Factor-based Investing with John Montgomery

26:27So less correlation to the market. Volatility doesn't matter. If anything, volatility could actually help returns. Can. No guarantees, but it could. Jacob Paggiorni, who led the research for a two-year period that resulted in three peer-reviewed articles, which for a firm our size is an astonishing achievement, he likes to say market agnostic. So long short, the success for us is defined as if you know the direction of the market, it tells you nothing about the direction of the returns of this strategy. Well, if you're long short, you should have half the volatility of long only, right? Yes. Is that a fair assessment?

27:09That's pretty much right in line with our target, not half the volatility. Is this an absolute return strategy? It is. The assumption is you're picking stocks that you think are going to do well, and you're also looking for stocks to short that you think you're going to do poorly and will do especially poorly in a drawdown. How's that working out? It's working out well. This is a big deal in terms of the design. A paper that caught my attention was following 2008. And this paper took a look at all hedge funds that reported to be market neutral. And the bottom line was, most of the time, they did a pretty good job.

27:48But when you really needed it in a downturn of 2008, the beta was 0.4. So about 40 % of the downside. Well, it's like, okay, that's cushion, but it's not zero. It's neither an anti-gravity fund, nor do you expect not to be hurt. We've done research on the competition as well, and this is fascinating, and also just over the last week. So we're now on two days that get us close to 20%. That's enough to run your numbers and see how they do. Our closest competitors to global opportunities have done a much better job than, quote, market neutral funds did back in 2008. All of them within a percent of zero.

28:35Well, no, one of them was 2 % negative. But out of seven strategies that I looked at just earlier today, I would say doing a better job. I think it was Cliff Asnes at AQR had a paper out, our hedge funds really hedged. And unfortunately, the conclusion for a lot of them were not very much. And that sounds like it's very consistent with the research you guys did. Well, we specifically designed this not to have the 2008 problem identified. But there are a couple more areas that we have a huge leg up on the competition with the strategy. Number one, again, getting back to our small size, our universe of stocks is so much larger.

29:18That's both domestic and international. Yes, and especially internationally. That's because out of the 9 ,000 or so stocks, significant majority probably our bigger competitors simply can't establish a meaningful position in. So there's a competitive advantage. Oh, and it's big. And by the way, those are the ones that are less liquid, less efficient, that you're likely to win with active management. Huh, really, really interesting. Hi, I'm Stephen Carroll. And I'm Caroline Hepker, here to introduce you to a podcast that brings you the news you need to start your day in just 15 minutes. It's called Bloomberg Daybreak Europe Edition, covering all the top stories across Europe and around the world.

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30:38Find new episodes of Bloomberg Daybreak Europe Edition by 7 a.m. London time on Apple, Spotify, or wherever you get your podcasts. So we talked earlier about donating tens of millions of dollars, half of the profits of the firm, to charity. How does that affect how you recruit employees, how you develop a compensation structure? Tell us a little bit about the impact of that on running an asset management business. Sometimes I get into conversation with a prospective client and you might hear something like, you know, it sounds like you're good guys, you know, you're philanthropically geared and you get awards as a great place to work.

31:21But all of that, like put that aside, I just want to talk about the investments. And what I would say is culture is everything. It's the housing within which we do what we do. So it's very important. And you can measure that in some statistical ways, like turnover. I would say there are proxies for commitment at Bridgeway. And then returns of the strategies. Why would you think that's independent of the culture that you've built up? You also have an internal rule. The highest paid employee earns no more than seven times the lowest paid employee. Is that right? So statistically, that's probably true.

31:58We don't measure it that way. There's a new statistic that came out from the SEC required of public companies, and those are some of the metrics that we look at currently. Some people think it's like, oh, so you underpay. That is absolutely not the intent. It's just not to pay outrageous salaries on the top. Makes a lot of sense. If you want to make the most money that you can make in our industry, you probably wouldn't come to Bridgeway. If you want to make an absolute livable wage, and if you invest, save and invest, you should do very well over a full career, then we're a purpose-driven firm.

32:34And we ascribe to Daniel Pink's, what really motivates people is not money, but its purpose, which we have in strong suit, its autonomy, and its mastery. So we really invest in our people by way of mastery, give them opportunities for learning and growth, invest by way of mentoring as well. And then the autonomy piece we're trying to continually up our game with in a system of structure called traction or entrepreneurial operating system. And the firm's culture also emphasizes accountability. Tell us about the Firewood Group. What does that do? Okay, so the Firewood Group is a personal accountability group.

33:21That's not inside Bridgeway. And what happened is in 1998, a friend of mine came to me and he said, so I want you to be on the board of directors. And he worked for a publicly held firm, but he was like, Charlie, you're not in a position to ask me on that board, and I don't know squat about that industry. And he said, no, no, not the company board, the board of directors of my life. And I said, well, what does that look like? I've never heard of that. Out of that came the following observation. We were each members of groups that were great at support, but lousy at accountability. And we both knew we needed accountability.

33:57So we formed this group specifically around the concept of accountability. And just to give you a very specific example, I had a life goal of ending genocide. This group starts and, you know, I'm sharing life goals like, well, you've made great progress on this one and this one, but we think it's time for you to actually turn the ignition on on this one. Out of that conversation, we turn the ignition on on our foundation and everything that you see that Shannon Davis is doing along with our partners. That's really fascinating. And I would assume if the founder and CEO has that degree of accountability in his personal life, how does that then affect the culture of the organization?

34:41How do you bring your work ethic and your sense of accountability into the office? Well, I like to think that I model it, number one. Number two, we attract people for whom that's an exciting concept. And number three, then you've got to actually live it out. And that's where aspects of this structure that I call traction or some people call entrepreneurial operating system come into play. There's an annual goal-setting process, and most companies have that. the 90-day goals that they refer to as rocks, there's a very high level of commitment toward. It's like when you take on that I'm going to do this in the next 90 days, everybody's looking at it.

35:21It's very high profile. It's online. We have to report to all of the partners, the leadership teams experience, and then every partner at Bridgeway, that's every person that has a long-term commitment to and from Bridgeway, has to do the same thing. So when I talk about accountability, One of the things I was thinking about is the company's annual report where you guys kind of own your biggest mistakes. Tell us about that. That's something we started, I don't know, maybe a year four or five. And it comes around accountability. The normal thing is this. In business or in government or academia or journalism, anywhere, you want to learn from your mistakes, but you don't want to own them too publicly, right?

36:08It doesn't feel good. People might ask the wrong question. We had a lawyer, a member of our board of directors at the time that said, you do realize you're like putting on a silver platter something that people could sue you over. And my answer to that is like, yeah, I get that that's true, but you can't cut it both ways. You either have to own your mistakes, get them out in the open, learn from them and make sure you don't repeat them or you sweep them in under a rug and you just can't do both. And I choose the former. Our shareholders, our investors, our clients are our boss. We have a fiduciary duty to them.

36:44And I had one, an early client say, you do realize like I'm your boss and there's accountability there. I should know what's really going on. And I'm like, I can't argue with that. That is a brilliant statement. This woman, by the way, didn't have a high school degree. And I learned so much from her. Huh. Really, really fascinating. So let's talk a little bit about what's going on in the marketplace. There has been a shift over the past 20, 30 years to passive from active, especially from expensive, underperforming active. I don't put you guys in that category. You've done well. Your fees are kind of middle of the road.

37:25How are you navigating what's going on in the marketplace? A few things that I can point to. Number one is you always have to keep working to stay ahead of the game and adding value, and that's the research part. So we like to say small incremental improvements, but it never stops. Number two, we were an early adopter of moving some mutual funds, converting them into ETFs. So we've done that. That was painful because it's costly. Out the other side, it's been helpful for the after-tax return of the shareholders. So big plus there. And those strategies are both in positive flows. So good for the advisor as well.

38:08And the last one is, you know, don't make indexing impassive the enemy. what can you learn from them? So Bridgeway actually came to market with our blue chip strategy. To really be an index fund, you have to have somebody else calculating it. And there are all rules. And we decided we weren't willing to do that. We just wouldn't call it an index fund anymore. But it's a mega cap strategy that gets off of what I think of as the inefficient market cap weighting portfolio construction of almost every index fund. Not Absolutely all of them, but all of them. We have more than a quarter century real-time data.

38:47Like this has been a mutual fund, now it's an ETF converted. You can look at that track record and draw your own conclusions. But I like to say market cap weighting is like a momentum strategy that you never rebalance. So you ride the wave up and then you ride it down, and that's just not very efficient. That leads to more volatility. This strategy, on average, has different ways to measure it. beta, standard deviation, drawdown of very roughly 5 % less than a market cap weighted index of a broad index like the S &P 500. So a little bit less risk, we believe. Not in every market environment, but you can measure it over the long term and last decade, for example.

39:31And then a little bit more return. And why is that? It's roughly equal weighted, which means you're always investing a little bit more in what's done poorly and harvesting a little bit from what's done really well, that's buy low, sell high. Isn't that a basic investing principle? And supposedly that sort of rebalancing is one of the few free launches in finance. So if you're not doing market cap weighting and you're talking about blue chip companies, how are you weighting the portfolio? So we look at the top 35, 36 companies. We make sure that we've got industry representation at the time of recomposition, and then we're rebalancing quarterly and reinvesting dividends along the way.

40:16And I'll say roughly equal weighting. So there's some cushion on harvesting from the top. It can go up. Our rule of thumb is about 4 % is the maximum weight in a strategy. So if Apple or Microsoft or somebody else is 8 % of an underlying market cap-weighted U.S. index, we're going to be half of that. But it gives you a more diversified fund in mega cap stocks, which gives you some of the downside protection and some of the risk characteristics. Well, as we've seen year to date in 2025, the MAG-7 have become the LAG-7. Yes. So not being full market cap weight certainly had a positive impact on returns.

41:02What happens when those stocks are doing great? How comfortable do you feel if you're not full market weight of NVIDIA, Apple, Amazon, Microsoft as they're going higher and higher? That's the discipline of any investment process in the design. So know the design of what you're investing in. Know when it's likely to outperform and when it's not. And then you need to be comfortable with those numbers. But in that strategy, you pointed out exactly when it would underperform, when the top seven, and there's a nifty 50 back in the 70s. Well, you and I remember the nifty 50 in the 60s. Half our listeners are unfamiliar with them.

41:42But people talk about the Magnificent Seven like it's something new. Yes. It's 50, 60 years old. We had the same sort of top-heavy market happen. when everybody clamored into the same sort of blue chips. Yes. Being weighted on a non-capitalization basis, having other elements drive the weighting, how do you manage around that? As a disciplined investment shop, we have everything documented in detail. So there are four portfolio managers on every strategy at Bridgeway. In theory, any one of the four can step in and do that job. One, because they're trained to do so. but two, because they have documentation of how to do it.

42:25In this case, blue chip. I mentioned there's a quarterly rebalancing process. There's instructions exactly how you rebalance, how you take care of unusual situations, which might be a merger, an acquisition, a spinoff. Now a company, you own a portfolio, it's no longer one of the top 35, 36 by size. So what do you do about that? So those are the kinds of exceptions that you document. And otherwise, it's fairly straightforward. What you're describing sounds like a very systematic process to evaluate securities and build a portfolio. Tell us a little bit about the things that go into that system.

43:05Let me shift gears back to global opportunities, which gives you more the full breadth of how we do what we do with respect to stock selection and portfolio construction. The stock selection side, as I mentioned, you're combining factors of value, quality, and sentiment. However, that's within a framework of intangible capital intensity. Intangible capital intensity. So are these things like intellectual property, patents, processes? Exactly. So high intangible capital would be exactly the things you mentioned, research and development. If you rank them by industry, things that float to the top would be pharmaceuticals, AI, software.

43:48Things at the other end of the spectrum would be things like manufacturing, transportation, utilities. So you think of old economy stocks and new economy stocks is another way to think about them, but we're measuring literally ranking these according to intangible capital intensity. The high intangible capital intensity ones don't work real well with the classic measures of value, for example. What we found is that sentiment is a stronger predictor of future returns for those. So we don't only use sentiment. We're always using the combination, but we're going to overweight the sentiment part of that.

44:25So we have these three categories of factors, underneath which, as I mentioned before, are multiple ones, in the framework of intangible capital intensity, which is original research that Bridgeway did over a couple of year period and published papers on. That's the overall framework. Then you've got in this particular strategy, it's global, and we like to be neutral exposure on things that we don't care about or aren't in the design and positive on the ones that we do. So what do we not care about? Sectors. So we're always trying to move back to it to be sector neutral, which means the same dollars on the long side as you have on the short side.

45:04Similarly with sectors, sectors, countries, certain factors, book value, for example, is a classic one. Don't like that one as much. It's problematic for reasons that relate. Well, book value doesn't really, it tends to measure physical plants, equipment, much more heavily, and IP kind of gets the short shrift there. Yes, exactly. So what that means is the industries that are on the low capital-intensive part of the spectrum tend to do fine with the classical measures of value. So you can see you put all that together. You constrain the portfolio according to certain things that you don't want it to be exposed to.

45:45People come and say, oh, global opportunities, that's got China. I don't want any China. Well, at any one point in time, we might be a percent or possibly even two positive exposure to China or negative exposure to China. On average, we're targeting that zero percent. So you're not going to get any value add over the long term. It shouldn't be coming from the actual country or the sector. It should be the specific factors that we're trying to give exposures to. And that leads to a much steadier stream of returns. That's really intriguing. So I've always kind of thought of you as sort of a factor shop, sort of a value shop, sort of a quant shop, a little bit of everything.

46:28Is that a fair description? I don't want to overgeneralize, but you guys do a little bit of a lot of things. Yes, I would say that that's true. The one thing that you left out, which is the hard piece in a significant part of our time is qualifying the data, cleaning the data, especially on the global side. Data is cleaner in the large caps on the U.S. side. For sure. And also the model assumptions. There's certain assumptions built into the model. You get a strong pick. Are the reasons that those picks of a model come to the surface ones that really hold true in the marketplace? Is there something that you don't know.

47:08For example, regulations that have just come out in a country that are going to change the earnings and financial characteristics that you care about with a particular model. So that's part of the work and the scrubbing, and that's why we chafe a little bit when people say, oh, you're just a smart beta shop. Clearly, there's a lot more going on than just smart beta. All right. I only have you for a limited amount of time. So let's jump to our favorite questions. We ask all of our guests, starting with what's been keeping you entertained these days? What are you watching or listening to? One of my favorite recent ones was actually a South Korean series called The Extraordinary Attorney Wu.

47:56And it's a fascinating study about a woman who's an adult autistic brilliant person in a law firm in South Korea and her experiences navigating a non-autistic world and the adjustments that people do and don't try and make assumptions that people make you know you might think that has nothing to do with investing but but the assumptions side and the statistics side and then the human interaction side and the behavioral side is all right there. That's one of my top recent ones. Really interesting. Let's talk about mentors who helped to shape your career. Several. I had a mentor that passed away last year, Henry Grappi.

48:40A soundbite from him was respect all people, all the time, no exceptions. And it's that last piece that's really challenging. So I'm going to put him as a top mentor. Had some at MIT, advisors there who taught me never come to my office just bringing problems, always try and bring solutions when you can. People that have engaged on a human level within these that didn't have to. Some of the better things that I've learned. Jack Bogle, certainly on the cost and structure side. A little gritty, which I like. I think that's fun. And those are some of my mentors. Really interesting. Let's talk books.

49:22What are some of your favorites? What are you reading right now? Right now, I'm reading two books. One is called People Dare to Build an Intentional Culture. So you can imagine why that would be attracted to me. Chapter two of that book is about love. We don't tend to use the word love in workplace. They say, well, a more acceptable word might be genuine caring. And so we think a lot about that. We play the Simon Sinek game of why is that important? And underneath that, why is that important? If you play that game at Bridgeway of why you're doing what you're doing and get to a core value, caring frequently comes out among different people, board members, partners at Bridgeway.

50:07The other book is Jason Swig's recent update on the intelligent investor. I'm halfway through that one. It's a thick read because it's really two books. It's Benjamin Graham's book, and it's Jason Swig's commentary on it. It's great. And not too long ago, I saw you mention, was it Dan Arley's The Truth About Dishonesty? Yes. Is that right? That's one of my favorites. It might be a decade old now, but wonderful book on humility in statistics and in non-statistics. And our final two questions, what sort of advice would you give to a recent college grad interested in a career in either investing or finance?

50:50I actually had this opportunity just yesterday. It was somebody, I'm going to guess he was about 25 years old and early stage in his career. And my advice is people scare you away when it's a declining industry or not declining, but where fee pressure is increasing. So the fee pressure has been very strong, different ways to measure it. But fees are less than half of what they were a dozen years back. And that scares a lot of people away. Within that, there's a lot of change. And within the change, there are strategic opportunities. And because it doesn't attract as many people, think supply and demand.

51:29They're kind of even bigger than normal mature company opportunities. And not as many people coming in. You can make a big difference in that environment. And I think it's fun and fascinating. I would definitely choose this as a career if I were doing it all over again. And our final question, what do you know about the world of investing today that would have been useful back in 1993 when you were first launching the firm? Wow. I was a contrarian by nature, but I didn't understand the dynamics of chasing hot returns and panicking and downturns. Understanding that dynamic better would have helped, not personally, but professionally.

52:11It would have given some good insights. For the individual investor, I would say build your portfolio and learn how to not pay attention in the downturns. If it's long-term money, and by the way, if it's not long-term money, you shouldn't have it in the stock market. So assuming it is long-term money, the only price you really care about is the last price when you want to take the money out. And that wasn't last week or this week ever, whether it's up or down. There's volatility in between. All those numbers are irrelevant. All you need to know is the last one. And the first day you're going to know that number is years in the future when you're actually going to need it.

52:48Absolutely fascinating. We have been speaking with John Montgomery, founder of Bridgeway Capital. If you enjoyed this conversation, well, be sure and check out any of the previous 500 or so we've done over the past 10 years. You can find those at iTunes, Spotify, YouTube, Bloomberg, wherever you find your favorite podcasts. Check out my new book, How Not to Invest, the ideas, numbers, and behavior that destroys wealth and how to avoid them. How Not to Invest wherever you get your favorite books. I would be remiss if I did not thank the crack team that helps put these conversations together each week.

53:30My audio engineer is Sam Danziger. Sean Russo is my researcher. Anna Luke is my producer. I'm Barry Ritholtz. You've been listening to Masters in Business on Bloomberg Radio.

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