars" aren't the less crisp kind that have
been in circulation a few years and don't stick together in your wallet. Really,
soft dollars means your money, money right out of the shareholder's own pocket.
Here's the way soft dollars work.
The SEC requires a fund family to get the best deal for its clients when
shopping for a broker. That means the lowest commission cost commensurate with
the best execution--with one exception. The fund can pay a higher commission if
the broker is also giving the fund something that adds to shareholder value. The
most frequent example is research. Other examples are data and information, for
example news services, Bloomberg terminals, and--you guessed it--trading
software like we just purchased. When I discussed paying for our trading
software, the salesman couldn't believe I was actually going to write a check
from the investment advisory firm when I could have our fund pay for it through
soft dollar commissions. Here is Bridgeway's position on soft dollar
commissions:
Our shareholders pay Bridgeway Capital Management a management fee, which is up
front and fair. It is based on performance. We make more when our shareholders
make more. This helps us focus on Portfolio performance rather than asset size
and revenues to the management firm. We pay for our own expenses related to
investment management: Bloomberg terminals, computers, news services, and
trading software. Period. This strategy 1) gets us out of a lot of games played
between brokers and investment advisors, 2) significantly simplifies my job, and
3) reduces your expenses. If Bridgeway did soft dollar commissions, I would make
(through my ownership in Bridgeway Capital Management) about $30,000 more in
2000, but I would have to spend my time keeping accurate, auditable records of
what we used the soft dollars for and who benefited. I'm just not going to do
it. A big part of our competitive advantage is cost efficiency and focus on
performance. They're related, and I think it shows up in both our expense ratio
and our Portfolio performance.
When it comes to soft dollar commissions, Bridgeway "just says no."
A Taste of Statistics (but not a meal)
TRANSLATION: Some studies have indicated that you should invest in large
companies through index funds, but in small companies through actively managed
funds. I believe that it is hard to beat market indexes in the large company
arena. The research is more clouded among small company funds. I believe the
vast majority are destined to become mid- or large-cap funds over time and that
most of the remainder will underperform market indexes. The possible exceptions
are funds like Bridgeway Ultra-Small Company and Bridgeway Micro-Cap Limited,
which are willing to close to new investors at levels that are laughably low by
industry standards.
I take issue with some mutual fund analysis that has been published in the last
decade. It concludes (roughly) that you should index your investments in large
companies and buy an actively managed fund for small company exposure to the
market. My hypothesis is that, in general, it is better to index both. Now this
may seem like a strange hypothesis from a guy who has all his own stock market
money invested in the actively managed portfolios of Bridgeway Fund. Let me
explain. Let's divide up the prior fund analysis into two parts: 1) you should
index your large company investments and 2) you should invest in an actively
managed fund for small stock exposure.
Hypothesis one: you should index large company stocks
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Over the last fifteen years, only 22 of the 103 domestic equity mutual funds
with a market capitalization (company size) in the range of the S&P 500 Index
actually beat the index in performance. (Specifically, these are the 103 funds
with a market capitalization one-half to one-and-a-half times that of the
index.) On the surface, this would seem to corroborate the research mentioned
above. I don't deny this conclusion: it's hard to beat large company indexes by
investing in large stocks. The big culprit is fund expense; these 103 funds have
an average expense ratio of 1.28%. A secondary culprit is "cash drag," or the
drag created by having about 4.5% of these funds invested in low yielding cash
(at, say, 5%) rather than stocks (which returned 18.4% for the period). The
effect of cash drag is roughly 0.60%. Interestingly, as a group these 103 funds
underperformed the S&P 500 by 1.87%, remarkably close to the sum of 1.28%
(expenses) plus 0.60 (cash drag). . . . . hmmmm. So one conclusion would be to
find a very low expense ratio fund that is 100% invested in stocks, not cash.
This is part of the exact design of Bridgeway Ultra-Large 35 Index, which is
100.0% invested in very large stocks and has an expense ratio of 0.15%.
Hypothesis two: you should invest in an actively managed fund for small stock
exposure
A cursory look at the 15-year performance of small-cap mutual funds also bears
out the conclusions of the second part of the research. 22 of the 35 small
company mutual funds with a fifteen-year track record have outperformed the
Russell 2000 Index of small companies. Nice job, funds. However, the true
picture is much more complicated. Here's what happens to small company mutual
funds. If they don't perform well, they tend not to attract much in the way of
assets. They don't become bloated, but they continue to underperform the
small-cap market indexes. You certainly don't want these funds. On the other
hand, if they do perform well, you have a different problem. They attract a lot
in the way of assets, and then one of two things happens: they start investing
in larger companies (since it's very hard to invest large amounts of cash
actively in very small companies) or their performance goes downhill (as their
transaction costs soar as a result of trying to put all this new cash to work).
Let's take a more detailed look at the 35 companies in this analysis.
My hypothesis one: most small company stock funds end up being mid- to large-cap
funds
Of the 11 funds with a market capitalization of less than $1 billion (slightly
more than the Russell 2000 Index), only three beat the index. Only one of these
three outperformed the index by more than two percentage points per year. Wow,
what happened to the strength of active management in small stock investing?
Here's what I think happened. The funds that were successful in the early part
of the last fifteen years got flooded with cash. They started investing in
larger companies, which actually helped their performance in the next period,
since larger companies significantly outperformed small ones over the last
decade. (As a matter of fact, looking at rolling five year periods of
performance, the five year period from the end of 1994 through the end of 1999
was the biggest five year dominance of large stocks over the last 75 years.) The
average median market capitalization of the 22 small company funds which beat
the index over the last 15 years is now $7.8 billion, eight times that of the
index. Talk about "cap-creep!" (Cap-creep is the phenomenon of small-cap funds
increasing in market capitalization as they increase in assets under
management.)
My hypothesis two: those funds that don't experience cap-creep end up
underperforming the small-cap market benchmark
The average median market capitalization of small company funds that lagged the
index during the last 15 years is now $1.3 billion, much smaller than the ones
that beat it. In other words, most of the funds that stayed true to their
small-stock focus ended up as poor performers. As assets swelled and the
portfolio manager tried to keep the fund invested in small stocks, transaction
costs soared. This hurt fund performance even more than the expense ratio. I
call this the "hidden expense ratio."
To take this a step further, let's subdivide the performance period. During the
first ten years, these same 35 funds handily beat the market index. In the
following (most recent five) years, only 38% of these funds outperformed the
market in spite of the fact that they had a company size advantage over the
Russell Index. In my opinion, they were already bloated, too bloated with
assets. Of the top ten performing funds during the first ten years, only four in
ten outperformed the market during the next five years, so they didn't fare any
better than the broader group of funds.
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Where do we go from here?
To summarize, here's the catch with small company funds. If the fund
underperforms, no problem, you get to stay in small stocks; you just don't have
market-beating performance. Or, if your fund performs well, you wake up one day
with a fund with too much money under management. Then you realize you've
inherited a mid-cap (or even large-cap!) fund, so you're no longer invested
long-term in the asset class you wanted to be in. This is particularly
troublesome for a long-term investor in a taxable account, since to change back
into a true small-cap fund after, say, ten years requires paying taxes on a
decade worth of capital gains. If you own one of the few funds with large assets
that remains in small company stocks, you're probably stuck again with poor
performance.
How does Bridgeway handle the problem of cap-creep?
So how does Bridgeway deal with this problem? We close our small-cap funds
early. Only three of the 35 funds above are currently closed to new investors,
even though the average assets under management is $1.5 billion. It doesn't pay
the sponsoring fund family to close a fund that continues to attract new assets,
but it sure doesn't benefit shareholders not to close it. Bridgeway Ultra-Small
Company Portfolio closed to new investors at half the level of any other fund
closing. We think this is part of the reason the Ultra-Small Company Portfolio
is the only small-cap fund to outperform both the Russell 2000 Index and the S&P
500 in four of the last five years. Bridgeway Micro-Cap Limited is committed to
closing at the same very low level.
Why am I personally invested in Bridgeway's actively managed funds?
Bridgeway's willingness to close the Portfolios early explains why two-thirds of
my retirement money is invested in Bridgeway's Ultra-Small Company and Micro-Cap
Limited Portfolios. It doesn't explain why I'm invested also in Aggressive
Growth (which invests in all size companies) and Social Responsibility (which
invests mostly in large ones). The answer here lies in my confidence in our
models. I do think it's much harder to "beat the market" in the large-cap
sector, but I don't think its impossible. After five and a half years, both of
these portfolios have beaten the S&P 500 Index by a significant margin on a
cumulative basis. Of course, I can't make representations about the future, and
these funds certainly will not continue to outperform in every shorter time
period.
Footnote
The analysis above may seem convoluted or complicated. In fact, the issues I
brought up are even more complicated. This discussion and analysis does not take
into account the problems of survivorship bias (funds that go out of existence
during the study period) nor other complexities concerning costs and other
reasons why funds underperform market benchmarks.
The illustration below summarizes the small cap issue in graphic form.
The "Catch 22" of Small-Cap Investing *
[CHART DESCRIBING THE POSSIBLE OUTCOMES OF INVESTING IN
SMALL-CAP FUNDS.]
* Based on a very small sample survey in my office, you won't know what "catch
22" is unless you are a baby-boomer or the parent of a baby-boomer. Roughly
translated, it means, "heads they win, tails you lose."
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Micro-Cap Limited Closing
Translation: Bridgeway's Micro-Cap Limited Portfolio could soon close to new
shareholders.
Bridgeway's Micro-Cap Limited Portfolio will close to new shareholders when net
assets reach $27.5 million. We are currently 85% of the way there at $23.4
million. By prospectus, the Portfolio will be closed to all shareholders,
regardless of other circumstances, any time net assets exceed $55 million.
Conclusion
As always, we appreciate your feedback. We take it seriously and discuss it at
our weekly staff meetings. Please keep your ideas coming.
Sincerely,
/s/ JOHN MONTGOMERY
John Montgomery
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