What to Make of Bridgeway's Run-In with Regulators

While there's no doubt Bridgeway Capital Management erred, we still think it's one of the most trustworthy fund companies around.

The small fund shop yesterday reached a settlement with the Securities and Exchange Commission. The SEC charged Bridgeway with overcharging its investors in three funds,  Bridgeway Aggressive Investors 1 (BRAGX),  Bridgeway Aggressive Investors 2 , and  Bridgeway Micro-Cap Limited , due to the advisor's mistaken computation of performance-based fees for those funds.

Here's what happened: The fees charged on the three funds consist of two components--a fixed management fee and a variable performance-based fee. The performance-based fee fluctuates based on how each fund performs versus a relevant benchmark over a specified rolling period (five years in the case of Bridgeway Aggressive Investors 1 and Bridgeway Micro-Cap Limited, and since its October 2001 inception for Bridgeway Aggressive Investors 2). If a given fund's returns exceed the benchmark's over the rolling period specified, the performance-based percentage increases. Conversely, if the fund's returns fall shy of the index's, the performance-based percentage is negative, thereby reducing the overall fee levied.

The problem arose in the way Bridgeway was applying the performance-based percentage (which typically ranged from -0.70% to 0.70%) to the funds' assets. The Investment Advisers Act of 1940 requires funds to apply the performance-based percentage to their average daily net assets over the performance period. However, Bridgeway multiplied the performance-based percentage by the most recent asset level, rather than the performance-period average mandated by the Investment Act. Because strong market performance and investor inflows pushed asset levels higher from one successive period to the next, Bridgeway's method of calculating the performance-based fee inflated the amount investors in the three funds were charged.

The settlement requires Bridgeway Capital Management, advisor to the three funds, to return more than $4.4 million in management fees, plus interest, to shareholders and to pay a $200,000 civil penalty. John Montgomery, Bridgeway's founder and portfolio manager to all three affected funds, is required to pay a $50,000 fine.

This infraction is disappointing. Montgomery and his staff owe it to shareholders to be intimately familiar with the laws governing mutual funds, and in this case, they simply failed--even though the advisor's calculation has been disclosed in prospectuses since they began. More generally, the offense highlights the operational risk that smaller shops like Bridgeway face in trying to comply with an increasingly daunting regulatory climate. In fact, this isn't the first time that operational snafus have occurred. In 2003, for example, the shop's fund-accounting function found some mispricings that caused it to restate NAVs on two of its funds.

Bridgeway has made improvements in its operational capacities since then, and the SEC settlement means that more improvements are coming. Although we thus believe further regulatory and operational issues are less likely now, we recognize that there continues to be a risk of other infractions as Bridgeway works to prove appropriate and effective procedures are in place, and compliance is given the fullest attention.

There is much to be confident about, however. Given the abundance of evidence that Bridgeway time and again acts in shareholders' best interests, we can't fathom that there was any intentional or malicious wrongdoing in this case. Indeed, had the three affected funds lagged their benchmarks, the funds might have undercharged shareholders (assuming assets grew), which would have been a clear detriment to the fund company. One other comforting note is that Bridgeway has plainly disclosed operational challenges in its annual reports, and its letter in response to the SEC settlement is thorough and candid.

Bridgeway has also taken many shareholder-friendly stances during its 10-year history. Perhaps most notably, Montgomery has made a habit of closing funds early, before assets become a hindrance. (In fact, both Bridgeway Aggressive Investors 1 and Bridgeway Micro-Cap Limited have long been closed.) Closing funds limits the firm's profitability, but Montgomery has put fundholders first. Bridgeway also works to keep trading commissions and taxable distributions low, and its communications with shareholders are some of the most candid to be found and include voluntary disclosure of manager pay.

Finally, although Bridgeway's failure to implement its performance-based fees in accord with regulations got it into trouble, we remain fans of performance-based fees. That's because they theoretically do a good job of aligning the advisor's interests with shareholders'. And the structure of Bridgeway's performance-based fees is admirable. One, they are long-term in nature, focusing on five-year returns. Most performance-based fees look at one-year, or at most, three-year results. Two, performance that merely matches a relevant benchmark would yield expense ratios well below respective category norms. We'd hate to see performance-based fees start to disappear, both from Bridgeway and elsewhere.

Make no mistake, Bridgeway isn't getting a free pass. We're disappointed in the firm's error, and we'll continue to look for signs that it is improving its procedures and its systems so that mistakes such as this are less likely to happen in the future. In all, however, we continue to believe that Bridgeway is a good steward of investor capital and that its fiduciary performance is strong.