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By Shannon Zimmerman | 06-09-2011 12:21 PM

Momentum's Run and Stumbles

Bridgeway's John Montgomery discusses momentum's long history of outperformance and troubles during market inflection points.

Shannon Zimmerman: For Morningstar, I am Shannon Zimmerman, here today with John Montgomery of Bridgeway Capital Management, which is based in the great state of Texas and the city of Houston.

John, thank you very much for joining us today.

John Montgomery: Very glad to be here, Shannon.

Zimmerman: John is in for a panel discussion that we're going to have tomorrow about the persistence of momentum, which has a decades-long track record of outperformance. I want to begin first, though, with a big picture take on Bridgeway and how you manage your funds. I believe you have 13 funds in the lineup now; all of them are quantitatively managed. What is the case for quantitative management? And then talk a little bit, because you have a interesting background as well, what was the genesis of the approach that you use at Bridgeway?

Montgomery:  I think the centerpiece number one with quantitative investing, and we also say evidence-based investing, so able to look backward, there are some big advantages around risk management because returns, as we know, go up and down and with all the caveats of past performance doesn't guarantee future returns--risk tends to be more persistent, however, and the quantitative style really allows you to measure that and manage that well.

But beyond that, taking a emotion out of the process, to me, if you have a disciplined process, now there are individuals and portfolio managers that may have a quant-based process, but if at end of the process they overlay a fundamental or come up with ideas about something that might happen with the stock market or the economy, then you're really significantly getting away from what we call evidence-based or quantitative investment.

Zimmerman: That would be more tactical, lurching into and out of the market, for instance, not based on signals from your models, but just because you're making a market call, essentially.

Montgomery: That's right.

Zimmerman: So, as a segue into talking a little bit more about momentum, and that's obviously not the only model that you have at Bridgeway--I think you have 17 models--although they're not deployed across all…

Montgomery: 17 stock-picking models.

Zimmerman: Right, one of which is momentum, and again that one's not used at all of the funds, but there is one fund that you've launched, I believe, last year, the Bridgeway Small-Cap Momentum Fund, and as we were speaking earlier, there is a risk-control aspect to that, but in terms of models, it's the only single-model fund at Bridgeway, and it's based purely on price momentum, if I understand correctly?

Montgomery: That's correct. So the momentum feature of that is purely simple priced-based momentum. It's looking back 12 months, the relative strength, the companies that have done the best over the last year, looking to hold those at least three months into the future and we rebalance on a roughly quarterly basis on that. The thing that's unusual about Bridgeway is that we overlay a risk analysis feature to that, so there are really two things going on with that one model, the momentum and then the risk part.

The risk part solves a major problem in the design of the fund that exists within momentum styles generally, which is they do great in a steadily up-moving market--that's what momentum is. They tend to do poorly at the infection points, and consequently the volatility of returns in a momentum style tends to be quite high. Our flavor of that actually ratchets that back down, generally speaking, to the market level, and we do much better at those infection points.

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