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Blog - Investing Notes

May 8, 2006 - Reader Question: Why Not BRSVX Instead of IJS?

A reader sent last week the following observations and questions:

1. I conclude from your blog entry of 4/24/06 that, except for possibly the last scenario, a long position in small-cap or mid-cap value investments would be prudent. Is this a correct interpretation?

2. Most of my investments are in mutual funds. Can you explain why your test portfolio doesn't use mutual funds as vehicles to test your hypotheses? I don't understand the rationale of utilizing Exchange Traded Funds (ETFs) except for the fact that you can get out of them immediately. How often has this happened since you had your portfolio? I'd guess it's rare. Would any day's change be so great, that once you've made the decision to get out of an investment, you'd be that wrong in getting out at the close of the day?

3. I use the Bridgeway Small-cap Value Fund (BRSVX) as my investment vehicle. A comparison for the past year shows that one would have made $1699 more in BRSVX than in iShares S&P SmallCap 600/BARRA Value Index (IJS) per $10,000 investment.

Responses are as follows:

A reasonable conclusion from our blog entry of 4/24/06 is that the market has already discounted some earnings deterioration and/or a moderate inflation shock in the next month or two, so downside risk is likely lower than upside opportunity. If there are no more inflation shocks beyond the recent crude oil spike, we should see a strong market as the inflation rate reverts to mean. One important external factor (not in the models) is the November Congressional election, which tends to make investors nervous (see our blog entry of 12/30/05).

In the absence of surprises, we will likely stand pat with the small-cap value ETF (IJS) as the major test portfolio position in coming months (see our blog entries of 3/22/06 on the value premium and 3/27/06 on the size effect). If the market declines as the election approaches, we will likely add risk (buy more). A very big inflation shock (turning our Real Earnings Yield Model down) or some euphoria after the Federal Reserve stops tightening (market heads dramatically up) might make us reduce this position.

Since the size effect seems to be concentrated in January (see our blog entry of 3/27/06), mid-caps may do as well as small-caps during the coming months.

While some small-cap value mutual funds in the same category have done better than IJS over some reasonably long periods, we stick with the ETF because of the following little edges:

• Annual expense ratios for comparable mutual funds with long-term success are typically about four times that for IJS (as for BRSVX).
• Buy and sell broker transaction fees are lower for ETFs
• We can buy and sell an ETF any time the market is open, avoiding an end-of-the-day pricing constraint.
• Some of the most attractive mutual funds have 1-2% management company penalties for selling within 90 or 180 days after purchase, reducing their usefulness as market timing vehicles. (Bridgeway appears to have no such fees.) Also, some brokers have extra fees for trading in and out of mutual funds during a short period.
• Since competing mutual funds are typically less diversified, they may not correlate so well as broad ETFs with our index-based models. And, as market conditions shift (for example, as inflation rises and falls or oil prices go up and down), the performance of such narrower mutual funds may be volatile and revert to a category mean.

You are correct that we have not traded in and out of IJS in the test portfolio. As we have developed and refined the Real Earnings Yield Model and Reversion-to-Value Model over the past two years, we have not had enough confidence in small perturbations of these models (the Real Earnings Yield Model is key) to do this kind of trading. Model adjustments have made them better, and we have not given up hope on using the models in this way.

Taxes on gains are also a consideration for any short-term trading.

Your recent experience with BRSVX is a good one, but probably not representative of the long-run future performance of that fund.

The following chart compares the to-date change in price, adjusted for dividends and distributions, of BRSVX since the fund was started in November 2003 to that of IJS over the same period. These results incorporate any fees charged by the fund managers. BRSVX tends to be more volatile than IJS. It is not clear which will perform better over the long run. I doubt that the BRSVX fund manager can demonstrate with statistical significance that they add value to the mechanical IJS allocation process.

To understand why these two funds perform differently, here is a comparison of the holdings by sector for BRSVX with the holdings by sector for IJS. Most notable differences are in Business Services, Financial Services and Energy. These differences suggest an advantage for BRSVX when interest rates and energy prices are rising.

Note that the comparison does not include buy/sell transaction fees, which tend to be higher for mutual funds than for ETFs (check your broker's commission schedule). Also, your broker may charge an early withdrawal fee (for example, TD Ameritrade currently charges from $39 to $199 extra if you trade out of a new mutual fund position within 90 days).